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Why Active Bond Managers Are Succeeding

Vanguard's Gemma Wright-Casparius cites manager skill in capturing credit premiums, along with low costs, as key drivers of outperformance.

Ben Johnson: I'm Ben Johnson, director of global ETF research with Morningstar, and I'm here on the sidelines of the 2017 Morningstar Investment Conference, just coming out of a panel discussion around the ins and outs of indexing in the fixed-income space. Our discussion centered around whether or not fixed-income and bond markets are the Achilles heel of indexing. Joining me to discuss more is Gemma Wright-Casparius. Gemma is a portfolio manager on the Vanguard US Core Bond Fund. 

Gemma, thank you so much for being here.

Gemma Wright-Casparius: Thank you for having me, it's been a pleasure.

Johnson: The center, sort of central topic of our discussion was whether or not there's certain things about the bond market that make it fundamentally different than stock markets and whether or not that goes some way toward explaining why active bond managers have fared much better relative to index funds than their stock-picking peers. What is it about the bond markets that has made it relatively easier for managers such as yourself to navigate these markets and to add value above and beyond the benchmark?

Wright-Casparius: Well there were two things that came out of the analysis that you showed on the screen. One was that low cost active managers outperformed even passive fixed-income managers. The second was the ability to collect different premia and over the last 10 years the ability to capture the compression in credit spreads really added value. When we've looked at our own internal funds and tried to determine what drove performance, we see that half came from the low cost advantage and the other half came from managers' skill. That managers' skill is really concentrated in collecting premiums, either term premia, credit premium, inflation premium, or vol premium. But definitely credit premium drove the performance in the last 10 years.

Johnson: Now looking back as you mentioned, the credit premia has been something that has driven performance over the past 10 years. Looking at where we stand today with rates still low, albeit trending higher with spreads and credit being very narrow, what are the opportunities that you're looking to capture? What are the premia that you're looking to exploit going forward, and what are those areas that you might be looking to avoid right now, that look somewhat rich?

Wright-Casparius: Our core view is that growth right now over the medium term in the U.S. is probably still 2% to 2.5%. Inflation's somewhere around 2%. It sounds rather much like the stagnation story, but we kind of see it as sort of a steady growth, steady inflation cycle. We look at where there's cheapness and value in the market, one is in inflation. Currently market is pricing that the Fed will never its 2% target anytime in the next 30 years and inflation expectations are almost 70 basis points cheap to realized inflation for this year and next year. We think that presents one opportunity. The other is duration. Duration has a negative correlation to credit. As you alluded to, credit spreads are incredibly tight. We rank them at the 39 percentile historically. We're a bit cautious on credit and to the extent that we think that steady growth, steady inflation may allow them to compress even further. We don't see much more value in that compression at this juncture. The offset to that or the negative correlation if you want to be underweight credit, would to be long duration. We like being long duration at this particular point in time.

Johnson: Well Gemma, I want to thank you again for being here and sharing your insights with us. It's been a fantastic conversation.

Wright-Casparius: It's been great to be here, thank you so much.

Johnson: For Morningstar, I'm Ben Johnson.