Fixed-Income Sectors Rise in the Third Quarter

The Federal Reserve announced a major policy shift on Aug. 27, 2020, that will allow average inflation to “overshoot” the 2% target rate that had been in place since 2012. U.S. government-bond yields rose following the news. It’s important to note that the personal consumption expenditures price index, the Fed’s favored inflation metric, has rarely topped that 2% target rate under the prior framework. Near-zero interest rates are also expected to remain for the next several years. This is a change to the Fed’s historical tendency to lift interest rates to manage rising inflation that can be brought on by a hot labor market. The pandemic, and the structural changes that have come with it, has certainly thrown a wrench into this equation. It is the Fed’s hope that this policy change will support the labor market and broad economy.

As markets stabilized and both hiring and economic activity picked up from their March and April lows, inflation steadily rose. With this, real yields (nominal yields less inflation) fell even further into negative territory. The rise in inflation sent Treasury Inflation-Protected Securities, also known as TIPS, higher (3%) for the quarter. Inflation can erode the purchasing power of future interest and principal payments, ultimately reducing the value of an investor’s income stream. The rise in inflation and increasingly negative real yields, coupled with low interest rates, pushed investors further out on the risk spectrum in search of income.

Core Strategies Move Higher The Bloomberg Barclays U.S. Aggregate Index, a proxy for core bond performance, gained 0.6% for the quarter--a solid gain that included a challenging September. The Fed remained accommodative, but risks to the economy, such as increased viral transmission and political gridlock as the election cycle hits full-swing, loom large.

U.S. Treasuries, which accounted for just over one third of the Aggregate Index, steepened modestly, with short-term rates edging down while rates beyond seven years were static. Corporate credit was the index’s key driver for the period as fundamentals remained relatively solid. That helped fuel Loomis Sayles Investment Grade Bond LIGRX, which has a Morningstar Analyst Rating of Silver, to a 3.8% gain, which topped most options in the intermediate core-plus bond Morningstar Category. The strategy’s allocation to investment-grade corporates routinely tops 50% of assets, and an additional 5% to 10% stake in high-yield issuers supplied another punch.

Securitized fare also performed well and helped boost the Aggregate Index. Mortgage rates, specifically 30-year fixed-rate offerings, fell below the 3% mark before ending the quarter at 2.9%. Bronze-rated JPMorgan Core Bond WOBDX posted a 1.1% gain. This strategy’s composition has historically differed from most peers through its emphasis on securitized assets over corporates. Meanwhile, commercial mortgage-backed securities (pools of loans backed by leisure, office, and retail properties among others) continued to recover from its March nadir.

Strong Demand for Credit There was a deluge of new issuance as corporations shored up their balance sheets in what can be described as a primarily defensive measure to build cash and refinance outstanding obligations. Given the demand for yield, the market absorbed it without complaint. Overall, credit risk was generally rewarded and strategies that held more-adventurous corporate stakes were lifted as investors paid up for the additional yield.

Within the high-yield bond space, Fidelity Advisor High Income Advantage FAHCX, one of the more aggressive strategies in the high-yield bond Morningstar Category, generated a 6.8% return for the quarter. This portfolio benefited from its flexible mandate that can carry up to 20% in common stock. The S&P 500 index, a proxy for large-cap U.S. companies, gained 8.9%. Meanwhile, a more conservative high-yield strategy like Silver-rated Harbor High-Yield Bond HYFAX trailed its Bloomberg Barclays U.S. High Yield Corporate Index benchmark by 60 basis points with a 4% gain. That strategy’s lower allocation to issuers rated CCC and below distanced itself from more-adventurous peers.

Elsewhere, the S&P/LSTA Leveraged Loan Index returned 4.1%, while convertible securities, which combine corporate bonds and an equity call option, soared during the period. Silver-rated AllianzGI Convertible Securities ANNPX and its Bank of America Merrill Lynch All U.S. Convertibles Index benchmark returned 15.3% and 13.9%, respectively.

Munis Continue to Recover Strong issuance also extended to the municipal-bond market, which has been hamstrung by growing liabilities related to the pandemic fallout. Municipal debt issuance topped $40 billion dollars during each month in the quarter, and through September 2020, issuance was approximately 25% greater than it was over the same span a year earlier.

Risk was similarly rewarded, with lower-rated munis outpacing higher-quality bonds. The high-yield muni market, proxied by the Bloomberg Barclays High Yield Municipal Bond Index, added a 3.1% result as spreads continue to narrow from the two prior quarters. State and local municipalities are closely correlated with U.S. gross domestic product, which experienced a sharp rise from lower economic activity earlier in the year. Strategies with longer durations also generally outperformed their shorter counterparts as the low-interest-rate environment remained. Silver-rated BlackRock High Yield Municipal MAYHX added a solid 2.7% through a modestly higher allocation to lower-rated fare than its typical peer. The more balanced Vanguard Intermediate-Term Tax-Exempt VWITX strategy, which typically holds less than 1% in speculative-grade issues, returned 1%.

Investing Abroad Historically low rates across economies and unprecedented levels of stimulus have weighed on the U.S. dollar relative to a basket of currencies. A weaker dollar has generally benefited emerging-markets debt issued in hard currency because the coupon is less expensive for the issuer. This weakening contributed to the JPMorgan Emerging Markets Bond Global Diversified Index's 2.3% rise over the quarter. Indeed, it was a relatively good quarter for hard-currency emerging-markets-debt-focused strategies, with Gold-rated TCW Emerging Markets Income TGEIX leading the way with a 3.5% gain. The world-bond category also fared well, posting an average 3% gain for the quarter, while the average world-bond USD-hedged category fund added half that due to a weaker greenback.

Argentina, Latin America’s third-largest economy, made headlines in early August as it agreed to terms with creditors on approximately $65 billion in debt after a months-long negotiation. Debtholders came away with a 45% haircut on their initial investments. Market reception was mixed despite a path forward. The challenged nation has defaulted nine times in its history.

Developed markets, as measured by the Bloomberg Barclays Global Aggregate Index, fared slightly better than emerging economies, rising 2.7% for the quarter. Its U.S. dollar-hedged version inched up just 70 basis points. Improving economic data slowed from the prior quarter amid sharply rising coronavirus cases across the eurozone, notably in France and Spain. Deflation also hit the region in August and September 2020 for the first time since 2016.