Where Vanguard sees opportunity to earn income right now
With the Federal Reserve rate-cutting cycle now underway, income investors may want to take a closer look at their portfolios. The central bank slashed the federal funds rate by half a percentage point in September and fed funds futures prices suggest a 93% probability that rates will drop another 25 basis points in November, according to the CME FedWatch Tool . One basis point equals 0.01%. Futures point to a 74% likelihood of another quarter point cut in November. In this environment, Vanguard likes higher-quality, fixed-income assets. The money manager expects the economy to slow to below-trend growth but avoid recession, and anticipates the yield curve will revert to its typical upward-sloping angle. “Historically, when economic growth has slowed but stayed positive, higher-quality fixed income has done well. We’re sticking to that playbook for now,” Sara Devereux, global head of Vanguard’s fixed income group, said in the firm’s quarterly update on Wednesday. Right now, she is approaching Treasurys more tactically over the near term. “Yields are reasonably priced for a backdrop in which the economy holds up and the expectation holds that the Fed will continue to cut rates,” Devereux wrote. “We continue to look for attractive entry points to position our portfolios longer in duration, as we expect growth to slow into next year.” Yields on the 10-year Treasury at 4.25% would provide an opportunity to add duration, she noted. The 10-year yield actually broke above 4.25% on Wednesday but has since eased back to 4.20%. Bond yields move inversely to prices. Devereux expects yields to fall “substantially” if recession probabilities rise. Corporate bond opportunities Vanguard is also constructive on investment-grade corporate bonds. The firm believes what are now expensive valuations are justified given the state of the economy and healthy corporate balance sheets. Shorter-dated bonds on the front end of the yield curve offer the most attractive valuations, according to the report. Vanguard sees the most opportunity in BBB-rated bonds. For instance, they make up 52% of the Vanguard Intermediate-Term Investment-Grade Fund ‘s portfolio. Investor shares of the actively-managed mutual fund have a 0.20% expense ratio and a 30-day SEC yield of 4.65%. VFICX YTD mountain Vanguard Intermediate-Term Investment-Grade Fund, investor shares “What we like about the BBB part of the market, these are companies who will work hard and use the levers they have at their disposal to maintain their credit rating,” said Colleen Cunniffe, head of Vanguard’s global taxable credit research. “We feel like we are getting paid in that part of the market for that dynamic.” Utilities and banks are the two sectors at the top of Vanguard’s list. Utilities generally have pretty solid balance sheets in a very structured regulatory environment, Cunniffe said. On top of that, on a longer-term basis, the world is facing an increasing demand for energy, driven largely by artificial intelligence data centers, she added. Meanwhile, banks are in better shape than they were in prior years, she said. “When we have an environment where a steepening yield curve will potentially improve net interest income, we see that as a positive environment for banks,” Cunniffe said. However, with high yield credit, Vanguard is focusing on bottom-up security selection due to the dispersion among issuers. “It is definitely part of the market where we have to pick our spots,” Cunniffe said. “We look for stories we can dig into — companies that may be facing some industry headwinds that we can really get our hands around and get a view on.” High-yield bonds have already seen outsized returns this year. CCC-rated bonds gained 12.5% year to date, as of Sept 30, versus the 4.3% return in AA credit, according to Vanguard. Individual investors can get access to corporate credit through mutual funds or exchange-traded funds comprised of investment-grade or high-yield bonds.
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