How Did Bond Funds Fare in the Second Quarter?

Rates on the Move The Federal Reserve elected to maintain rates in May but followed up with a 0.25-point rise in June, continuing a trajectory of tighter monetary policy that began at the beginning of 2016. Over the quarter, the yield on the 10-year U.S. Treasury oscillated between 3.0% and 3.3%, driven by expectations of rising inflation and continued concerns over growing U.S. government debt. The 10-year U.S. Treasury ended the quarter at 2.9%, well above its 2.5% starting point for the year. In general, yields on short- to intermediate-term bonds increased more than those on long bonds, contributing to a flattening of the yield curve. As of June 30, the difference between the 30-year and five-year points tightened to 25 basis points at the end of the period from 42 basis points at the quarter's start.

Of particular note, demand for longer maturities remained strong, with a modest drop in those yields, particularly in May, contributing to a 31-basis-point gain for the Bloomberg Barclays U.S. Treasury Long Index over the quarter. Stubbornly low yields on longer-maturity bonds have stoked anxieties over the possibility of an inverted yield curve in the near future, a potential indicator of a forthcoming recession. Treasury Inflation-Protected Securities delivered 77 basis points on a wave of increased inflation expectations. Mortgages eked out a 0.25-point return for that same period, while asset-backed securities, bolstered by strong enough underlying U.S. consumer data and a positively performing auto-loan subsector, shone in the securitized sphere by generating 42 basis points of return.

Given a backdrop of rising rates and geopolitical tensions, the Bloomberg Barclays U.S. Aggregate Bond Index held up reasonably well over the quarter, losing a modest 16 basis points relative to the first quarter’s 1.5% dip. The index’s underlying corporate-credit component was the weightiest drag on performance. The intermediate-term bond Morningstar Category lost 0.24% for the quarter. Funds with shorter duration and exposure to ABS and Treasuries had an advantage. For example, Silver-rated

Fidelity Intermediate Bond

FTHRX produced 4 basis points of positive return for the quarter with biases to that profile. In contrast, Gold-rated

Western Asset Core Plus Bond

WACPX, with its currency exposure, healthy allocation to investment-grade credit, and 7.2 years of duration, lost 1.5% for the quarter.

The Highs and Lows of Corporate Credit U.S. investment-grade corporate credit lost 0.98% for the second quarter, less than its first-quarter 2.3% drop, but motivated by similar dynamics, including rising interest rates, bellicose U.S. threats around trade, and a strengthening dollar that has made the hedging costs for foreign buyers unpalatable. In May, the U.S. imposed steel and aluminum tariffs of 25% and 10%, respectively, on its allies, contributing to counter-actions and heightened uncertainty surrounding the direction of the global economy. In contrast, high-yield credit produced 1.0% of return for the quarter, with lower credit tiers outperforming higher credit tiers, signalling that broad confidence in credit markets remains healthy. The energy sector benefited from rising oil prices, which were coaxed upward following expectations of reduced supply given the U.S. departure from the Iran nuclear deal in early May. The West Texas Intermediate crude oil price rose to around $70 at the end of the quarter, up from around $60 at the period's start.

Within the high-yield category, funds with greater exposure to lower-quality tiers of credit outperformed. Bronze-rated

Artisan High Income

ARTFX generated 1.2%, well above the high-yield category’s 0.56% gain, given its larger exposure to CCC rated credits and energy exposures, while more-conservative high-yield options, such as Silver-rated

Vanguard High-Yield Corporate

VWEHX, generated a much more modest 0.34%.

Munis Were a Relative Bright Spot

Against the backdrop of solid economic growth and relatively constrained supply, municipal bonds posted a solid showing over the quarter, with gains across the muni categories. Longer-maturity muni bonds and high-yield munis led the pack, with tobacco-backed securities and Puerto Rico turning in particularly strong performances. As a result, the high-yield muni category posted a 1.7% gain for the quarter, contributing to a 1.6% return for the year to date. Bronze-rated

MainStay MacKay High Yield Municipal Bond

MMHIX was up 2.9% for the quarter.

Outside the U.S.

The U.S. dollar strengthened against the euro and the yen over the quarter. In June, the European Central Bank reiterated that it would pare back its quantitative easing slowly but surely. However, pressures on Italian banks, coupled with fiery geopolitical arguments across the eurozone, did little to bolster the continent’s market outlook. The Bank of Japan continues to grapple with underwhelming inflation numbers. As a result, funds with heavier U.S. dollar exposure were among the better performers for the quarter, including

AB Global Bond

ANAGX and

PIMCO Global Bond (USD-Hedged)

PAIIX, which were roughly flat.

Emerging markets have come under even greater pressure in the second quarter, owing to the stronger U.S. dollar and negative headlines in a handful of countries including Argentina and Turkey. Local-currency emerging-markets debt experienced the swiftest sell-off for the period. To illustrate, Bronze-rated

TCW Emerging Markets Local Currency Income

TGWIX slid by 11%. Funds like Neutral-rated

PIMCO Emerging Markets Bond

PEBIX that had some emerging-markets corporate bond exposure, which held in relatively well for the quarter, fared better. That fund was down 3%. Global-bond funds with emerging-markets currency exposure were hit harder as well: Silver-rated

BrandywineGLOBAL Global Opportunities Bond

GOBIX was down 7% owing to its heavy helpings in the Mexican peso and Malaysian ringgit.