Second-Quarter 2019 Fixed-Income Markets in Review

Mixed signals left bond investors to their own interpretations. The broad Bloomberg Barclays U.S. Aggregate Bond Index generated 3.1%--its highest quarterly return in over seven years--despite signals of slowing economic growth and unpredictable near-term monetary policy actions. In mid-May, the yield curve modestly twitched, as the yield on the 10-year dropped below that on the three-month yield, an event that is widely interpreted as signaling an impending recession. Through June, that yield-curve relationship stayed inverted and fueled expectations that the Federal Reserve would cut rates in the coming months; yet chairman Jerome Powell and his board maintained the 2.25% to 2.5% federal-funds rate at both meetings over the quarter and qualified factors weighing on inflation as merely transitory. Anxieties over a contracting credit cycle underpinned volatility in the corporate-bond markets, as did various tariff threats from the United States aimed at China and Mexico. The corporate-bond Morningstar Category delivered 3.8% from April through June, while the high-yield corporate and bank-loan Morningstar Categories managed positive but far more modest performance than the previous period. The agency mortgage-backed securities portion of the aforementioned index delivered 2.0% for the quarter.

Funds such as Western Asset Core Plus Bond WACPX, which has a Morningstar Analyst Rating of Gold, that have a longer duration profile and selective credit exposure benefited in this environment. Western Asset Core Plus Bond returned 3.9% relative to the median 3.0% of its distinct intermediate core-plus bond Morningstar Category peers. Mortgage-focused Bronze-rated TCW Total Return Bond TGLMX generated 2.8% and lagged that same cohort for the quarter.

Economic anxieties underpinned outflows in riskier fare. Corporate credit markets absorbed wave after wave of challenging headlines, beginning with the connotation of the inverted yield curve, followed by bellicose trade rhetoric emanating from the U.S. In May, the U.S. government increased tariffs on specific Chinese imports, from 10% to 25%, escalating the trade antagonism between the world's two largest economies. By the end of that same month, the U.S. threatened Mexico with tariffs if it didn't assist with immigration along the border between the two countries. Trade instability reverberated through riskier credit markets; high-yield and bank-loan funds experienced outflows in May as investors rotated into higher-quality assets but still returned 2.3% and 1.3%, respectively, for the quarter.

The price of a barrel of West Texas Intermediate oil began the quarter at $62 and climbed through the end of April. Then it fell to a quarter-low of $51 in early June but clawed its way back to end the period at $58. Below investment-grade energy subsequently lost 0.9% for the quarter, the only high-yield subsector to venture into negative territory.

A preference for higher-quality names within the below-investment-grade universe that are also more sensitive to Treasury yield shifts helped buoy the 3.2% gain of Silver-rated Vanguard High-Yield Corporate VWEAX relative to more-adventurous peers, such as Bronze-rated Hotchkis & Wiley High Yield HWHIX, which returned a more muted 1.7%.

Negative-yielding debt increases. Unanswered questions across global bond markets also contributed to waning economic confidence. The United Kingdom's exit from the European Union was delayed until Oct. 31, 2019, as the government has been gridlocked on how to proceed, resulting in the resignation of prime minister Theresa May and an impending election to select a new leader. The pound fell versus the U.S. dollar over the quarter. Italy's economy is weighed down beneath the pressures of austerity and low growth, while Germany sold 10-year bunds yielding negative 0.24%, a record low. In June, these pressures prompted the European Central Bank president, Mario Draghi, to reiterate that the bank would either cut interest rates or continue with asset purchases if inflation remained low. The Bank of Japan also maintained a dovish policy; it kept interest rates at negative 0.1% in June and continued to buy government bonds. The euro and the yen modestly strengthened against the dollar over the quarter.

Emerging markets were also susceptible to geopolitical pressures. In June, the price of Argentina’s sovereigns fell on the hint that a leftist candidate might overtake the pro-reform incumbent. Ukraine’s election of a president with little formal political experience also raised concerns around whether the country would default on its IMF loans. The political uprisings and social unrest in Venezuela continued, and confrontations between Iran and the U.S. escalated fears of a war in the Middle East. Despite the headline risk, hard-currency and local-currency emerging-markets debt Morningstar Categories still managed to generate healthy 3.7% and 4.8% gains, respectively, over the quarter.

Given dovish policies by many central banks, a longer duration as well as selective currency exposures (particularly to the euro and yen) served as advantageous positions. Silver-rated PGIM Global Total Return PZTRX exhibited both and topped the world-bond Morningstar Category with a 4.8% return, while Gold-rated Templeton Global Bond TPINX, another category constituent with one of the shortest durations relative to peers (negative 2.8 years as of June 30, 2019) as well as substantial shorts to the euro and yen, sat at the bottom of the category with a far more modest 0.7% return.

Slow and steady for municipal markets. The Bloomberg Barclays Municipal Index produced a 2.1% gain during the second quarter, supported by favorable market technicals. New supply continued to come in beneath historical levels and demand remained robust from U.S. investors in high-income-tax states as well as from foreign investors who viewed investment-grade municipals as a safe haven from many of the anxieties underpinning riskier taxable markets. The municipal yield curve flattened in April and May before lightly steepening in June, with a flattening overall effect for the quarter. Lower-quality credit outperformed higher quality, and revenue bonds outperformed general-obligation bonds.

As a result, municipal-bond funds positioned with a longer duration and exposure to lower-rated credits benefited over the quarter. With its roughly 5% allocation to BB rated credits and 6.2-year duration, Silver-rated BlackRock National Municipal’s MANLX 2.2% gain outstepped its typical muni national intermediate Morningstar Category peer, for instance. On the other end of the spectrum, Bronze-rated Franklin Federal Intermediate-Term Tax-Free Income FITZX, with its 3.6-year duration, emphasis on A or higher-rated credit, as well as meaningful allocation to general-obligation debt, lagged that same cohort with a 1.5% return.