Global Credit Bond Fund – Q3 2024 update – Full
Welcome to the Q3 2024 performance update for the Vanguard Global Credit Bond Fund.
This securities selection-driven active fund is managed by Vanguard's Fixed Income Group and is attracting strong investor interest.
It has outperformed its peer group and its benchmark in every calendar year since inception.
Delighted to be joined today by the lead portfolio manager, Sarang Kulkarni.
Thanks, Andy.
So, Sarang, perhaps we could start by looking at the macro.
We had the first Fed cut in four years or so, 50 basis points with the potential for more later this year.
How did you see events in the quarter and how that impacts the asset class?
So as I mentioned in previous calls, this is a really good environment for fixed income.
Central banks are looking to cut rates, but you've got to think about why they're doing that.
And that's in response to what's been happening with growth and with inflation.
Now, managing inflation with interest rates, as we always say, is a bit like turning around a supertanker.
Whatever we are seeing today as a result of like policies made maybe two years ago and the result of like policies made today will really see that impact two years from now.
And so we've just started this rate cutting cycle, and I think that will continue.
And you can see that, with bond yields and with curves potentially going steeper.
But we do expect to continue to see, inflation continue to decline, decline and central banks continue to cut on the back of that.
Now, there is a lot of debate about the timing and the extent of that.
But if you can like fast forward and think about like for the end of next year, you know, it for sure, like central bank rates are going to be materially lower than where they are today.
Curves could be steeper.
And you should see, you know, yields probably trading at a lower level.
And we had 5.1% return in the quarter for the USD version, slightly less and similar for for the euro and and sterling versions of the fund.
That's obviously very healthy.
What drove the performance of the asset class in the quarter?
And I imagine it's...
I think just a lot of stability and as you know, the change in the fixed income outlook.
So you did see yields come down, across the board.
And you know that itself helps support, positive returns.
Spreads were pretty rangebound.
So again you benefit from carrying a little bit of performance.
But for us on the fund, you know, we just continue to do what we normally do, look for undervalued opportunities, and emerging markets in you know, periphery Europe and, you know, see, the benefits of that stock selection strategy come through.
Yeah.
And the strength of that relative value has really come through with 26 basis points of alpha in the quarter.
So that adds up to 70 basis points year to date.
So very, very strong return.
How did that performance you know in the quarter compare to expectations?
I think we we sort of expected you know spreads to probably be a bit more robust and then spread tightening.
We thought returns from that would be probably better.
But you know, a lot of our themes continue to play out like we have talked a lot about, like the real estate sector, how it's improving, how you're actually seeing, you know, spreads tighten but not just that, you’re also seeing fundamental improvement come through.
We've talked about periphery Europe, how the upgrades are starting to come through, in the sovereign space as well as in the corporate space and how that's kind of driving performance.
We've talked about, the backdrop for financials, both in the US and in Europe and the impact that has on, you know, swap spreads, which is quite an important, you know, risk proxy for European markets.
Now, that's been going tighter.
But that also drives the performance for sectors like sub sovereign and supranationals.
So a lot of these things are actually starting to play out now.
But we thought they would probably start a little earlier.
We did have some volatility in August.
You know, the unwind of the carry trade, you know, the macro data points from the US weren’t as robust as people expected.
So that did create some volatility as a result of which like, you know, spreads kind of like stayed rangebound instead of tightening.
So, I think I'm happy with 26 basis points over a quarter.
I mean, it's a good, you know, steady run rate.
But, you know, they it has been quite a kind of, asset stable quarter in terms of performance.
And you have the challenge of obviously the world and particularly your world of investors being so macro-driven, so news-flow driven at the moment.
How do you balance that with that fundamental bottom up securities selection?
It doesn't matter. Right?
I mean, I think you raised a really good point because this kind of like relates to our style.
It's... if you don't know much about what's happening with geopolitics and like macro drivers, like, why try to make money by putting risk behind that?
So we don't tend to take a lot of risk on these macro factors.
And they are happening.
They influence a lot of what's happening.
But we tend to focus on, you know, bottom up fundamental stories, how the market's pricing these stories and essentially look for situations where you probably have like an improving story where, you know, bonds are still really cheap and we can actually benefit from the market, you know, coming to the realisation that there's a gap between valuation and fundamentals.
So the macro picture is the backdrop.
It does kind of like, you know, drive the whole total return of the fund.
But we're not trying to generate a performance from timing macro.
That is not where we see our strengths.
Our strengths lie from our fundamental research and being able to build portfolios, from a bottom-up perspective.
And, you know, this is the biggest advantage.
And we've we've highlighted this several times before.
If you focus on macro, you have like two bets in your fund, like what are rates going to do?
And what are spreads going to do?
Because between Europe, the US, investment grade, high-yield, spreads tend to be very highly correlated.
And as we've seen like between the UK, Japan, even though central banks are moving in different directions, the Fed and you know, the euro zone as well, yields tend to be really correlated.
So you end up having like this two bets in your fund when you focus on macro.
And if you get one of them wrong, let's say like, you know, we were underweight duration over the quarter.
that would have been really hard to make up from what's happening on the spread side.
So we don't you know, if it doesn't, you get one of them wrong, t's hard to really compensate for that.
You really don't have much of a budget for being wrong.
Whereas like in a stock selection-driven strategy, you actually have more of a but you can afford to get things wrong.
And, I think it's been good in this quarter that there haven't been anything that really moved.
But so our expectations are from a fundamental perspective.
But just having that diversification in the long run gives you a much better risk-adjusted return profile on your fund.
Kind of makes your fixed income allocation more defensive.
And so from this bottom-up view, you know, what areas are you finding more attractive credit?
