The Year in Bond Funds 2019

This past year was one of the best since the financial crisis for fixed-income returns. The year started with a significant dovish shift in Federal Reserve policy, which led to increased demand for both interest-rate and credit risk. Because of the Fed’s pause, followed by rate cuts in the second half of the year, the environment remained supportive throughout 2019.

Every bond fund Morningstar Category had positive returns in 2019, led by the 19.3% average return on long-term bond funds, while the worst-performing category (ultrashort bond) still posted a respectable average return of 3.1%. The Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for typical U.S. core bond exposure, returned 8.7%, its best year since the financial crisis.

Let’s take a deeper dive into some of these dynamics and explore how they impacted bond-fund performance.

The Fed Pivot Based on its view that the U.S. economy was strong and growing, the Federal Reserve hiked its target interest-rate range four times in 2018, from 1.25%-1.50% to 2.25%-2.50%. However, rising rates led to market jitters that finally blossomed late in the year, with the S&P 500 losing over 13% between October and December 2018. Credit-sensitive fixed-income categories (such as high-yield bonds and bank loans) also posted negative returns in that period.

Early in January 2019, however, Federal Reserve chairman Jerome Powell said that the Fed would pause rate hikes and left the door open for rate cuts down the road. This “pivot” led to an immediate shift in market sentiment and began the positive run of returns we see today. The Fed went on to cut rates three times in 2019, down to the current (as of this writing) range of 1.5%-1.75%, nearly completely reversing the prior year’s hiking cycle.

Short-term government-bond yields were the most directly impacted by the Fed’s actions, but long-term bond yields also fell, which, given their greater sensitivity to interest-rate movements, produced big gains. They also benefit from their higher coupons, which make them more attractive to investors hungry for yield and return potential. As a result, the average long-term bond fund returned 19.3% in 2019, the category’s best year in the last decade.

Indeed, duration was the biggest driver of fund returns in 2019. Any manager--in any category--that had a longer duration relative to their peers benefited from that dynamic and likely outperformed.

Credit Not to be outdone, credit sectors also performed extremely well in 2019. In this case, the Fed's pivot reignited demand for both higher-yielding assets and assets expected to do well during periods of easy monetary policy, such as corporate credit. For instance, after experiencing more than $50 billion in net outflows from the beginning of 2017 through the end of 2018, the high-yield bond category took in over $7 billion in 2019 (through November). The corporate-bond Morningstar Category returned 13% on average in 2019, trailed close behind by the high-yield bond category's 12.6% return. While demand for high-yield bonds was robust, the investment-grade category was able to beat it thanks to that cohort's longer duration and greater sensitivity to U.S. Treasury yield movements.

On the other hand, bank-loan funds lagged most other categories, with the average loan fund returning 7.5% for the year. This is still impressive in absolute terms and demonstrates the continued demand for credit-sensitive assets. But because bank loans have a duration near zero, they did not benefit from the Fed’s rate cuts. Indeed, the Fed’s actions reduced the attractiveness of bank loans’ most distinctive feature, their floating-rate coupon that rises and falls along with short-term interest rates. With that benefit negated, investors moved swiftly and pulled $34 billion out of the category (through November). On the other hand, because the Fed now appears to be done cutting rates, we may see demand for loans pick back up.

Emerging Markets and World Bond Among emerging-markets and world-bond funds, the strong U.S. dollar was the primary driver of returns, with unhedged and local-currency funds lagging their dollar-hedged peers. For example, the emerging-markets local-currency bond Morningstar Category returned 11.4% for 2019, while the emerging-markets bond category (which includes strategies that emphasize dollar-denominated debt and mixed portfolios) exceeded that, with a 12.6% return on the year.

This same dynamic played out to an even greater degree among world-bond funds, with the USD-hedged category returning 8.7%, 200 basis points above the unhedged category’s return of 6.7%.

While calendar-year returns were strong across all flavors of the non-U.S. bond market, it was roiled by periodic and localized bouts of volatility. For example, August saw Argentina’s currency and stock and bond markets all crash following the news that market-friendly President Mauricio Macri would most likely not be reelected. Meanwhile, Venezuela remains embroiled in a major political battle between Nicolas Maduro and Juan Guaido. As a result, oil production--which the country is highly dependent on--has fallen precipitously. Bond funds with exposure to one or both countries had a rough time in 2019 and continue to face elevated risks.

As a backdrop to this turmoil, negative-yielding debt around the world rose from $8 billion at the start of the year to over $11 billion by the end of it. European and Japanese bonds make up nearly all of that amount; in particular, the European Central Bank has committed to additional asset purchases in order to hit its inflation target, a policy that is likely to keep rates negative for the foreseeable future.

Municipals Municipal-bond fund returns varied widely depending on the level of interest-rate and credit risk. High-yield muni funds led the year with a 9.1% average return, thanks to both a higher yield and that sector's much longer duration than the rest of the municipal market. Tobacco bonds--one of the largest and most popular sectors for high-yield funds--continued to be one of the best-performing municipal sectors. Meanwhile, Puerto Rico bonds saw their fortunes reverse, and returns were strong in 2019; many fund managers that had historically sworn off owning the territory's debt, such as Nuveen, began adding exposure throughout the year.

The muni national short Morningstar Category was the worst-performing muni category but still turned in a 3.1% return on the year.

Notable Performers Among core-plus bond funds, some of the best performers include Western Asset Core Plus Bond WACPX (2019 return of 12.3%) and PGIM Total Return Bond PDBZX (11.0%), while some of the laggards include Guggenheim Total Return Bond GIBIX (4.7%) and DoubleLine Total Return Bond DBLTX (5.8%).

The wide spread of returns within the intermediate core-plus peer group can be explained by funds’ degree of exposure to interest-rate risk and credit risk. For example, Western Asset Core Plus Bond and PGIM Total Return Bond both had longer durations than the category average and maintained healthy exposure to credit-sensitive assets. Meanwhile, Guggenheim Total Return Bond and DoubleLine Total Return Bond both maintained shorter durations and relatively limited exposure to below-investment-grade corporate debt.

(Editor's Note: This article has been updated to reflect a correction in high-yield bond flows.)