The Third Quarter in Bond Funds

After a three-year stretch of interest-rate hikes that ended in late 2018, the Federal Open Markets Committee approved a rate cut in July 2019 for the first time since the financial crisis, affecting global markets on multiple fronts.

Fed Chairman Jerome Powell described that 25-basis-point cut as a "midcycle adjustment" and "not the beginning of a long series of rate cuts." At the time, that spooked markets as it made additional future cuts appear less likely. Powell led a subsequent quarter-point cut in September, though, effectively bringing the federal-funds target rate to between 1.75% and 2%.

In a rare act, the Fed also injected billions of dollars into the overnight repurchase agreement market in mid-September to stabilize it and ultimately loosen the cash crunch observed in mid-September. The so-called repo market, which facilitates short-term financing across the financial system, is typically prized for its liquidity and low risk. However, a funding mismatch existed between an excess supply of Treasuries and insufficient bank reserves. This imbalance contributed to the rate spiking as high as 10%.

The European Central Bank eased, too, cutting its deposit rate to negative 0.5% from negative 0.4% in September and committing to an additional EUR 20 billion per month stimulus package for the foreseeable future. ECB President Mario Draghi suggested that rates will remain low until both inflation and growth prospects near the governing body's target.

Treasury Yields Continue Their Fall The Treasury curve remained inverted over the quarter, signaling an impending recession to many investors. Investors flocked to U.S. Treasuries in search of safety, and the demand added downward pressure across the curve, though more at the shorter and longer ends. The yield on the 10-year Treasury dropped to 1.47% before retracing upward to end the period at 1.65%. The 30-year Treasury breached the 2% threshold and marked an all-time low at 1.94%.

Mixed economic data across jobs, inflation, and slowing gross domestic product growth, combined with sour trade negotiations between the Unites States and China, played a role in heightened demand for government debt. The U.S. imposed additional tariffs on Chinese goods and even labeled the nation a currency manipulator. The higher tariffs and greater uncertainty surrounding trade weighed on corporate earnings, though many analysts still argue that fundamentals remain solid.

The Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for the U.S. investment-grade market, gained 2.3% during the quarter. Investment-grade corporate debt added 3.1% while U.S. Treasuries were up 2.4% as yields continued their precipitous drop. Overall, funds with longer duration profiles generally benefited from the Fed's dovish signals and outearned those positioned at the short end.

As such, within the intermediate core-plus bond Morningstar Category, Bronze-rated Invesco Core Plus Bond ACPSX added 2.9% on the back of an above-average stake in speculative-grade bonds and midquality corporates. In contrast, strategies with a more defensive posture borne of higher credit quality or larger cash stakes, such as Gold-rated Loomis Sayles Core Plus Bond NEFRX, still returned 2.1%.

Corporate Markets Diverge On the other hand, investors have been pulling money out of credit-sensitive bank-loan funds--whose payouts float with short-term rates--since the Fed pivoted in late 2018. Despite positive corporate performance across credit tiers, high-yield corporate offerings trailed BBB rated issues, which tend to be more sensitive to changes in interest rates. Energy-related debt was affected by seesawing crude-oil prices amid political turmoil in the Middle East. An attack on a Saudi Arabian oil facility in mid-September sent benchmark Brent crude oil prices higher soon after: It reached approximately $70 per barrel before receding to around $60.

Strategies with greater exposure to energy and other commodity-related industries were challenged for the quarter. Gold-rated BlackRock High Yield Bond BHYIX added 2.1%.

Global Bond Happenings Yields on developed-markets government debt also dropped during the quarter around the world, pushing the U.S.-dollar hedged Bloomberg Barclays Global Aggregate Bond Index up 2.6%. Negative-yielding debt accounted for $15 trillion, up from approximately $13 trillion at the end of the prior quarter.

The JPMorgan Emerging Markets Bond Index Global Diversified, which tracks the performance of hard-currency emerging-markets debt, returned a modest 1.5% over the period. Many currencies and geographies experienced mid- to high-single-digit gains, but Argentina comprised more than 2% of the index at midyear, and its awful third-quarter performance was exceeded only by Venezuela. Venezuela's troubles were already well-known, but Argentine voters surprised investors as market-friendly President Mauricio Macri lost in primary elections to left-leaning Alberto Fernandez. Following the landslide defeat, the Argentine peso plummeted against the U.S. dollar and the country's debt lost over 40% for the quarter. Local-currency-denominated Argentina debt was hit even harder, and funds with exposure there paid a price: Gold-rated Templeton Global Bond TPINX was among those with low- to mid-single-digit stakes in the troubled nation's debt and lost 3.2%. But all global funds did not suffer the same fate. Silver-rated PGIM Global Total Return PBTRX gained 2.2% for the period. The fund held less than 1% in Argentine debt throughout the quarter.

Technicals Drive Municipal Bond Market The Bloomberg Barclays Municipal Index produced a 1.6% gain during the third quarter as investor demand outstripped modest new issuance for most of the period. Foreign investors and U.S. buyers in high-income-tax states continued to seek attractive yields from a relatively safe corner of the market. Despite the muni curve's modest flattening, it remained relatively steeper than the U.S. Treasury yield curve from the prior period.

That said, municipal bond strategies with longer duration profiles did benefit from the long-maturity rally, outperforming their shorter counterparts, as did funds that ventured into lower-rated debt. Bronze-rated American Funds Tax-Exempt Bond AFTEX generated a 1.7% gain for the quarter. Its approximately 6.0-year duration added to returns, while Bronze-rated Franklin Federal Intermediate-Term Tax-Free Income FITZX maintained a short profile and returned just 1.0%.