Time To Move Fixed-Income Assets Out Of Short Duration: Vanguard

For the past several years, advisors have been content to put their money into short duration products such as money market funds to the tune of $60 billion per year because of elevated inflation and high interest rates, the firm noted in a new report. 

However, as inflation has started to come down and the Fed has stopped raising interest rates and even indicated it will start to cut them, investing in the short end of the curve has not been as beneficial as it once was, Vanguard analysts say. 

In fact, many advisors who have used the Bloomberg U.S. Aggregate Index (US Agg) as their duration benchmark, found that it has not allowed their investments to reach their full potential.

Over the last few years, the US Agg has fluctuated between 5.5 and 6.5 years. Meanwhile, in the same period, Vanguard’s advisors reported that they maintained a somewhat stable but shorter duration profile relative to the index, according to the report. The result meant that the active risk varied year-to-year.

“Running a consistent short-duration position against the US Agg is not without risk when it comes to long-term client outcomes, as a short-duration positioning can lead to prolonged and significant periods of underperformance,” the report said.

The underperformance of the shorter end coupled with greater potential coming from long duration investments, has led advisors to start to gravitate further down the yield curve. 

“After this period of interest rate increase and after this bout of uncomfortable inflation, the market out on the curve is serving up a pretty attractive real return,” Dan Newhall, head of portfolio solutions within Vanguard’s Financial Advisor Services division, said in an interview. “It’s an attractive time to at least evaluate your positioning relative to your benchmark and probably in all likelihood we think the risk/reward is opportune to be out the curve.”

The flows have indicated that movement toward longer duration bonds is a growing trend as most of the inflows have gone to core bonds, which saw a net inflow of $69 billion, core plus with net inflows of $30 billion, multi-sector bond funds that had a net inflow of $25 billion, and intermediate/long Treasury products, which recorded net inflows of $32 billion, according to the report. 

“We suspect that the motivation is that advisors have been cautious and have been taking the yield they’ve been given but perspectively realize that what they’ve been given on the short end may not be there a year from now,” Newhall said. “So now would be the opportune time to move before all of the changes get baked into the yield curve.”

However, determining where on the curve to invest is complicated as there is not a one-size-fits-all solution, the report explained. For advisors, it is best to take a client-centric approach, the report pointed out. That means focusing on a client’s goals when making portfolio decisions, Newhall explained. 

In other words, if an investor has a set amount of money earmarked for a major purchase such as a house, they can't afford too much risk and will be shorter on the curve, Newhall explained. On the other hand, another investor may not have any spending plans in the next year and not planning to retire for several years meaning they can carry more risk and will be on the longer end of the curve, he pointed out. 

“The advisor has to understand their client and what they’re trying to achieve and how much risk clients are willing to take,” Newhall said. “Many clients can expect some risk for the extra return potential.” 

Given the Fed’s anticipated move with interest rates, Newhall said that the potential is there within the fixed-income space. 

“The risk-reward today is much more attractive,” he said. “There is a reasonable real return to be earned in fixed income and that return prospectively looks attractive relative to both the money markets ... or even the stock markets.”