Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.
In the most tumultuous year since the global financial crisis in 2008, markets experienced significant volatility as investors got to grips with the coronavirus pandemic. The virus roiled fixed-income markets in the first quarter of 2020, causing a wide-scale sell-off in risk assets and a flight to safety, before unprecedented monetary and fiscal stimulus paved the way for a rebound in credit that flowed throughout the remainder of the year.
Ultimately, all fixed-income Morningstar Categories generated a positive return in 2020. Long government funds led the way, with an average return of 17.5%, while bank-loan funds trailed the pack with an average gain of 1.3%. The Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for typical U.S. core bond exposure, returned 7.5% for the year, not far below its 8.7% return in 2019’s far less rocky environment.
An Unprecedented Fed Response When coronavirus-related market turmoil gathered pace in March with credit spreads blowing out and liquidity drying up, the Federal Reserve took quick and decisive action, cutting the federal-funds rate by a total of 150 basis points, reinstating large-scale quantitative easing, and launching a number of programs to support the smooth functioning of markets. U.S. Treasury yields fell across maturities in the first quarter, while the curve modestly steepened over the rest of the year as risk assets recovered.
The Fed continued its dovish tone throughout 2020, maintaining the pace of its bond purchases and indicating that rates will likely remain close to zero through the end of 2023. In August 2020, the U.S. central bank introduced an average inflation targeting framework, which allows for periods wherein inflation overshoots the central bank’s target. Amid that backdrop, inflation expectations rose over the year and the Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index gained 11.0%, boosting strategies with stakes in the sector.
The Bloomberg Barclays Long Treasury Index rose 17.7% over the year, propelled by its elevated sensitivity to rate cuts in the first quarter, before it modestly pared some of its gains in the fourth quarter as investors began to anticipate a steepening yield curve. Strategies with longer duration, a measure of interest-rate sensitivity, were big beneficiaries of falling rates and, as such, ranked among the top bond-fund performers in 2020. For instance, Pimco Long Duration Total Return PLRIX, which has a Morningstar Analyst Rating of Silver, gained 17.8% for the year, aided by both its duration stance and healthy exposure to credit sectors.
Within the intermediate core and core-plus bond Morningstar Categories, strategies that were able to nimbly pivot from a conservative, Treasury-heavy posture to a more credit-heavy stance were the top performers in 2020. Silver-rated American Funds Bond Fund of America RBFGX and Bronze-rated Carillon Reams Core Plus Bond SCPZX were two such offerings, rising 11.1% and 16.6%, respectively, outpacing nearly all peers in their respective core and core-plus categories.
Credit Busted, Then Boomed As economic activity ground to a halt, corporate spreads widened dramatically in the first quarter. However, that didn't last long. The Fed's investment-grade corporate credit programs initiated in March sparked a rebound, which mostly offset the first-quarter losses. In April, those programs were expanded to include fallen angels and high-yield exchange-traded funds, fueling the uptrend momentum. Energy bonds also had to contend with a crash in oil prices triggered by a Saudi-Russo price war. Crude Oil (WTI) fell below $20 a barrel in April, at one point falling into negative territory, before regaining some ground over the remainder of the year to end it at $49, having started 2020 at roughly $60.
The Bloomberg Barclays U.S Investment Grade Corporate Index and U.S. Corporate High Yield Index gained 9.9% and 7.1% for the year, respectively. AAA rated credits outperformed overall, thanks in part to their relative strength during the first quarter, though BBB and BB rated issues weren’t far behind at the end of the year, while lower-rated credits lagged, despite leading the way in the second half of the year. The top performers in the high-yield Morningstar Category largely consisted of funds that tread carefully in the lowest-rated names. Silver-rated Diamond Hill Corporate Credit DHSTX was within that group, with an 9.7% gain that bested over 90% of category peers.
Meanwhile, as the prospect of rate hikes extended into the horizon, floating-rate bank loans trailed in 2020, with the S&P/LSTA Leveraged Loan Index returning 3.1% for the year. On the other hand, strategies that invest in convertibles, hybrid securities that combine debt and equity characteristics, rocketed 38% on average over the year, thanks to a red-hot equity rally since March.
Negative Yields on the Rise Across the Globe Alongside the Fed, central banks across the globe responded robustly to the coronavirus pandemic, introducing a range of expansionary measures. The European Central Bank's asset purchase program has steadily expanded since its introduction in March 2020, most recently increasing by a further EUR 500 billion in December 2020, to a total of EUR 1.85 trillion. Elsewhere, the Bank of Japan also expanded asset purchases and continued its yield-curve control program. Amid the backdrop of supportive monetary policy, negative-yielding debt swelled to roughly $18 trillion globally, up from $11 trillion at the start of the year.
The U.S. dollar initially strengthened relative to a basket of currencies amid the first quarter flight to safety, but low rates and an increase in risk appetite weighed on the dollar over the last nine months of the year, helping the unhedged version of the Bloomberg Barclays Global Aggregate Index return 9.2%, while the U.S.-dollar-hedged version trailed with a 5.6% gain. Bronze-rated BrandywineGLOBAL Global Opportunities Bond’s GOBSX willingness to load up on beaten-down bonds and currencies gave it a significant boost during the post-March rebound, helping it rise 12.7% over the year.
Emerging-markets debt plunged when investors sought out safe havens in February and March, though it has rallied since as investors have begun to eye higher relative yields. China has been one of the bright spots, with economic activity in the nation rebounding close to pre-pandemic levels. All in all, local-currency-denominated emerging-markets debt lagged hard-currency fare, with the J.P. Morgan Index for the former rising 2.7%, while the latter added 5.3% for the year.
Demand for Munis Holds Up Municipal debt wasn't spared during March's market panic, as investors weighed the impact of pandemic-induced shutdowns on states and local municipalities. Support from the Fed via its municipal liquidity facility fueled a bounceback in the second quarter, and munis continued to recover ground over the remainder of the year. Political uncertainty and low rates prompted municipalities to bring a glut of new issuance to the market prior to November's U.S. election, helping push long-term muni sales for the year to the highest total annual volume on record. However, robust demand met the burst of supply, and munis came through the election unscathed, helping the Bloomberg Barclays Municipal Bond Index ultimately add 5.2% over the year.
Muni issuers with greater financial flexibility and sources of revenue less linked to economic activity fared better overall, while lower-rated fare trailed despite leading the pack during the second half of the year. Low rates also saw longer-duration muni bonds outperform. As such, strategies within the muni national long Morningstar Category were among the muni best performers. Bronze-rated MainStay MacKay Tax Free Bond MTBIX and Gold-rated Vanguard Long-Term Tax-Exempt VWLUX were two such funds, rising 6.4% and 6.3%, respectively, aided by a common emphasis on higher-quality fare.