Fixed Income Funds: Third-Quarter Wrap-Up

The third quarter of 2021 was volatile for bonds: July brought strong gains as rates continued to decline, but then rates spiked upwards in late September and much of these gains were washed away as bond prices declined.

As a result, bonds experienced mixed performance over the quarter. The Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for typical U.S. core bond exposure, gained just 5 basis points for the third quarter after gaining 1.8% last quarter. Despite the reversal, two themes from the first and second quarters held. One is the stretch for yield as investors favored more-aggressive sectors, and the second is inflation, as the Consumer Price Index continued to climb, up 5.03% over the last year through September 2021. That led to strong performance for sectors including high-yield bonds and Treasury Inflation-Protected Securities.

The Fed Could Start Tapering Next Month

Interest rates were volatile throughout the quarter and ultimately rose sharply in late September in response to the Federal Reserve potentially reducing its asset purchases later this year and raising interest rates next year. After rising 81 basis points in the first quarter and subsequently falling 30 basis points in the second, the yield on the 10-year U.S. Treasury note rose 3 basis points in the third quarter and sat at 1.49% at the end of September.

In the face of rising inflation and improving employment numbers, the Fed signaled at its September meeting that it could begin reducing (“tapering”) its $120 billion in monthly purchases of U.S. Treasuries and mortgage-backed securities at the next meeting in early November; the Fed also maintained short-term interest rates near zero. In response to this, investors sold U.S. Treasuries across the curve, leading to an upward yield spike. This partly contributed to Treasuries losing money in September, but it wasn’t enough to offset strong gains in July when Treasury yields broadly declined (when yields fall, prices increase) in the face of a speed bump in the ongoing economic recovery.

As the Fed signaled it may start raising rates as early as next year, the best-performing parts of the U.S. Treasury curve in the third quarter were greater than 10 years. For example, the Bloomberg Barclays U.S. Treasury 20+ Year Index returned 0.47%, while the Bloomberg Barclays U.S. Treasury Bellwethers 10 Year Index lost 0.07%.

High inflation continued to drive demand for U.S. TIPS, which were the best-performing fixed-income asset in the third quarter. For example, the Bloomberg Barclays U.S. Treasury U.S. TIPS Index returned 1.75%.

Investors Continue to Stretch for Yield

Still, credit-sensitive assets, not rates, were the main driver of returns for most strategies in the third quarter.

Investors continued to reach for yield on the backdrop of an improving economic outlook. While the more rate-sensitive investment-grade corporate bond cohort benefited from a dramatic fall in Treasury yields for much of the second quarter, bank loans and high-yield corporates led the way in the third quarter. For example, the S&P/LSTA Leveraged Loan Index gained 1.11% and the Bloomberg Barclays U.S. Corporate High Yield Index returned a still respectable 0.89%. The best-performing part of the high-yield universe in the third quarter was lower-rated bank loans: The S&P/LSTA U.S. B Ratings Loan Index returned 1.14%.

Top performers in the bank loan Morningstar Category included Eaton Vance Floating-Rate Advantage (EIFAX); it gained 1.28% in the third quarter partly because of its hefty weights to the lower-rated segments of the market.

Within the high-yield category, funds with elevated exposure to lower-rated credits proved the best performers, consistent with each of the prior three quarters. Indeed, the Bloomberg Barclays U.S. High Yield Caa Index has returned 17.67% for the trailing 12 months through September 2021. The top performers in the high-yield category included Fidelity Advisor High Income Advantage (FAHCX), which gained 1.33% in the third quarter partly because of its overweighting in BB credits.

U.S. Dollar Strengthens

An improving American economy, likely Fed tapering later this year, and possible rate hikes in 2022 led to a strengthening U.S. dollar relative to a basket of currencies over the quarter, which buoyed hedged strategies over unhedged strategies. For example, the hedged Bloomberg Barclays Global Aggregate Bond Index gained 0.09% in the third quarter, while the unhedged version lost 0.88%. One of the best performers in the quarter was Janus Henderson Developed World Bond (HFAIX), which returned 1.04% partly because of an overweighting in high-yield credit and hedging its non-USD exposure back to USD. A similar theme played out in emerging-markets debt on the back of a stronger U.S. dollar.

Mixed Munis

U.S. municipal bonds had mixed performance in the third quarter, delivering positive returns in July, which then turned flat to negative in August and September. Rising interest rates and months of rich muni valuations and tightening credit spreads were drags on relative performance in the later weeks of the quarter. An uptick in the supply of new tax-exempt issuance also contributed to muted performance during the period.

The general fixed-income theme of lower-quality fare outperforming over the quarter also extended to the muni market. The Bloomberg Barclays Municipal Bond Index lost 0.27%, while the Bloomberg Barclays High Yield Municipal Bond Index added 0.38% over the period. High-yield munis tend to have a longer duration than high-yield corporate bonds, which makes them very sensitive to swings in interest rates. Still, lower-rated munis remained attractive enough over the quarter to eke out gains. T. Rowe Price Tax Free High Yield (PTYIX) remains one of the top year-to-date performers in the category, up 5.1% for year to date after gaining 0.21% in the third quarter.