And are there other areas of the market where you're thinking, ‘you know what that you know, just going to leave that alone right now.
That's looking tight enough’?
There have been a number of themes that have been playing out, like we did talk about in the past.
The regional banking sector is to like that.
We've talked about... real estate.
We’ve talked about like the UK water sector is to like that.
The more volatile markets are, the greater dispersion you have between names and the greater dispersion you have between names, the more alpha we can generate without actually taking any kind of directional bets on the market.
That's what makes our style very different, is like we actually look for the volatility because we can actually make more money from that.
And, you know, with that potential, you know, widening of spreads, it sounds like you're trying to keep some powder dry for an event like that.
Yes. That's right.
I mean, I think just given how, relaxed markets have been about like the upcoming risks, where changes could happen, we have been keeping our powder dry.
We've been actually trying to like, you know, reduce our exposure to things that could be on the front line from policy changes from the US.
So, those are areas where we've been trying to sort of like make sure that we have a disciplined in terms of where we take our risk.
One of the interesting areas when, you know, when you're on the investment floor that we perhaps haven't talked about in the past, is your team's use of AI and machine learning to assist the process, perhaps you could explain how you're doing that and what value that having.
Well, it's a global fund.
And you have to, you know, work with big data to be able to narrow your focus because the universe of bonds that we could possibly look at, you know, if you cover US, Europe, Asia, emerging markets, high yield SSAs, sovereigns, you’re probably talking about over 20,000 to 25,000 bonds that you could look at to build up your portfolio for.
So you know, the rates trades, we kind of, you know, focus on much more conservative and longer term sort of driven strategy.
We're not trying to sort of like capture small movements in it in a meaningful way.
But for the credit trade, you need to be able to like take this universe of like maybe 15, 20,000 bonds and narrow it down to a select set where you can really, you know, do a deep dive from a fundamental perspective that you're under.
So you can't expect your analyst to cover all like 2,500 and 3,000 issuers that are out there.
so you have to help them kind of like narrow on that.
And so one of the areas that we do use is we're using AI to kind of like be able to look at bonds where we think that they have an interesting risk return profile.
And once we have that list, we can either do two things.
We can either trade that list kind of systematically, kind of going, let's just go with what the machine learning algorithm is telling us.
And let’s try to put some money behind it.
And so we have, one strategy in the fund that is just purely systematic.
But the other thing is like, it helps narrow down that universe of bonds to a much more manageable set that we can sit down with our analysts on and like do more of a deep dive and kind of go, okay, you know, these are bonds that look interesting at the moment.
What do you guys think?
And it's interesting because sometimes you can like see these, you know, there's a mismatch between what the analyst thinks and what machine learning algorithm thinks.
And that always creates opportunities because it kind of like shows that in the marketplace maybe there's emotional plays at work, which don't really last forever.
I mean, you know, people can be worried about something for some time, but after a point in time they kind of like change their views.
But the, the drivers of performance, the technicals, the way the street's positioned tends to follow more of like the, you know, the the kind of like the emotional gut feel kind of thing.
So these machine learning strategies actually pick out some really interesting opportunities that help drive outperformance.
That's fantastic to understand in a bit more depth.
With your expectations for, you know, potential credit market volatility, how are you you know, positioning the fund to make sure it can weather that?
Well, as you mentioned earlier, we have had more dry powder in the fund.
So, you know, compared to the level of risk, the number of opportunities that we've been having in the fund in the past has definitely gone down.
And we've put in place, sort of like convex plays on the macro front in FX using FX options.
We're doing like pair trades in the rate space, and doing pair trades in the CDS space between the US and Europe because we think that events, that might play out over the next quarter or so could cause these to kind of like, move in a particular direction, which could, you know, we're trying to like, play that convexity in a sense that if we’re wrong, we don't lose that much.
But if we're right, we can actually make a lot more.
So those are the kind of profiles I'll be putting in these overlays for the fund.
And with that in mind, you know, what do you see the role of your fund in a diversified portfolio?
What value does it add? and why it's a core holding, right?
Well it's a core holding, right?
It's, I mean, it's... investment grade credit is fantastic because and especially with yields coming back to around like 5% and with the duration of around like six years.
I mean, really, what it's telling you is like, you can and average over six years, expect to make like 5% return over that.
Now they're interesting views going out that you just given where equity markets are at that moment.
It may be that over that five, six year horizon that we're looking at, credit equity returns could be very similar.
And so I think it's a great, you know, investment grade funds play a very important role because they're a source of income, 5%, is a pretty good income to be clipping every year.
They’re a source of liquidity, like markets are still really good, a lot of money coming in.
New issuance is pretty healthy.
So you kind of have like, that good liquidity to be able to buy and sell as you want to.
It’s a source of returns because like, as central banks cut rates and duration rallies and yields fall like that positive return over and above the 5% income, right, can actually something that can accrue quite nicely over that time frame.
But finally, given that we're at 5% and you know, you can never rule out over that kind of like time frame, some kind of like a economic accident or a wobble that could happen.
You know, central banks would respond using their traditional playbook.
They'd be cutting rates quite aggressively.
Yields can fall dramatically.
And so investment grade credit can actually deliver some pretty good positive returns in a recessionary environment where equities will struggle to deliver positive returns.
So that becomes like that natural offset within that.
So it definitely makes sense to be like increasing exposure to investment grade credit, you know, at this point in the cycle within a balanced portfolio.
I agree, you know, on an absolute basis, the asset class looks good on a relative basis, other asset classes look potentially overvalued.
So, you know, it's another feather in its cap.
And then the consistent alpha that the team are delivering.
You know on top of that you know seven years now of track record and outperforming in each and every calendar year.
Sarang, thank you very much for your time. Thank you.
