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A Period of Relative Calm for Bond Funds

Modest gains for most investors, but the riskiest funds continued to flourish in the third quarter.

The third quarter of 2017 was a relatively uneventful one. Although short-term yields ticked up slightly, U.S. Treasury yields across the maturity spectrum finished the quarter remarkably close to their levels as of June 30.

The yield on the 10-year Treasury fell for the first two months of the quarter and bottomed in September amid escalating tensions. However, it then rose sharply and finished the quarter at 2.33%, a modest 2 basis points higher than its level at the end of June. A relatively hawkish tone from the Fed, coupled with the release of the Republican tax plan, was credited for helping to buoy expectations for economic growth and higher rates. 

Stable bond yields translated into modest gains for investors in investment-grade bonds. The Bloomberg Barclays U.S. Aggregate Bond Index finished the quarter with a 0.85% gain, while the intermediate-term bond Morningstar Category posted a 0.88% gain. Gains on low-yielding, short-term debt were the most muted, leaving funds in the various short-term bond categories as laggards for the quarter; the long-term government category also fell to near the bottom of the list following losses in September. Meanwhile, the quarter was generally rewarding for riskier funds, especially those with exposure to emerging-markets local-currency debt, which continued its strong run, and high-yield bonds.

Fed Update
The Federal Reserve did not raise short-term rates in the third quarter but did make news in September with the announcement that it would start to reduce its holdings of mortgages and U.S. Treasuries in October by reducing its reinvestment of principal payments. The plan, which includes a cap on the total volume of mortgages and Treasuries that will be allowed to roll off in any given month, had been well-telegraphed ahead of the meeting. Although chairwoman Janet Yellen acknowledged that inflation remains below the Fed's 2% target, the Federal Reserve also left open the possibility of a rate hike later in the year. As of Oct. 4, the Fed futures market priced in a roughly 75% chance of a December rate hike.

Emerging Markets Still a Bright Spot
Emerging-markets bonds have had a strong run so far in 2017, and that trend continued in the third quarter. Emerging-markets currencies also generally strengthened, with a few exceptions, driving gains for funds with exposure to local-currency bonds, including  Eaton Vance Emerging Markets Local Income (EEIAX) and  PIMCO Emerging Local Bond (PELBX). Both held meaningful stakes in currencies that surged relative to the dollar, including the Brazilian real and Colombian peso. These funds came out near the top of the heap for the year to date through Sept. 30.

Corporate Bonds Continue Their Run
Corporate credit has enjoyed strong returns since hitting bottom in early 2016, and that trend continued in the third quarter, despite a bout of modest volatility in August. Investment-grade corporate bonds had a solid quarter, while high-yield fared even better. The spread on high-yield bonds widened early in the quarter but finished September tighter than its level at the end of June. This tightening indicates that investors require less yield to take on the credit risk in junk bonds and helped buoy prices and returns within the high-yield bond category. That group posted the third-best gain in the fixed-income universe. Funds with relatively large allocations to energy-related fare did particularly well over the quarter.  Eaton Vance Multisector Income , a multisector fund with large allocations to junk bonds and significant stakes in the strong-performing Canadian dollar and Brazilian real, posted a healthy gain.

The equity markets flourished, helping to drive strong returns in funds with large investments in convertible bonds and common stock.  Fidelity Capital & Income (FAGIX), which has held close to a fifth of its portfolio in common stock in recent years, benefited from this surge.

Municipal Bonds
Like their taxable cousins, municipal bonds posted a modest gain over the quarter, with the Bloomberg Barclays Municipal Bond Index up 1.06% over the period. After a solid July and August, the increase in broad market yields and strong supply made for modest losses in September. High-yield muni bonds generally fared a bit better, with the Bloomberg Barclays High Yield Muni Index up 1.5%.

But not all of the muni market's riskiest bonds did equally well. Illinois-related names benefited from an end to that state's budget impasse in early July. However, bonds issued by Puerto Rico fell sharply following Hurricane Maria's devastation of the territory. As a result, performance across the high-yield muni group varied considerably.  Nuveen High Yield Municipal Bond (NHMRX), which benefited from its stakes in Chicago and Illinois and a lack of exposure to Puerto Rico, and  AB High Income Municipal (ABTYX), another aggressive fund that has also largely avoided Puerto Rico, were among the market's winners. However,  Franklin High Yield Tax-Free Income (FRHIX), which retained a 3% stake in Puerto Rico, was up a much more modest 0.3%. That fund also held less exposure than some competitors to below-investment-grade municipals--bonds which carry more credit risk and generally outperformed over the quarter.

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Sarah Bush does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.