In a recent note seen by Bloomberg, Vanguard Group Inc., the world's second-largest asset manager with $9.3 trillion in assets under management, has urged investors to "right-size" their allocation to bonds over stocks as the Federal Reserve slows its path toward cutting interest rates.

Following the Federal Reserve's decision to leave interest rates unchanged and Fed Chair Jerome Powell's avoidance of offering a timeline for a rate reduction, Vanguard's fixed-income team, led by Sara Devereux, emphasized the prolonged opportunity to lock in attractive yields for a longer period. They argued that persistent inflation should keep the Fed cautious in the near term, making it less likely for any additional rate hikes to occur.

The Vanguard team emphasized the potential for better risk-adjusted returns for bonds compared to stocks over the next five years. They highlighted the supportive backdrop for fixed income credit sectors, stable fundamentals, and strong demand from yield-seeking investors. Investment-grade risk premiums, which indicate the additional premium investors receive for holding riskier debt compared to U.S. Treasuries, are currently close to levels last seen in November 2021. Additionally, average high-grade bond yields are hovering near six-month highs, further boosting demand for bonds.

Vanguard expects these favorable conditions to continue into the second quarter, particularly as the largest wave of bond issuance for the year has already passed, limiting supply in the market. Despite a dip in performance last month, Vanguard believes the probability of a U.S. recession in the near term is low, even with restrictive policies that could potentially slow down economic growth. However, the firm noted that spreads could widen if economic conditions worsen, such as through higher inflation or slower growth.

To adjust their bond portfolios, Vanguard has been cutting credit risk across sectors, especially in emerging markets and lower credit quality corporates. They have been favoring shorter-dated bonds from the financial sector and BBB rated bonds from industrial firms. The firm also sees relative value in European credit and views the opportunities in the mortgage-backed securities market, agency collateralized mortgage obligations, select specified pools, and agency commercial mortgage-backed securities.

While opportunities lie in high-yield bonds, Vanguard acknowledges that further spread tightening may be limited in BB and B-rated bonds. Instead, they find value in lower-quality and stressed parts of the market, particularly high-quality bank loans.

In conclusion, Vanguard Group Inc. is urging investors to shift their focus towards bonds over stocks in light of the Federal Reserve's delayed approach to interest rate cuts. With the potential for better risk-adjusted returns and supportive market conditions, Vanguard's fixed-income team sees bonds as an attractive investment option for the coming years.