Bonds in the Second Quarter: The Flattening

Nearly every taxable-bond Morningstar Category posted a positive return for the three months ended June 30 as credit spreads tightened and the yield curve flattened.

The Fed and the Flattening Yield Curve

Long-term bonds did well last quarter as the yield curve flattened. The short end of the curve shifted up as the Federal Reserve raised interest rates in June for the second time this year, but investor appetite for Treasury bonds pushed the longer end of the curve down. The Fed also announced plans to reduce the size of its balance sheet--meaning it would stop reinvesting coupon payments and eventually begin selling bonds--but the market largely shrugged at the news. The yield on the 10-year finished the quarter at 2.31%, down 9 basis points from the end of March. This dynamic was especially helpful for funds with super long durations, such as

The flattening curve also aided the Bloomberg Barclays U.S. Aggregate Bond Index, which gained 1.5% for the quarter, in line with the second-quarter return for the average intermediate-bond fund. One of the biggest winners in the intermediate-bond category was

The worst-performing category was the inflation-protected bond group, which suffered a 0.5% loss on average for the quarter. Ultrashort-bond and short-term government funds were also laggards but still managed to post modest gains in the face of rising yields.

Spread Compression Continues

Credit spreads continued to tighten modestly this quarter following the Fed’s June rate hike. Through June 23 the yield spread on the investment-grade Morningstar Corporate Bond Index had tightened 12 basis points from the start of 2017 to 116 basis points over a comparable Treasury bond, which is tighter than its long-term average of 167 basis points. Most of that tightening (8 basis points) took place in the second quarter, helping the average fund in the corporate-bond category to a gain of 2.3%. The average fund in the corporate-bond category has a longer duration than the Aggregate Index, so the flattening yield curve also played a role in the strong returns for the category. Funds in this category hold mostly investment-grade corporates, but some hold sizable stakes in junk-rated corporates. Last quarter, AAA and BBB rated bonds outperformed middle-quality investment-grade bonds and higher-quality junk bonds fared better than lower quality junk bonds--again, largely because of the yield-curve dynamics as higher-rated bonds are more interest-rate sensitive.

The average high-yield bond fund gained just 1.7% for the quarter. Funds that skewed higher quality and had lower energy allocations tended to fare better, as higher-rated junk bonds outperformed lower-quality offerings and as spreads on energy-related bonds widened after oil prices slid to a low of $43 per barrel in June. The option-adjusted spread on the BofA Merrill Lynch U.S. High Yield Index widened in June but managed to close the quarter lower than where it started (377 basis points over Treasuries as of June 30 versus 392 basis points at the end of March).

Continued Strength in Emerging Markets

Emerging-markets local-currency bonds were among the best-performing funds this quarter, with the average fund in the category up 2.9%. Emerging-markets currencies have been on a tear this year, with most posting positive returns for the year to date. The Mexican peso, up 7% for the quarter, gained nearly 22% for the year to date. Other strong-performing currencies included the Polish zloty, Turkish lira, and Czech koruna, each up more than 7% for the quarter.

The Fed’s interest rate hike sent the U.S. dollar higher against some developed-markets currencies, most notably the yen. Against the U.S. dollar, the euro strengthened significantly during the quarter. Within the world-bond category, funds with larger allocations to emerging-markets currencies, and those with small or no allocation to the yen, did particularly well, including

A Quiet Quarter for Munis

Extending the rally that began in early 2017, municipal bonds posted modest gains during the second quarter against a backdrop of limited supply. Despite negative headlines out of Connecticut, Puerto Rico, and Illinois, as well as uncertainty around tax reform and infrastructure spending, the average intermediate-term muni fund gained 1.7% during the second quarter. Muni bonds across the quality spectrum, across sectors, and in most states posted positive returns for the three months ended June 30. Longer-duration funds generally outperformed those with shorter durations because of the flattening yield curve. High-yield muni-bond funds also performed well, up 2.2% for the quarter. Those that held smaller allocations to troubled Puerto Rico performed even better, including

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