Bond Funds Year in Review: A Tale of Many Markets

This has been anything but a quiet year for bond-fund investors. The gain on the broad taxable market Bloomberg Barclays U.S. Aggregate Bond Index stood at an unremarkable 1.9% in the closing days of 2016, but that result obscured a number of twists and turns. In January and into early February, plunging oil prices and concerns about the impact of a slowing Chinese economy on global growth sent prices on riskier bonds plummeting and fueled a rally in U.S. Treasuries. Coming into the spring and summer months, the domestic economic picture improved as geopolitical risk took center stage: the Brexit vote in the United Kingdom and the U.S. election. Bond markets reacted sharply to the U.S. election--and the expectation of fiscal stimulus--and an increase in U.S. Treasury yields that started in the third quarter accelerated sharply after Nov. 8.

A Bond Bull and Bear Market All in One Year The first half of the year brought good news for investors in high-quality bond funds, as the Federal Reserve remained on hold and U.S. Treasury yields steadily declined. In the weeks following the U.K.'s Brexit vote, the yield on the 10-year Treasury fell to 1.4% down from more than 2.3% at the beginning of the year. The long-term government-bond Morningstar Category was the top-performing fixed-income category, posting a nearly 13% gain. While not quite as impressive, the Aggregate Index returned a solid 5.3% over the period, and the intermediate-term bond category, home to most core funds, was up close to 5% on average.

The story turned sharply in the year's second half. Rates began to creep up in the third quarter, a trend that accelerated in the weeks following the election. Inflation expectations, as measured by the 10-year break-even inflation rate, also increased sharply. (Break-even inflation rates reflect the difference between yields on Treasury Inflation-Protected Securities and Treasuries of similar maturities.) By the time the Fed hiked rates on Dec. 14, Treasury yields along the yield curve had all increased from their levels at the beginning of the year and the 10-year Treasury yield stood at 2.54%. This meant losses for most high-quality bond categories for the second half through Dec. 22. The long-term government category led the way down with a 12% decline, and the Aggregate Index suffered a roughly 3% loss.

Risk-On for Credit

After getting off to a rough start, credit was a bright spot in 2016. Commodity prices stabilized after the early February low in oil prices, and high-yield and investment-grade corporate bonds rebounded sharply. Credit was also one of the only sectors to hold up relatively well following the election. For the year to date, high yield was the top-performing fixed-income category with a 13% gain; the bank-loan category was not far behind with a 9% return. In both groups, funds with ample exposure to energy and lower-rated credits--which were among the hardest hit in 2015--garnered the most impressive gains. For example,

The rebound in the credit market made its mark on the other categories as well, rewarding funds with sizable allocations to high yield and corporate credit. In the intermediate-bond category, for example,

Global Bond Markets: Negative Yields and a Rebound in Emerging-Markets Debt Developed-markets high-quality bonds followed a similar path to U.S. Treasuries, with yields falling through the first half. That drove the stock of bonds with negative yields to an estimated $13 trillion as of early August, sending prices soaring. As in the U.S., yields started to rise in the third quarter, especially after the U.S. election. Still, the negative yield story is far from over. A number of developed European sovereign issuers still have substantial debt outstanding that trades at negative yields, especially in shorter maturities.

Buoyed by stabilizing commodity prices, emerging-markets bonds enjoyed a strong year. Although the category suffered losses following the U.S. elections, the median fund in the emerging-markets bond category had posted a 10% year-to-date gain; funds holding exposure to corporates and quasi-sovereigns did particularly well. Although the local currency emerging-markets category also turned in strong returns, the story was more mixed for bonds denominated in local currencies. The Brazilian real, Russian rouble, and South African rand were among the winners. The Mexican peso was a big loser, however, with concerns about the outcome of the U.S. election taking a toll.

A rally in emerging-markets debt was good news for some of the more aggressive entrants in the world-bond category. For example,

Munis: A Lackluster Showing Back in the United States, munis lagged early in the year and prices tumbled in the fourth quarter. Increases in broad market bond yields and the expectations of more-hawkish Fed policies took their toll, as did a surge in supply during the fall. Uncertainties surrounding the likely tax and fiscal policy of the incoming Trump administration had a disproportionate impact on the sector, as investors worried tax cuts would reduce the value of the muni tax exemption. The relatively large healthcare sector remained vulnerable to a potential dismantling of the Affordable Care Act. For the year to date, the high-yield muni category posted a 0.5% gain, while most other muni categories were in negative territory.