The First Quarter in Bond Funds

The new year brought mostly good news regarding a potential return to normalcy for economies, which largely left fixed-income markets worse for wear in the first quarter of 2021. The introduction of the $1.9 trillion U.S. fiscal stimulus package and the ongoing coronavirus vaccine rollout boosted expectations for economic growth and higher inflation, both of which caused interest rates to spike and the U.S. Treasury yield curve to steepen over the quarter. Inflation, in particular, spooked bond investors as rising prices erode the value of coupon payments.

The jump in rates spelled trouble for most fixed-income sectors. For the most part, all but the highest-yielding and least rate-sensitive bond sectors sold off as investors stretched for yield and cut exposure to rising rates. The Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for typical U.S. core bond exposure, fell 3.4% for the quarter. Ultimately, most fixed-income Morningstar Categories lost ground in the first quarter of 2021. Long government funds trailed the pack with an average fall of 12.8%, while floating-rate bank-loan funds led the way with an average gain of 1.5%.

The Fed Stands Its Ground

As investors raised concerns over the prospect of higher inflation, the Federal Reserve remained unmoved, indicating that it believed the rise in rates was orderly and that elevated inflation is likely to be transitory. Although the Fed did indeed raise its economic growth projections, the U.S. central bank maintained its program of purchasing $120 billion of Treasuries and agency mortgage-backed securities a month and continued to indicate that the federal-funds rate will likely remain close to zero through the end of 2023.

Against that backdrop, the yield curve steepened, with short-term rates anchored by Fed policy, while longer-term rates rose as government debt lost its luster. The 10-year yield spiked 81 basis points to 1.74% over the quarter. In February, disappointing demand for an auction of 7-year U.S. Treasury notes further stoked the sell-off in government debt. Given its elevated interest-rate sensitivity, the Bloomberg Barclays Long Treasury Index plunged 13.5% in the first quarter, while the Bloomberg Barclays US Treasury 1-3 Year Index posted a modest decline of 0.1%. Meanwhile, short-term government debt offering inflation protection fared even better; the Bloomberg Barclays US 0-5 Year TIPS Index added 1.1%.

Funds with shorter duration, a measure of interest-rate sensitivity, or a focus on inflation-protection were among the best performing high-quality fixed-income strategies over the quarter. BBH Limited Duration BBBIX and Pimco 1-5 Year US TIPS ETF STPZ gained 0.5% and 1.1%, respectively, and were among the top performers in their respective ultrashort bond and inflation-protected bond categories.

Within the more rate-sensitive intermediate core and core-plus bond categories, strategies that had elevated exposure to agency MBS fared better amid the sell-off, thanks in part to the shorter duration profile of MBS. JPMorgan Mortgage-Backed Securities OMBIX and DoubleLine Total Return Bond DBLTX were two such offerings, dropping 0.4% and 1.5%, respectively, a smaller fall than most peers’ in their respective core and core-plus peer groups.

Investors Stretch for Yield

Investors continued to move toward the riskiest realms of credit markets in their hunt for yield, furthering the trend of 2020’s second half. In light of the demand for yield, junk-rated corporate issuers rushed to take advantage while conditions remain favorable, flooding the market with new issuance in a record-breaking quarter for high-yield sales. Meanwhile, energy bonds were boosted by a rise in oil prices over the quarter given the increasing economic optimism. (Crude Oil [WTI] rose 22.2% over the quarter to end at $59 a barrel.)

Credit quality largely dictated performance among corporates over the quarter. The Bloomberg Barclays U.S. Corporate High Yield Index gained 0.9%, while the Bloomberg Barclays U.S Investment Grade Corporate Index dropped 4.7% over the period. Given that the Bloomberg Barclays U.S. High Yield Ca to D Index rocketed 14.6%, aggressive approaches to credit risk were generally rewarded during the quarter. Fidelity Advisor High Income Advantage FAHCX gained 4.2% in the first quarter, besting most peers in its high-yield bond category, thanks to its elevated stake in lower-rated bonds along with its roughly 20% allocation to equities.

Convertible bonds, hybrid securities that combine debt and equity characteristics, also benefited from the continued upswing in equities. MainStay MacKay Convertible MCNVX rose 3.1% and landed in the convertibles category’s best quintile over the period. Meanwhile, bank loans experienced a change in fortunes following a challenging 2020. The S&P/LSTA Leveraged Loan Index added 1.8% for the quarter as investors eyed the sector’s floating-rate coupons, which increase as interest rates rise. Similar to the theme across corporates, lower-rated loans outperformed. Thanks in part to its overweight to loans rated below B, Credit Suisse Floating Rate High Income CSHIX gained 2.2% in the first quarter and bested almost 90% of bank-loan peers.

A Global Knock-On Effect

The rise in rates extended across the globe as sovereign bond yields spiked in the first quarter. Amid concerns that the rise in yields could derail the recovery across the eurozone, where the vaccine rollout has yet to gather significant pace, the European Central Bank signaled in March that it would ramp up the speed of its asset purchases in the second quarter. On the other hand, the Bank of England adopted a stance closer to that of the United States, leaving monetary policy unchanged in March, viewing the rise in rates as a sign of economic optimism. Meanwhile, the Bank of Japan made some subtle tweaks following a three-month review of its monetary policy but by and large maintained its dovish stance.

Given the relatively strong pace of the U.S. economic recovery, the U.S. dollar strengthened relative to a basket of currencies over the quarter. That partly cushioned the 2.5% fall of the U.S. dollar-hedged version of the Bloomberg Barclays Global Aggregate Index for the quarter, while the unhedged version of the index dropped 4.5%. Hartford World Bond’s HWDIX combination of heightened U.S. dollar exposure and shorter duration positioning helped it post a flat return for the quarter, which bested nearly all world bond category peers, which are either unhedged or tactically manage non-U.S. currency exposure.

Emerging-markets debt had begun to prove attractive to investors in the second half of 2020, but rising U.S. yields put a halt to that in the first quarter of 2021, reducing the relative lure of riskier emerging-markets sovereign debt. In March, Brazil's central bank raised interest rates 75 basis points as it sought to combat a recent surge in inflation. Turkey also increased its policy rate in March in the face of rising inflation, though its central bank chief was dismissed shortly after the rate hike in a dispute over the decision. All in all, local-currency denominated emerging-markets debt lagged hard-currency fare; the J.P. Morgan Index for the former dropped 6.7%, while the latter declined 4.5% for the quarter. Treading lightly in local-currency fare helped keep Pimco Emerging Markets Bond's PEBIX 4.8% fall close to that of its typical emerging-markets bond category peer.

Munis Aided by Stimulus

Despite the jump in rates, U.S. municipal bonds held up relatively well in the first quarter, supported by robust investor demand. The credit outlook for munis received a boost from the $1.9 trillion U.S. fiscal stimulus plan, which earmarked $350 billion in federal aid for state and local governments. Muni investors also digested the Biden administration’s plans to introduce tax reform and bring an infrastructure spending package to the table. Credit fundamentals across muni issuers showed signs of improvement over the quarter. The state of Illinois was one such issuer; S&P upgraded its outlook to stable from negative in March.

Against that backdrop, the theme of lower-quality fare outperforming over the quarter also extended to the muni market. Bloomberg Barclays Municipal Bond Index posted a modest loss of 0.4%, while the Bloomberg Barclays High Yield Municipal Bond Index added 2.1% over the period. BlackRock High Yield Municipal MAYHX was one of the strongest performers over the quarter in the high-yield muni category, rising 2.5% thanks in part to its overweighting to lower-rated fare.