What's drawing advisors and investors back to bonds?

With inflation slowing ahead of long-anticipated rate cuts from the Fed, financial advisors and their clients are picking bonds over cash.

Asset managers presenting to more than 500 advisors and 1,500 other industry professionals at last week's Morningstar conference in Chicago pressed their case for active products in particular for fixed-income investments. 

For example, Vanguard has drawn several hundreds of millions of dollars in assets to two actively managed ETFs it launched roughly six months ago, according to John Croke, a senior manager for investment product management and strategy. Those two vehicles carry "a very full cross-section of the U.S. investment-grade fixed-income market" in Treasurys, mortgages and corporate bonds, he noted in an interview. While they're for nonmunicipal, taxable accounts, the debt issued by states, cities, counties and other governmental institutions is looking attractive to advisors and clients as well, Croke said.

"The benefit of holding a muni bond portfolio is that, per the IRS code, the income that is generated from a muni bond portfolio is exempt from federal tax," he said. "On the taxable side, there's not necessarily a deep tax awareness to the day-to-day management. It's more about, how does the investor, how does the advisor place it in the client's portfolio?'"

READ MORE: The 20 ETFs with the biggest inflows of May 2024

Corporate bonds were the "star of the quarter" in the first three months of 2024, with $627.6 billion in issuance that represented the second-highest total dating back to 1980 in the database maintained by the Securities Industry and Financial Markets Association, a brokerage industry trade group. Overall, total bond issuance jumped 6% year over year to $1.46 trillion, and fixed-income trade volume surged 12% to $1.26 trillion in the quarter.

That growth followed the movement of global high net worth investors into bonds and out of cash by the beginning of the year, according to the latest annual World Wealth Report compiled through a survey of more than 3,000 of them by consulting and technology firm Capgemini. The investors boosted their fixed-income holdings by 5 percentage points to 20% while slashing their cash holdings by 9 points to 25%.

"Fixed-income assets were complicated in 2023, as high inflation diluted inflation-adjusted (real) returns from fixed-income assets even as interest rates were high, making them less lucrative for [high net worth individuals]," the report said. "However, the tide began to turn by Q4, and cooling inflation boosted fixed-income real returns. HNWI expect inflation to tone down further in 2024, even as elevated interest rates continue, making fixed income an attractive asset class."

While passive bond ETFs and funds are drawing much of the inflows into fixed income, the active products could get infusions from investors whose advisor harvested losses in 2022 and 2023 by transferring the assets into index funds and are now coming back to active vehicles, according to Croke. Others could see potential for investing in, for example, debt issued by a small liberal arts university, he noted.

"You're going to need an active team to find those things and source those opportunities and pick up those nickels and dimes," he said. "It's hard for an advisor to find and underwrite and buy into those opportunities."

READ MORE: The 20 ETFs with the biggest outflows of May 2024

About two-thirds of the asset flows into bonds over the past 12 months has gone into ETFs, and active ones in particular have "really exploded in the fixed-income landscape," Chris Pettit, a senior manager in Vanguard's Investment Advisory Research Center, said in a panel held by the firm at the Morningstar conference.

"We've gotten a lot of questions about getting cash off the sidelines," Pettit said.

A mobile straw poll of a few dozen attendees at the panel suggested advisors are thinking about bonds again for several reasons. At a three-way tie with 25% each, advisors answering via the conference app chose "interest rate movements," "credit quality and risk premiums" and "sector allocation" when asked to identify what they believe is the "primary source of excess returns" in fixed income. Security selection (15%) and duration management (10%) came in lower. 

The signals are proving somewhat confusing to the investment community, according to Jill DeBerardinis, the leader of Vanguard's RIA East Sales Executive Team. In an exchange with Chris Tidmore, another senior manager with the firm's research center, she cited her many meetings with advisors.

"You don't feel that the role of bonds overwhelmingly has changed. I do get some pushback on this," she said. "A lot of advisors really wonder if the rising correlation between stocks and bonds changed that."

The trends look different when measured over the last century, according to Tidmore, who said there is "not much of a relationship between stock-bond correlations and the returns of a 60-40 portfolio" when the two types of assets displayed similar trajectories.

"It looks like a giant cloud," he said.

READ MORE: Clients want to know: Why buy bonds when 'safe' cash yields 5%?

Vanguard's recently launched active products respectively charge expense ratios of 10 and 20 basis points — which is higher than its passive ETFs and other funds but "still differentiated" from funds that are more costly, Croke noted.

"It allows us to think through and take risks differently than a bond manager who has a 40 or 50 basis-point expense ratio," he said. "In fixed income, there's always a bond that you don't own that yields more than the bond you own right now. … We're happy to stay on the sidelines. We're happy to accumulate dry powder. We'll be ready to be a buyer when the rest of the market's a seller, and we love harvesting that for our clients."