Bond Funds Endure a Year of Economic Anxiety

Following two years of risk-on market fervor, 2018 delivered a reality check to bond investors.

Even with new leadership, the Federal Reserve continued to raise short-term interest rates and simultaneously pared back its quantitative-easing-inflated balance sheet; both were efforts to normalize monetary policy while U.S. economic data appeared strong. A strengthening dollar, escalating U.S. trade-policy fears, and myriad geopolitical tensions further rattled markets at points throughout the year, which ended with a meager single-basis-point return for the Bloomberg Barclays U.S. Aggregate Bond Index.

The broad intermediate-term bond Morningstar Category lost 50 basis points for the year, though funds with less duration and more-tailored exposure to U.S. Treasuries and mortgages outperformed those with a significant overweight in corporate credit. JPMorgan Mortgage-Backed Securities OMBIX, which has a Morningstar Analyst Rating of Silver, was a good example of this, generating a 1.8% gain for the year, while Gold-rated Western Asset Core Plus Bond WACPX lost 1.5% on the back of significantly more credit exposure and a longer duration.

A Return to Normalcy The Fed's extreme measures in the wake of the 2008 financial crisis, which included years of rock-bottom interest rates and robust purchases of U.S. Treasuries and mortgages, provided support to a fragile economy but also left many questioning when and how the central bank would extricate itself from those programs without upsetting the apple cart.

A decade on, the Fed signaled its answers; chairwoman Janet Yellen initiated a slow but steady increase in short-term rates in late 2017, and successor Jerome Powell followed suit in 2018. Four quarter-point rate hikes--in March, June, September, and December--lifted the federal-funds rate to a 2.25%-2.50% range. Its large balance sheet still under scrutiny, the Fed continued to pare back its U.S. Treasury and agency mortgage holdings, as well.

All of that activity was not lost on the Treasury and agency mortgage markets. The latter eked out a roughly 1% gain for the year despite the impacts of Fed selling and duration extension from expectations that homeowners would pull back on refinancings. The short end of the Treasury curve rose steadily over 2018, while the long end refused to follow at various points, even falling in the fourth quarter. On balance, though, yield spikes in the first and third quarters resulted in a 1.8% loss for Bloomberg Barclays' long Treasury index in 2018, a reversal from its 8.5% return a year prior. When riskier fare sold off in December, investors piled into intermediate-maturity Treasuries. The year-end volatility also stoked speculation of an impending yield-curve inversion--and the possibility of a follow-on recession--as the spread between two- and 10-year Treasuries tightened to 11 basis points in mid-December from 78 basis points in February.

On the Brink Nowhere were anxieties more palpable than in the corporate-credit markets. The prior two calendar years generated healthy returns, underpinned by low interest rates and relatively muted volatility. Many expected the late-2017 passage of U.S. corporate tax reform to boost earnings and provide a counterweight to looming interest-rate hikes. That Goldilocks outcome proved elusive in the bond markets. With the size of outstanding U.S. corporate debt, according to the Securities Industry and Financial Markets Association, having nearly doubled to $9.0 trillion from $5.5 trillion a decade earlier, balance sheets looked more vulnerable in the face of aggressive Fed tightening. A surge of tariff rhetoric tossed between the United States and China also left many fearful of a trade war, and erratic commodity prices--a barrel of West Texas Intermediate oil rose to roughly $77 by late June before reversing course to $44 by late December--only compounded a sense that a recession might come sooner rather than later.

Against this backdrop, investors in corporate credit became jumpy. Investment-grade corporate bonds, where Treasury volatility is felt more sharply than in riskier tiers, toppled 2.5%, while corporate high-yield slipped a less-dramatic 2.1%. The bank-loan sector, with its combination of higher credit risk and floating-rate structure, fared better than investment-grade credit, too, as the S&P/LSTA Leveraged Loan Index returned 0.4% for the year.

The high-yield bond category looked worse on average, with a 2.6% drop in 2018, but it was marked by a range of outcomes. Less duration and more-differentiated security selection worked in favor of some funds, such as Bronze-rated Diamond Hill Corporate Credit DHSTX, which returned 0.6%. Those with a broad risk appetite fared much less well, including Silver-rated Fidelity Capital & Income FAGIX, which has held around 20% of the portfolio in equities and lost 5.8%.

Stressed Currencies and Muted Global Growth Jitters around central-banking policy weren't limited to the U.S. in 2018. The European Central Bank left short-term rates unchanged for the year, but its leader Mario Draghi announced in October that the bank would pare back its asset purchases, suspending the program by the end of the year. Bank of Japan governor Haruhiko Kuroda also signaled in remarks that it was time to limit asset purchases while intending to continue buying JPY 80 trillion a year for asset-price stability.

In either case, the signal is that tightening monetary policy is on the horizon but remains a challenge in the face of anemic global growth. In Japan, inflation is nowhere as high as its target, while the situation in Europe is hampered by political tensions. Two populist political parties formed a governing coalition in Italy, but their proposed budget doesn't comply with European Union guidelines, and the situation has exacerbated tensions around the country's place in the trading bloc. Additionally, a lack of agreement on the terms for the United Kingdom's March 2019 exit from the EU led to contentious politicking and negotiations during 2018 but remained undefined at year's end, keeping Britain's economic uncertainty simmering. Rioters across France protested an increased gas tax, and President Emmanuel Macron relented, another clash of tensions between the reality of slow growth and a political desire to redirect a country's economic future.

Emerging-markets debt also faced challenges. Despite a heated economy, Turkey's central bank refused to raise interest rates, and its currency plummeted roughly 30% relative to the U.S. dollar in the third quarter, before capitulating with a rate hike in September. Argentina was running a large current-account deficit, and creditors became impatient over the course of 2018. Ultimately, the International Monetary Fund stepped in with a bailout package in September, but by the end of the year, the Argentine peso lost half its value relative to the U.S. dollar.

The Bloomberg Barclays Global Aggregate Index lost 1.2% for 2018, while the U.S.-dollar-hedged version of the benchmark fared better given the strengthening dollar and delivered a 1.8% gain. Funds with significant non-U.S. currency exposures and emerging-markets debt allocations were at a disadvantage, such as Silver-rated BrandywineGlobal Global Opportunities Bond GOBSX, which lost 4.9%. In contrast, Gold-rated Templeton Global Bond TGBAX rode its ultrashort duration positioning and currency short to the euro to a 1.4% return for the year, despite holding significant emerging-markets debt.

The Little Engine That Could Back in the U.S., investors worried that demand for municipal bonds would decrease over 2018 with lower tax rates set by the Tax Cuts and Jobs Act, and that the asset class would suffer as interest rates rose. After a first-quarter stumble, though, it regained its footing on the strength of the U.S. economy and muted supply. Through the end of the year, the municipal market remained stable, and aided by healthy technicals in November and December, the sector returned 1.3% for the year. Municipal funds with strong fundamental security selection that were able to navigate market potholes--including tobacco bonds, Puerto Rico, and finicky general-obligation debt--stayed a step ahead of the pack. The winners included Silver-rated Nuveen Intermediate Duration Municipal Bond NUVBX, which returned 1.6% for 2018 relative to the broad muni-national intermediate category's 0.8% gain.