Vanguard CIO Greg Davis on approaching the fixed income market amid volatility

Well, thank Joe. Thanks for having me on this morning. You know, it's one of those things where we've always tried to encourage clients to make sure they maintain a highly diversified and balanced portfolio across equities, bonds, cash, and ultimately trying to focus on controlling what they can control, because we never know exactly what's going to happen with the market longer term. But if you have a highly diversified portfolio across those three sectors, you can weather any significant market volatility. We've seen a lot of our investors do just that during this pandemic.

Well, you've seen in our active fixed income process we've been focused primarily on taking advantage of some of the dislocations that happened in the investment grade market as well as high-yield. We saw spreads widen pretty dramatically when it comes to emerging markets, but there were also some unique opportunities even within mortgages, within the TIPS sector, as those became unbelievably cheap from our perspective. We had an opportunity to add some risk in that portion of the market, and so we've created a highly diversified portfolio that, because we were conservatively positioned coming into this pandemic, we've been able to add risk along the way to help boost return.

I mean, we've been really impressed by the activity from the Federal Reserve as well as the fiscal response that we've seen out of DC in terms of trying to mitigate some of the economic challenges that are coming out of this pandemic. What I would say is if you go back to March and take a look at how dislocated portions of the markets were becoming, the Fed stepping in, buying large amounts of Treasuries, buying large amounts of mortgages, coming out with the money market liquidity facility which was a big improvement to market functioning, you couple that with the secondary market corporate credit facility, those were all things that helped stabilize the market and actually saw us have a pretty significant rebound across all risk assets from that point forward. So we think the Fed has done a tremendous job helping stabilize and provide liquidity in the marketplace, and that's why we've seen a pretty significant boost in risky assets from that point forward.

Well, I think longer-term, the first thing you have to keep in mind, Joe, is look, you have an environment where we're in a crisis situation, so you want to make sure that you throw everything that you can at it to try to get us out of this significant downturn from an economic standpoint, this health crisis that we're facing. And the Fed and the fiscal authorities have really done that. Longer-term, clearly there's going to be some reckoning that has to happen in terms of the amount of debt that's outstanding and the impact that's going to have on interest rates. But if you look at other markets outside of the US, you look at Japan where they have a debt-to-GDP ratio over 200%, we're a long ways away from a place like Japan. So there's still significant room within the US to expand the balance sheet. But it is a risk factor that the Federal Reserve, the Treasury, and investors need to keep in mind longer term. But right now, the focus should be on stabilizing the economy and getting people back to work.

When we think about the economic side of the equation first, we would say that look, things are probably still going to get worse before they get better. We are expecting that the second half of this year we'll start to see improvement. A big part of that is assuming that we are going to get closer to seeing a vaccine being developed, with probably more details coming out as we go to later this year and beginning part of next year, which should provide some positive momentum from an economic standpoint. In terms of your question around negative interest rates, the Federal Reserve has come out multiple times and indicated they have no desire to go negative. They have a number of other policy tools that they could use to continue to try to help boost economic activity. And the question becomes, have negative interest rates actually been effective in places like Europe or Japan? And we have a big difference with the US market is that we have a much larger money market industry in the US relative to those other countries, so the impact that it would have on money market funds in the US, the banking industry, I think is something that the Federal Reserve is keeping top of mind.

Well, I think the way you have to think about it is there's always going to be that interest rate sensitivity in a fund like that. Where we try to typically add value is around the corporate positioning, the weighting that we have in emerging markets, trying to be thoughtful in terms of the types of mortgages, the specific pools that we invest in, and trying to add value more from a security selection standpoint. But overall, you're going to have that interest rate exposure, so if you do get a big backup in yield, you do run the risk of some price deterioration.