Despite anxiety over an ever-lengthening credit cycle, contentious trade negotiations, and tightening monetary policy, U.S. fixed-income markets remained resilient over the summer. The Bloomberg Barclays U.S. Aggregate Bond Index delivered a meager 0.02% return in the third quarter. The most rate-sensitive sectors suffered modest losses as yields pushed higher, with the index’s U.S. Treasury and mortgage components each losing 0.59% and 0.12%, respectively, over that period. Investment-grade credit provided a countering lift by generating 0.97% following two quarters of losses.
The broad intermediate-term bond Morningstar Category average returned 20 basis points in the third quarter, but across its constituents, those with shorter durations (a measure of interest-rate sensitivity) and higher allocations to U.S. corporate credit--in particular mid- and lower-quality tiers--generally outperformed. For example, Gold-rated Loomis Sayles Investment Grade Bond (LSIIX) has one of the shortest durations in the category as well as a noticeably higher allocation to below-investment-grade corporate credit; this positioning boosted performance to 0.96% over that period. In contrast, Silver-rated JPMorgan Core Bond (JCBUX), a more securitized-centric option with an up-in-quality bias and longer duration, generated 0.03%, lagging its more intrepid peers.
Rates Continue Onward and Upward
The Federal Reserve raised rates one fourth of a percentage point to 2.25% in September, the third rate hike this year, and that's not the last anticipated move upward given positive economic indicators including low unemployment and increased wage growth. The yield curve remained flat over the period, as the spread between a five-year and 30-year U.S. Treasury waffled between a historically narrow range of 20-30 basis points. Yields also climbed modestly during the quarter; the 10-year U.S. Treasury yield surpassed 3.0% in late September, a peak it hadn’t crossed since May 2018, up from 2.9% at the beginning of July.
The intermediate-government category average lost 0.31% for the quarter, while GNMA-focused funds within that group fared better than peers with significant U.S. Treasury stakes. For example, Gold-rated Vanguard GNMA (VFIIX), which focuses exclusively on GNMA securities, lost 0.17%. Silver-rated BlackRock U.S. Government Bond (PNIGX), with its diversified investment menu that includes half of its portfolio in U.S. Treasuries in addition to modest slivers of non-U.S. sovereign exposure, lost 0.60%. Government bond funds with the flexibility to own some structured credit, such as asset-backed securities, generally fared a bit better (the investment-grade ABS index gained 0.49%).
The Credit Cycle Continues to Lengthen
Investment-grade U.S. corporate credit was under pressure in the first two quarters of 2018, but given improving U.S. economic data and a combination of lighter issuance with strong demand in July and August, the index delivered a 0.97% gain for the third quarter as credit spreads narrowed. While the current credit cycle continues to lengthen, analysts question the underlying fundamentals of the richly priced sector. Corporate leverage ratios sit above historical norms, while increased company cash flows from the recently passed tax reform and overseas earnings repatriation have been used for share repurchases rather than strengthening balance sheets (which would bolster credit fundamentals). Interest rates continue to rise, and diminished liquidity coupled with uncertainties surrounding the effects of in-negotiation trade policies have generated more questions than confidence.
U.S. high yield posted a healthy 2.4% return for the third quarter, supported by a strong corporate earnings season and generally favorable supply-demand dynamics. Primary subsector contributors included mid-stream energy, which delivered 2.6% over the period and benefited from climbing oil prices. Transportation also delivered attractive relative returns, generating 3.1%, while the telecommunications sector provided 3.2%. Generally, lower-quality tiers outperformed higher-quality tiers, with CCC bonds outperforming B and BB bonds. Funds with ample CCC stakes such as Bronze-rated Artisan High Income (APHFX), which gained 2.4%, outpaced the high-yield category average’s 2.0% gain for the quarter.
Non-U.S. Bond Markets Dominated by Politics and Currency Volatility
Non-U.S. developed bond markets struggled in the shadow of political tensions. Though Britain is scheduled to depart the European Union in March of 2019, the details of its separation remain under negotiation, with neither party expressing willingness to compromise on critical factors, in particular, access to the EU’s single market. As a result, global financial institutions with offices in London have begun to execute contingency plans by bolstering their resources on the continent. Meanwhile, the pound sterling experienced a precipitous fall relative to the U.S. dollar in mid-August, though it recovered to end the quarter roughly in the same position as at the start of the period. The euro followed a similar pattern, but its August dip was attributable to concerns around Italy’s budget and widening yields on its debt.
The continued strength of the U.S. dollar coupled with a barrage of idiosyncratic risks across emerging-markets countries contributed to a tough environment for the sector. Turkey, which pursued aggressive economic growth policies over the preceding years, was under pressure as its central bank’s credibility eroded. Argentina’s bonds and currency also struggled, as the IMF agreed to accelerate and increase the size of its bailout. While steep losses for Turkey’s and Argentina’s local currency debt (down 27% and 35% for the quarter, respectively, mainly owing to currency depreciation) dominated headlines, the pain wasn’t widespread. The hard-currency JPMorgan EMBI Global Index resisted contagion and generated a 1.9% return for the quarter, for instance.
Slow and Steady for Municipals
The supply of new municipal issuance was low over the third quarter, a continued consequence of the glut of issuance in late 2017, as well as a typical seasonal downturn for municipals in the summer months. When combined with continued investor demand, the technical backdrop supported municipal performance. Similar to corporates, investors were rewarded for taking more credit risk; the investment-grade Bloomberg Barclays Municipal Index lost 15 basis points for the quarter, while its sibling high-yield index returned 76 basis points. Of note, battered high-yield Puerto Rico holdings generated 8.7% for the quarter, while high-yield municipal tobacco, which has often served as a performance differentiating position over recent quarters, eked out a modest 2 basis points of return. While the muni national intermediate category average lost 16 basis points for the quarter, funds with the flexibility to hold slivers of lower-quality holdings, such as Nuveen Intermediate Duration Municipal Bond (NUVBX), outperformed and generated a positive though modest 0.08% over the period.
Emory Zink does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.