Opportunities for Vanguard’s fixed income team
“Our disciplined approach to risk paid off in this challenging environment,” Mr. Nagstrup said. “Toward the end of 2019, we were carrying a fairly low level of risk across our active funds as we viewed valuations in the credit market as being relatively expensive compared to historical levels. We obviously didn’t see the coronavirus pandemic coming, but our conservative positioning did allow us to take on more risk in March and April as the market sold off. That wasn’t the case for some asset managers who were carrying more risk ahead of the pandemic, chasing a few extra basis points of potential return despite valuations being elevated.”
Vanguard’s global team of research analysts and traders were able to analyze the degree to which sectors and companies were likely to be affected by COVID-19. This allowed the funds to take advantage of the major market dislocation and add risk in names where valuations were very attractive relative to their fundamental credit profile.
“The global team did a great job identifying issuers and sectors with attractive risk/reward characteristics and we were able to add a lot of value to the funds and our investors during the first half of 2020,” said Sarang Kulkarni, portfolio manager for Vanguard active global credit strategies.
Vanguard also was able to take advantage of concessions, or discounts on newly issued bonds. “Counterintuitively, during the spring some of the highest-quality names offered the largest concessions because they were among the earliest to tap the market,” said Scott Miles, a U.S.-based senior North America credit analyst. “We took advantage of those opportunities. Later on, lower-quality names that drew on their bank lines of credit during the panic were actually able to raise public debt capital at relatively smaller concessions as markets were healing, so where we had confidence in individual issuers, early and proactive risk-taking on the part of our traders paid off.”
Active management and the road ahead
Recovery from the initial COVID-19 economic shock is likely to be gradual and uneven. Revenue growth will likely be modest, so cost management will be key for many companies to grow their earnings.
The risks remain that increases in COVID-19 infections could lead to the reimposition of broad lockdowns that would further hurt economies, and that a vaccine may still be a long way off. Those risks are somewhat mitigated, however, because governments are better prepared now to deal with outbreaks. Moreover, central banks have asserted their readiness to continue to support bond markets, which would likely help support risky assets. Companies have also built up their liquidity buffers to cushion against further market volatility.
Vanguard expects less issuance than usual in the second half of 2020 given the amount of funding raised in the first half. Yet the low-interest-rate environment affords opportunities for firms to refinance to extend maturity profiles, and that is likely to continue throughout the rest of the year.
In sectors less affected by COVID-19, many issuers’ bonds have been bid up to expensive levels, with markets disregarding factors that weighed on valuations before the pandemic. As the global economy slowly normalizes, however, underlying company fundamentals are again becoming the dominant narrative. That may result in lower prices for weaker issuers in sectors such as retailers, and active managers need to be positioned for that, Mr. Nagstrup said. At the same time, some “winners” from the pandemic such as large e-commerce and technology companies may grow even stronger.
In sectors more affected by COVID-19, on the other hand, Mr. Nagstrup notes that opportunities are emerging among issuers beginning to recover. “Their spreads in some cases widened a lot despite fairly solid fundamentals, but we would expect them to normalize and trade more tightly over time.” That could be the case in sectors such as consumer cyclicals and media, where some companies in “losing” segments from the pandemic emerge with more market share, less competition, or improved business models.
It is also worth noting that some sectors will take several years to recover and may not get back to pre-pandemic revenues and earnings. “From an investment implications perspective, let’s not throw the ‘COVID losers’ out with the bathwater,” said Alicia Low, head of credit research for the Asia-Pacific region, based in Australia. “At the same time, let’s be mindful not to simply chase ‘COVID winners,’ as their valuations could well be fully baked in.”