Vanguard Urges Investors 'Right-Size' Toward Bonds on Fed Delay

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(Bloomberg) -- The Federal Reserve's slowed path toward cutting interest rates offers an extended chance to lock in attractive yields for longer and investors should "right-size" their allocation to bonds over stocks, according to Vanguard Group Inc.

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Policymakers left interest rates unchanged on Wednesday and Fed Chair Jerome Powell kept hopes alive for an interest-rate cut this year but avoided offering a timeline for a reduction. Persistent inflation should keep the Fed cautious over the near term, and the bar is high for any additional rate hikes, Vanguard's fixed-income team led by Sara Devereux wrote in a note seen by Bloomberg.

"All eyes are searching for signs of a more definitive inflation trend," wrote the team. "Higher market volatility should provide more opportunities for our portfolios."

The world's second-largest asset manager, overseeing $9.3 trillion globally, sees the potential for better risk-adjusted returns for bonds than stocks over the next five years. The backdrop for fixed income credit sectors continues to be supportive, fundamentals remain mostly stable, and demand from all-in yield buyers is strong, said the team, which also includes Chris Alwine, Roger Hallam and Paul Malloy.

Investment-grade risk premiums, or the added premium over US Treasuries investors get paid to hold riskier debt, are close to levels last seen in November 2021. Average high-grade bond yields are hovering near the highest in six months, boosting demand for the asset class.

"We expect these tailwinds to continue into the second quarter," Devereux and her team wrote. "We're past the largest wave of issuance for the year, which will limit supply as demand should remain constant or increase."

Noting Taylor Swift's Eras Tour, Vanguard in October declared a new era for fixed income and recommended loading up on investment-grade bonds. In November, the bonds posted their best monthly returns since 2008 as economic data suggested the Fed may be done hiking rates.

Last month, the asset class posted its worst performance on a total return basis since September as traders trimmed their rate-cut expectations.

Potential Problems

The money manager sees a low probability of a US recession over the near-term, even though policy is restrictive, which usually poses a risk to further an economic slowdown. Spreads have room to widen if economic conditions worsen, either because of higher inflation or slower growth, according to Vanguard.

The window to take on higher credit risk was between late October through mid-Apri, the investment firm said. Now, with upside surprises in inflation data and credit valuations less compelling, Vanguard has been cutting credit risk across sectors — particularly in emerging markets and lower credit quality corporates — and moving higher in quality.

The firm favors shorter-dated bonds from the financial sector and BBB rated bonds from industrial firms.

"We like the relative value of shorter-maturity bonds, where spread levels look cheap," they wrote. "We also like opportunities in European credit. Valuations are more compelling versus those in the US."

In high yield, BB and B-rated bonds offer attractive yields but upside from additional spread tightening is limited. Vanguard said it sees opportunities in the lower-quality and stressed parts of the market and find high-quality bank loans attractive.

Spreads for mortgage-backed securities remain in the middle of the firm's fair-value range and Vanguard sees better opportunities in agency collateralized mortgage obligations, select specified pools, and agency commercial mortgage-backed securities.

Also, the long end of the curve offers the best value in higher-rated municipal bonds, while opportunities in lower-quality municipals are best at the short end.

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