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The Tell: Why Vanguard likes U.S. high-yield bonds in near-term after recent big gains

U.S. corporate bonds with below-investment-grade ratings may still have room for gains, after a strong run so far this quarter, according to Chris Alwine, head of global credit at Vanguard Group.

Alwine, who oversees $250 billion of assets, said in a phone interview Monday that within U.S. credit he likes high-yield, or junk, bonds over the next one to three months. At least for now, corporate fundamentals remain “healthy,” he said, while cautioning that Vanguard is anticipating a recession in the second half of 2023.

In recent weeks, equities and riskier corporate bonds have rallied with big returns amid increased optimism that the Federal Reserve could achieve a “soft landing” for the economy as it aims to bring soaring inflation under control by tightening monetary policy, according to Alwine. The Labor Department reported last week that inflation measured by the consumer-price index fell in July on a year-over-year basis to 8.5%, from 9.1% in June.

“The market has priced in a soft landing and now we’re actually going to have to see the data prove that out,” said Alwine. “It’s ‘show me’ time.”

Vanguard likes high-yield bonds as a near-term opportunity, said Alwine, describing their current valuations as being at “average” and “fair” levels. 

“That leaves us constructive over the next three months, but cautious over the intermediate term as the Fed tries to engineer a soft landing,” he said. “There’s still room for gains, but we’re still left with a macro environment that says we have a Fed needing to slow the economy down.”

Credit spreads for U.S. investment-grade and high-yield bonds have narrowed so far this quarter, driving “outsized returns” amid a “broad-based shift in risk sentiment,” according to a CreditSights report Monday. 

During the third quarter, U.S. investment-grade bonds have produced total returns of 2.3% based on data as of Aug. 12, while high-yield bonds returned 7.6% over the same period, the report shows.

The gains came as high-yield debt spreads dropped 27.6% since the end of June to 4.25 percentage points over comparable Treasurys, while investment-grade corporate bond spreads narrowed 14% to 1.41 percentage points, according to CreditSights

Spreads are a sign of credit risk. They tend to widen as investors worry about potential challenges companies face in an economic slowdown, or as a borrower’s ability to meet its debt obligations deteriorates.

Reaching for yield in lower-rated bonds is a risky strategy that may pay off in good times, but investors may get hurt should sentiment suddenly sour in the face of a potential recession. 

Within high-yield debt, risky bonds with a CCC rating had a total return of 8.9% in the third quarter through Aug. 12, according to CreditSights. Bonds rated BB, the first rung below investment grade, returned 6.9% over the same period. 

Within the junk bond universe, Vanguard likes bonds with a higher credit quality over the next three months, Alwine said, pointing to high-yield debt with BB and B ratings. 

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He cautioned that some high-yield bond funds with higher expenses sometimes take on more risk by reaching for yield in lower-rated credit to help make up for what they’re charging investors. In Alwine’s view, “they need to buy bonds that yield more so they can quote a yield that looks competitive.”  

But in a recession, “lower credit-quality corporate bonds would be expected not to perform well,” as they’re more at risk of default, Alwine warned. “We feel that the triple-Cs are vulnerable to an economic downturn.”

Looking further out beyond three months, Alwine said that he prefers an investment strategy that upgrades credit portfolios due to recession concerns, potentially by trimming high-yield exposure or increasing allocations to investment-grade bonds.

Read: The stock market risks ‘swooning again’, so BlackRock prefers credit over equities

Achieving a soft landing will be “challenging” in a world still marked by elevated inflation, and investors will want to see more evidence that it may be possible as the Fed continues raising its benchmark interest rate to tame high inflation, according to Alwine.

The actively-managed Vanguard High Yield Corporate Fund

has seen a total return of 7.1% during the third quarter through August 12, after losing 12.5% during the first half of 2022 as fixed-income assets broadly suffered, according to FactSet data. The fund has an expense ratio of 0.23%.

Beyond U.S. corporate credit, Vanguard also likes high-yielding emerging-market sovereign debt over the near-term as “it’s still cheap” after more fully pricing in recession risks, Alwine said. But as with U.S. junk bonds, he is similarly cautious over the intermediate term as emerging market debt is “sensitive” to U.S. growth. 

The U.S. economy is not out of the woods. 

Inflation will have to keep coming down while “growth is going to have to slow to a level that’s not too slow, but also not too fast,” said Alwine. The Fed will have to affirm that by slowing its pace of monetary tightening — “or eventually going on pause” — as it seeks to “correctly” calibrate its monetary policy.

“So it’s a narrow path to achieve a soft landing,” he said.

In the U.S. stock market, major benchmarks ended higher Monday afternoon despite concerns over a slowdown in China and a sign of weakness in U.S. manufacturing based on a fresh reading of the New York Fed’s Empire State business conditions index.

The Dow Jones Industrial Average

finished with a gain of around 151 points, or 0.4%, on Monday, while the S&P 500

rose 0.4% and the technology-heavy Nasdaq Composite COMP advanced 0.6%.

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