Vanguard's head of product, Americas explains how the coronavirus selloff became a time to shine for bond ETFs
To critics, the discounts to NAV between fixed-income ETFs and their underlying bonds in March stood as positive proof that the instruments struggled in the midst of stressed markets.
But according to Scott Johnston, head of Product, Americas at Vanguard, the haters are looking at things all wrong.
“It’s true that the underlying bonds had a stressed market, especially in March,” Johnston said. “But bond ETFs continued to trade, acting as a source of liquidity and price discovery for fixed-income investors, so they actually improved the overall outcome in the bond markets. I think to criticize bond ETFs in that situation is to bark up the wrong tree.”
To further highlight the importance of fixed income, Vanguard Canada recently reduced fees on three of their Canadian bond ETFs. That’s not really anything new; in Canada, Vanguard has announced price reductions on various components of its fund lineup six times over the last seven years. Every time, the intent was to return more value to clients – a gesture that becomes more meaningful each year, for bond ETFs in particular, as interest rates remain at depressed levels near 0%.
“We also think it’s important for advisors and investors to have low-cost access to Canadian fixed income, as the recent downturn showed how valuable fixed-income ETF allocations can be,” he said.
An eye on stability
According to Johnston, Vanguard’s observations of the markets’ peak-to-trough performance from February 19 to March 23 showed a 37% plunge in Canadian equities, and just a 2% drop in fixed income. “It did exactly what it was supposed to do, which is act as the ballast in your portfolio to offset what happens with equities,” he said.
Having a stabilizer to counteract equity volatility can also meaningfully help performance. Johnston said that from the end of May 2019 to the end of May this year, a balanced portfolio with a 60/40 mix of stocks and bonds would actually have produced a 3% gain in spite of drawdowns in March, showing the importance of staying the course through periods of uncertainty.
“That’s reflected by our Canadian balanced asset-allocation ETF, VBAL,” he said. “It has a Canadian home bias, but also global exposure, which we expect to closely represent what advisors have.”
The events of the past few months seem to have forced advisors to make prudent adjustments to their fixed-income allocations. Looking at the flows into and out of their bond ETF products, which include seven Canadian fixed-income strategies and three global bond strategies, Vanguard saw slight net outflows in March and April, suggesting moves to rebalance portfolios in the face of massive drawdowns in equities.
“In May, we started to see more positive flows back into the fixed-income space,” Johnston said, noting the significant recovery in equity markets during that time. “In our case, we saw advisors favouring our Canadian core and global core bond ETFs, as well as being more deliberate about their credit and duration decisions, which are very meaningful as the crisis showed.”
Unlocking opportunities in fixed income
From a tactical perspective, there’s potential upside in using fixed-income ETFs that focus on Canadian corporate fixed-income markets. According to Johnston, Vanguard’s economic outlook calls for a relatively short recession with a relatively rapid turnaround, and it sees attractive valuations in the corporate credit space at present. That means investors willing to take a risk-based approach may want to consider allocating to investment-grade corporate bonds.
Those who want to play it safer are apt to benefit from a core allocation to fixed income as ballast against equity volatility in their portfolios. However, that doesn’t necessarily apply to high-yield or unconstrained active bond funds; investors with too much of either, Johnston said, would have found their fixed-income holdings behaving more like equities during the recent turbulence.
“The crisis also showed us the value of fixed-income ETFs as a source of liquidity for clients’ portfolios,” Johnston added, noting how the vehicles continued trading even as bond markets seized up. “Now quite a lot of institutional buyers are speaking with us about increasing the liquidity sleeve in their fixed-income portfolios through index ETFs so they can more nimbly deal with future challenges.”
