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Vanguard CIO Sounds Alarm on Fixed-Income Portfolios

At the Inside ETFs conference in Florida, Gregory Davis said he’s seen bond managers “stray away” from their “sweet spot” in a reach for yield.

Vanguard Group’s chief investment officer Gregory Davis is urging caution in fixed-income markets out of concern that bond managers are reaching for yield in riskier deals. 

During a keynote address Monday at the Inside ETFs conference at the Diplomat Beach Resort in Hollywood, Florida, Davis warned that he has seen managers “stray away” from their “sweet spot” in hopes of bigger returns. He said Vanguard’s active credit bets are defensively positioned.

There are “dark clouds on the horizon,” Davis said. “Be careful about pushing too hard in the defensive portion of your portfolio.” 

Vanguard has increased the odds its sees for a recession this year to 35 percent, from 30 percent, while forecasting the likelihood will rise to 40 percent to 50 percent in 2020, according to Davis. He expects the Federal Reserve will hike rates this year, most likely in June, and that market volatility will continue amid slowing economic growth.

Davis, who oversees more than $4 trillion of assets in fixed income and equities, sought to put 2018’s market turmoil in perspective, saying the majority was confined to a “small window.” The Standard & Poor's 500 index had 20 days of 2 percent swings, up or down, he said, compared with 35 days during the European debt crisis in 2012. 

“We’ve been sailing relatively calm waters,” Davis said.

During periods of low volatility, most investors focus on what they’re paying in fees, according to Rory Tobin, the head of State Street Corp’s global SPDR ETF business. But when volatility returned during the fourth quarter, institutional investors spent more time worrying about liquidity, Tobin said Monday during a panel discussion at Inside ETFs. In other words, they were concerned about the ease of trading amid the tumult.

State Street does a lot of risk analysis and is constantly evaluating the liquidity of underlying assets in high-yield debt ETFs, Tobin said. ETFs are different from open-ended mutual funds in that that they trade like a stock.

[II Deep Dive: Paul Tudor Jones: Corporate Credit Will Cause the Next Crisis]

Last week, Fitch Ratings said that “open-ended bond funds are a potential risk to global financial stability given their rapid growth and increasing liquidity mismatches and credit risk.”

The credit rater said the risks are “most pronounced in purely credit-focused funds with less-liquid underlying assets, such as corporate loans and bonds.”

Sitting on the same panel as Tobin, Rodney Comegys, global head of equity indexing at Vanguard, had some simple advice for navigating liquidity concerns amid expectations for continued volatility.

“Don’t buy an asset that you don’t want to have to sell in in a downturn,” he told conference attendees.

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