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First-Quarter Sell-Off Soon Roils Calm Fixed-Income Market

The global pandemic caused fixed-income market volatility not seen since the global financial crisis.

Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

The start of 2020 was relatively calm for the fixed-income markets, but things changed rapidly as equities began to sell off on Feb. 20. The credit markets and all other bonds not backed by a developed-markets government were hit the hardest, but even longer-dated U.S. Treasuries and other government debt experienced bouts of volatility between Feb. 20 and March 31. Liquidity became problematic in some areas--notably high-yield, bank loans, and parts of the securitized market--and bid-ask spreads widened to unusual levels. Bond-fund managers were hit with redemptions in most sectors, driving them to sell liquid assets to free up cash, further accelerating the drop in prices in some areas. The credit quality of corporate bonds were put under pressure, especially energy given the oil price drop, and some expect over $200 billion in investment-grade corporates will be downgraded into high-yield territory.

Central banks around the world have lowered rates and purchased government, corporate, and mortgaged-backed debt, helping stabilize some areas of the bond market in the last days of March. But given the swiftness of the overall sell-off and investors' risk aversion, government-bond yields shifted notably lower: The long-government Morningstar Category returned 20.5%, its highest return since the third quarter of 2011 when it climbed by 28%. On the other side, massive dislocations occurred in the riskier parts of the fixed-income universe in March. This caused the most pain in the high-yield, bank-loan, and emerging-markets bond categories, which were down 12.7%, 12.7%, and 14.6%, respectively.

Cash, and Long Treasury Bonds, are King The U.S. Treasury curve shifted drastically lower as investors flocked to safety, though yields swung wildly at times. There were days when Treasuries sold off in tandem with equities as leveraged investors had to unwind trades or investors fled to cash. Yields on 30-year Treasuries, which started the year at 2.4%, dropped below 1.0% for the first time in history on March 9, 2020, before ending the quarter at 1.4%. The decline in yields across the curve benefited funds in the long-government category the most: Its 20.5% average return for the quarter blew past the 4.2% and 2.2% average returns for the intermediate-government and short-government categories, respectively. Fidelity Advisor Government Income's FIKPX slightly longer duration and use of leverage helped its Z share class return 7.0%, close to double the return of the intermediate-government category.

The Bloomberg Barclays U.S. Aggregate Bond Index, which holds roughly 40% in Treasuries, 29% in agency mortgages, and 21% in investment-grade corporates, was up 3.2%. Corporates of all stripes were punished during the sell-off, while exposure to government bonds and agency mortgages was a plus. Strategies in the intermediate core bond category averaged a return of 1.5% (the only other category to post a positive return for the quarter aside from the government categories), while the intermediate core-plus category was down 1.1%. Funds with higher credit risk, either in corporates or structured credit, such as Western Asset Core Bond WATFX, suffered the most. This strategy's institutional share class underperformed its intermediate core category peers by 1.8 percentage points (it was down 0.2% for the quarter) because of its generally riskier profile, which included higher exposure to investment-grade corporates, nonagency residential mortgages, and emerging-markets debt.

Corporate Credit Spreads Spike Initially, investment-grade corporate-bond investors dismissed the economic side effects of the virus, but by mid-March they were in full panic mode. Investment-grade corporate bond spreads reached a peak on March 23, a level similar to high-yield bonds from a few weeks prior. More recently, prices came off their lows as the Federal Reserve announced in late March that it would support both the primary and secondary corporate credit markets by purchasing investment-grade securities.

Bonds that were impacted the most by the government-mandated shutdown in industries such as airlines, cruise lines, and entertainment traded at distressed levels. The energy industry, which makes up 12% of the outstanding high-yield bonds market, fared the worst. Crude oil (WTI) crashed to $20.48 per barrel to end the quarter, down from above $60 at the beginning of the year. The energy segment of the high-yield bond market was down 42% over the quarter. American Beacon SiM High Yield Opportunities' SHOYX Y share class lost 19.3% as a result of its 15% exposure to energy, which was concentrated in the exploration-and-production subindustry and overweight its benchmark.

Bank-loan funds experienced heavy outflows during the sell-off. Many strategies had to call on a line of credit in order to meet redemptions and avoid selling into a weak market. Although the loan market has less energy exposure than the high-yield market, the performance of the bank-loan category was just as bad as the high-yield category, down 12.7%. Eaton Vance Floating-Rate Advantage's EIFAX institutional share class was down 15.7%, partly owing to its use of leverage.

Muni/Treasury Dislocation Municipal bonds sold off along with corporates because of concerns over the government-mandated shutdown. High-yield municipal bonds fared worse than their higher-quality counterparts. Although, even the yields on the highest-quality AAA rated muni bonds saw a significant dislocation from Treasury yields. The muni/Treasury ratio, which was closer to 80% prior to the pandemic-induced sell-off, blew out to over 200% in March. This created an attractive opportunity for some investors to take advantage of high tax-equivalent yields for those willing to assume the credit risk.

The dislocation from Treasuries also caused problems for funds that control duration with Treasury futures and interest-rate swaps, which introduces basis risk. Treasuries typically rally when municipal bonds sell off, which hurts both sides of the basis trade and can amplify losses. Nuveen High Yield Municipal Bond NHMRX deploys this tactic and underperformed most peers in the high-yield muni category. The fund lost 8.6% over the quarter compared with 5.5% for the category average.

Developed-Markets Sovereign Debt Provides Some Safety While Emerging Markets Suffer Sovereign debt from developed markets such as Germany, Japan, and the United Kingdom were safe havens, like U.S. Treasuries, as risk assets sold off globally. Although the U.S. Fed cut interest rates to zero, the U.S. dollar strengthened against almost all global currencies owing to investors flocking to the world's safe havens, which also include the yen and Swiss franc. The U.S. Dollar Index was up 2.8% over the quarter. As a result, the world-bond category's loss of 5.1% was worse than the world bond-USD hedged category's 1.9% loss. BrandywineGlobal Global Opportunities Bond GOBSX, a world-bond fund with significant exposure to emerging-markets debt, suffered as its positions in oil-exporting nations, Brazil and Mexico, were impacted by the plunging commodity price. The fund's IS share class slipped by 11.2%, more than twice the category average.

Yields spiked across emerging-markets debt denominated in U.S. dollars or the local currency during the downturn, and their currencies depreciated against the U.S. dollar. The emerging-markets bond category finished the quarter as the worst-performing fixed-income category, averaging a loss of 14.4%. One of the hardest-hit strategies was TCW Emerging Markets Income TGEIX, which was down 19.2% over the quarter. The strategy was also a victim to declining oil prices, given its heavy exposure to Middle Eastern bonds and other commodity-linked issuers.

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