Vanguard leaders discuss the risks of default or downgrades in the bond markets.
Markets and economy

High-quality bonds, low expenses serve in stormy weather

Vanguard leaders discuss the risks of default or downgrades in the bond markets.
5:12 minutes
  •  
May 15, 2020
Markets and economy
Market volatility
Article
Video
Bonds
Investing costs

Vanguard leaders discuss the risks of default or downgrades in the bond markets.

Transcript

Tim Buckley: John, to state the obvious, we’ve seen massive declines in revenues for firms and for municipalities. So, a lot of people are talking about what’s the fallout? Are people missing payments? Will we start to see downgrades of bonds, defaults? What will the workouts look like? Can you give us some perspective about how your team’s thinking through this?

John Hollyer: Sure, Tim. And you’re right—this is a time when there will be downgrades and there will be defaults. But let’s keep it in perspective. If we look at investment grade corporate bonds, for example, even in the worst recessions, it’s unusual to have defaults be more than 1% of the bonds. In municipal bonds, defaults are typically well below that, even in the worst recessions. In the high-yield world, it’s not unusual to have maybe as high as a 10% or somewhat higher default rate in a really bad year.

But particularly in the case of investment-grade corporate and municipal bonds, if you look at that within a diversified portfolio, and we look at the valuations that we have today, a number of those risks are probably pretty fairly compensated. Downgrade, where the credit rating agencies reduce the credit worthiness estimate of a bond, is also a risk.

If you look at the corporate bond market, there’s been some concern that there could be a large volume of downgrade from the investment-grade universe to high yield. Some estimates are that as much as $500 billion of U.S. corporate bonds could be downgraded that way. We’ve already seen $150 billion downgraded that way. But what we’ve also seen is that the high-yield market has been able to absorb it.

So, to some degree, the market is functioning in a way to accommodate this. And when you look particularly at higher quality bonds where a downgrade will likely cause the price of the bond to fall—again, in a diversified portfolio—those downgrades and price declines are probably really increasing the yield of the fund, and probably increasing the expected return going forward.

So, the risks are real. They are priced in somewhat, already. And history would tell us that in higher quality segments, these should not become overwhelming. Now this is an unprecedented time, it could be somewhat worse, but we don’t expect there to be rampant default in areas like investment-grade corporate and municipal bonds.

Tim: John, fair enough. If we just go back and we step up a level, the strategy that you employ is one that says, well, you’ve got low expenses. And if you have low expenses, you have a low hurdle to get over. You don’t have to earn as much in the market to kind of pay the bills and then make sure our clients get a great return. So you don’t have to traffic in the riskiest of bonds out there.

To use a baseball analogy, you like to go out and hit singles time after time after time, and over five, 10-years, even three years, they really crank up, so that you’re able to outperform not just competitors, but the actual benchmarks themselves.

John: I think that’s right. It’s one of the benefits of our structure, where we have a really talented team adding value across a widely diversified set of strategies and leveraging our business model to take a really appropriate amount of risk to produce a top-quartile-type return for our clients, over longer periods of time.

Also, it really supports the “true-to-label” approach that we like to take. Our portfolios can stay invested in the corporate bond market or the mortgage-backed securities market, if that’s their primary sandbox, and not go searching really far afield for the kinds of investments that are more speculative. They might pay off, but they also might really surprise an investor to find that their portfolio had those kinds of things in it. We really value that true-to-label approach, and it’s supported by the low-fee approach of Vanguard.

Tim: Yes, let’s keep it that way. Now let me flip over to a more portfolio strategy for the individual client. We’re often telling them, hey, bonds, they’re the ballast. They’re your ballast so you can weather a storm. And people wonder, have they served that purpose? As the bond expert here, are you happy with how bonds have performed and how they’ve performed in an individual’s portfolio?

John: Yes, I think it’s been a good news story for people who were diversified across stocks and bonds. If we go back to the beginning of 2020, interest rates, particularly in government high-quality bonds, were already pretty low. People were questioning, “why do I own bonds?” But if we roll ahead to the end of March, a broad portfolio of high-quality bonds was up about 3% in return, while the S&P 500 was down about 20%.

So there again, even with low yields as your starting point, as a ballast and a diversifier to a portfolio, bonds have again this year proven their merit. I think that is completely in sync with our long-term guidance to be diversified in your investing.

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Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.

Diversification does not ensure a profit or protect against a loss.

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