Vanguard’s case for fixed income, despite current volatility

What’s driving yields higher?

Lee notes that fiscal deficits are on investors’ minds, but that some of the initial ideas of correlation between all developed market bonds might be overstated. He contrasts French and German bonds as an example. France has a public debt to GDP ratio of 119 per cent and 10-year government bonds are hovering at yields around 5 per cent. Germany has a debt to GDP ratio of 63% and it’s 10-year bond comes with a yield of around 3.5 per cent.

US bond yields, Lee says, are largely being driven higher by inflation and expectations of Fed policy. Investors are growing more concerned that a prolonged period of oil prices above $100 per barrel will cause inflation to widen beyond energy. Those fears were validated at the September Fed meeting when Federal Reserve Chairman Kevin Warsh made it clear that the Fed would be more strident in achieving its 2 per cent inflation goal. While Lee acknowledges that there are a host of prevailing narratives explaining this volatility in US bonds, he believes energy prices and inflation remain the core concern for the Fed and for investors.

Despite energy prices’ role as a catalyst in this bond volatility, Lee doesn’t yet know if a fall in energy prices automatically prompts a fall in yields. While yields and energy prices have been highly correlated in the later part of this year, he notes that the relative strength of the US economy introduces other inflation drivers. The market is still trying to figure out if the Fed’s tightening will get those drivers under control, he says.

Is it time to reassess fixed income?

While another period of bond volatility can be difficult for investors’ fixed income sleeves, Lee adds the context that we’re starting from a point of far higher yields and lower prices than we saw in 2022. The ‘income cushion’ of a US aggregate bond vehicle with a yield to maturity of around 5.5 per cent offers some stability. He adds that the current ‘breakeven yield’ on those US aggregate bonds is around 100 basis points, meaning yields would have to rise by another full per centage point to wipe out the returns an investor would get from the income on their bonds.

While Lee believes a wholesale reassessment of fixed income allocations may not be warranted, he notes that divergent performance is something investors and advisors need to stay aware of. Developed market debt is showing less direct correlation as investors factor in different debt to GDP ratios. Credit markets, too, are being reshaped by significant bond issuances by AI and technology hyperscalers. Lee says that Vanguard is responding to this demand for more targeted exposures, working with clients to combine active and index products to offer the kind of fixed income that advisors want for their clients.