Michael Chang, co-head of high-yield corporate credit at Vanguard, takes a defensive approach in the portfolios he manages. By Debbie Carlson
A resilient economy and strong growth in corporate profits make this a good time to own corporate credit. Decent starting yields and a patient Federal Reserve also contribute to the positive backdrop, says Michael Chang, co-head of high-yield corporate credit at Vanguard.
Chang recommends that investors stick to higher-quality credits across the board, and especially in high yield, given geopolitical turmoil and lofty valuations.
Vanguard is the world's second-largest asset manager, with $13.3 trillion in assets under management. Although it is best known for index funds, the firm has a strong lineup of active bond funds. In addition to overseeing Vanguard's high-yield corporate credit division, Chang is the lead portfolio manager on the Vanguard's Multi-Sector Income Bond mutual fund (ticker: VMSIX) and the exchange-traded fund $(VGMS)$, the Vanguard High-Yield Corporate mutual fund (VWEHX), and the Vanguard High-Yield Active ETF (VGHY), with Wellington a subadvisor.
Barron's spoke with Chang on June 10 about the current attraction of fixed income, the private-credit market's troubles, and where he sees high-yield bargains now. An edited version of the conversation follows.
Barron's : What is Vanguard's approach to high yield?
Michael Chang: We believe fixed income is pretty asymmetric. There generally is more downside than upside, and that is even more so in a market like high yield, where the cost of being wrong is very high. Our approach is centered around disciplined risk-taking, diversification, and an emphasis on bottom-up selection to minimize or avoid defaults and the losses associated with defaults.
Your outperformance in a market like high yield is going to come from your ability to minimize your exposure to the problem areas and issuers in most periods and your ability to pick the winners.
What is Vanguard's bond-market outlook generally?
Our top-down outlook for corporate credit is pretty good from a fundamental perspective. Regarding the Fed, the June [Federal Open Market Committee] statement, projections, and vote [to hold interest rates at current levels] indicate a greater focus on inflation. Vanguard's view is that the Fed has flexibility to remain patient and data dependent around future policy changes.
For high yield specifically, the things that matter are a U.S. economy that is growing, not shrinking, and monetary policy that is generally neutral. The combination is pretty supportive for corporate fundamentals.
It's a strong environment for earning income and yield. That is mainly due to a higher level of base interest rates. The Bloomberg U.S. high-yield index yields 7%, while the Bloomberg U.S. investment grade corporate index yields 5.18%.
The thing that holds us back from being more constructive is valuations. Current valuations across credit markets appear on the rich side of fair, as the additional spreads earned above U.S. Treasuries are among the narrowest we've seen historically.
There is some moderation in the positive outlook, then?
When we think about where spreads are compared with long-term levels, current valuations feel like little risk is being priced in. While we can't predict what the catalyst may be for the next selloff, recent history shows that exogenous risks [such as tariffs and the Iran war, most recently] can have an outsize impact on credit spreads when starting valuations are tight.
Given relatively tight valuations and the lack of compensation for going down in credit quality, we favor higher quality over lower quality, both at an asset-class level, which means favoring investment grade over high yield, and within an asset class such as high yield. In the high-yield market, we favor higher-quality double-B-rated credits [one grade below an investment-grade rating] over lower-quality triple-C-rated credits.
We are focused on adding bonds whose prices fluctuate less than the broader market and whose yields are higher than the prevailing index. That aligns with our overall view on credit: that spreads are likely to remain in a range-bound environment.
The high-yield market is much higher quality today than 10 or 15 years ago. What brought about the change?
In 2007, before the financial crisis, close to 35% of the market was higher-quality, double-B-rated issues. The percentage today is closer to 60%. On the flip side, the proportion of the market that is lower quality, or riskier -- call it triple-C-rated -- has fallen from nearly 25% to nearly 10%. Before the financial crisis, 25% of the market was in leveraged buyouts. Now it has moved on to other markets: leveraged loans, bank loans, private credit.
What are the implications of a higher-quality junk bond market?
You need to make some adjustments as you think about what that means for credit spreads. As you go down in credit quality, the spread versus Treasuries widens. There are also important implications for default rates today, and expected default rates in the future.
Within high yield, investors historically were compensated for two factors: expected credit losses, which are a function of defaults and recoveries, and less liquidity. They earn an excess risk premium to invest in a less-liquid asset class like high yield.
With current spreads at around 270 [basis points above U.S. Treasuries; a basis point is a hundredth of a percentage point], and default rates trending around 2% -- and expected to stay there over the near to medium term -- the excess premium investors are earning in high yield is at the tight end of historical averages. Absent an increase in default-rate expectations, high-yield spreads in the 320-basis-point range would represent better value, as this would get us closer, at least, to historical averages for excess premiums.
Higher-quality high-yield debt means our expectations for default rates in high yield should be lower in the next recession or next credit cycle compared with prior recessions.
Where are we in the credit cycle?
The credit markets are sending some mixed messages in terms of where we are in the credit cycle. Depending on which part of the market you look at, we are most likely in the middle to later part of the credit cycle. Looking at the public bond markets, both investment grade and high yield, I would say we are in the middle part of the cycle.
The private-credit and leveraged-loan markets are flashing more late-cycle indicators, with the more aggressive underwriting of the past several years laying the foundation for higher defaults and credit stress.
Many people worry about defaults in the private-credit market spilling over to the public markets. What's your view?
One of the differences between private credit and subprime [mortgages], for example, is that private credit doesn't represent systemic risk to the U.S. economy. The reason is that all this issuance and most of the losses potentially are outside the banking system, since the business has grown at the expense of the banking system. Worry is probably not the word [we'd use]. We're keeping a watchful eye to the extent that we can. Private credit has limited overlap with the high-yield market because there is no real overlap between the issuers in both markets, although there are potential spillover impacts.
I believe we are getting closer to a point of reckoning in the private-credit market. Private credit has two problems. One is that a lot of the private-credit deals that private-credit managers are sitting on right now were done in the 2020 to 2022 time period, in a zero-rate environment. Sponsors paid too high a price, put on too much leverage, and made too many assumptions that the good times were going to last. They are no longer able to sustain that type of debt.
You add on top of that software-company exposure, which has a much higher weighting in private credit by orders of magnitude compared with the bank-loan market, and especially the high-yield market. Depending on your calculation, it could be five-plus times more.
The second big issue is that most private-credit deals were underwritten with fixed maturities, so there is a big debt-maturity wall coming for all of the deals underwritten five, six years ago. Somebody needs to refinance them. These companies are generally good companies, but they were underwritten and acquired in a much different period. Therefore, there is too much debt.
It's an open question how these issues are going to get resolved.
The redemption cycle is also unnerving for people.
We are in a period when investors, for various reasons, are asking for their money back. This is kind of foreign territory for the private-credit market. The private-credit market has never needed to figure out how to raise liquidity, because it was in a relatively long period when the flows went only one way.
Private credit isn't supposed to trade, whereas public credit is marked to market daily. That private credit doesn't trade is beneficial from a return perspective, but less so when you need to meet redemptions. That is the underlying issue. I'm not saying it can't be dealt with, but there is a potential mismatch between the liquidity that private-credit managers can generate in their underlying portfolios and the liquidity that maybe they regret having offered to investors in some of these structures.
As a portfolio manager for high-yield and multisector bond funds and exchange-traded funds, how are you approaching fixed income?
Because of the high valuations, we are more defensive in our portfolios. In addition to leaning into higher-quality asset classes, we have a preference within each asset class for more-defensive industries, such as banks and utilities in investment grade, and healthcare, food, and consumer products in high yield.
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