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Following one of the most rapid and severe market drawdowns in history, fixed-income markets roared back to life in an inversely swift recovery over the second quarter of 2020. The Federal Reserve maintained the momentum of its thorough, “kitchen sink” response to the coronavirus-related crisis. After bringing the federal-funds rate toward the zero range at the end of the first quarter, the Federal Open Markets Committee provided forward guidance throughout the second quarter, committing to indefinitely low rates. Though the FOMC ruled out negative rates, the Fed expanded its securities-purchasing regime to include high-yield corporate bonds and provided monetary assistance to both institutional and “Main Street” borrowers through a broad basket of lending facilities and related programs.
Weighing unprecedented government and central bank support for bond markets against the broad impact of the coronavirus, investors poured back into risk assets as well as conservative fixed-income securities, including short and ultrashort bond funds, they had dumped for cash in the sell-off. Most notably, investors piled back into riskier fixed-income assets on “V-shaped recovery” hopes. Leveraged loans, high-yield bonds, and emerging-markets debt, the three biggest losers of the first quarter, reemerged from the rubble in 2020. Their respective Morningstar Category averages returned 12.5%, 8.7%, and 8%. On the other hand, the long government category, which saw its highest return since 2011 in the previous quarter (up 20.5%), posted a nearly flat result.
Government Debt Takes a Backseat Though Fed Chairman Jay Powell strongly committed to keeping rates "lower for longer" throughout the quarter, he stated his intent several times to keep away from a negative rate policy, effectively putting a floor on U.S. rates. After falling dramatically across the curve in the first quarter, U.S. Treasury yields rose slightly on the long and short ends of the curve over the second quarter as investor demand for safe assets waned. The 30-year Treasury Yield, which ended the first quarter at 1.35%, rose to 1.41% at the end of June 2020. Similarly, the three-month Treasury Yield, often used as a proxy for risk-free returns, rose from near zero (0.05%) to 0.16%. Spread widening on the long end of the curve reversed the fortunes of investors in the longest-dated government debt; the Bloomberg Barclays U.S. Treasury Bellwethers 30 Year Index shed 0.7% over the second quarter after rocketing nearly 25% over the first. Investors in intermediate-dated government debt did better, but not impressively. The iShares US Treasury Bond ETF GOVT, which tracks the ICE U.S. Treasury Core Bond Index, rose a mere 0.2% in the second quarter after rising over 8% in the first. Agency mortgages, though buoyed by purchasing programs from the Fed and improving clarity around forbearance programs, too posted only modest results in the second quarter amid the broad rush to risk assets, with the Bloomberg Barclays U.S. MBS Index returning 0.7%.
The Bloomberg Barclays U.S. Aggregate Bond Index, dominated by U.S. Treasuries (40%), investment-grade corporates (27%), and agency mortgages (27%), returned 2.9% over the second quarter. While U.S. Treasuries and agency mortgages were muted, outsize returns in corporate credit buoyed the overall performance of the Aggregate Index. After stumbling precipitously in the first quarter, investment-grade corporates (as tracked by the Bloomberg Barclays US Corporate Bond Index) returned 9% over the second quarter as corporate spreads shrank dramatically from their March highs. Strategies within the intermediate core Morningstar Category with a focus on credit relative to Treasuries generally benefited from these market moves. Gold-rated Baird Aggregate Bond BAGIX, which has long held an overweight to corporate credit relative to the Aggregate Index, returned 4.8% and outpaced three fourths of its distinct rivals.
Full Speed Ahead for Corporate Debt Investors gleefully piled into corporate debt amid optimism over robust central bank and government support for the market. Throughout the quarter, the Fed provided additional ballast for both investment-grade and high-yield corporate bonds, both increasing the scope of its bond-buying program and extending eligibility to "fallen angels" (bonds recently downgraded from investment-grade to high-yield), high-yield exchange-traded funds, and eventually buying individual corporate bonds outright. As a result, investment-grade and high-yield corporate spreads fell far below their March 23 highs by the end of the quarter. Though investment-grade corporates of all quality tiers performed well over the quarter, those with the near-speculative BBB rating outperformed their more high-quality peers. Bronze-rated Invesco Corporate Bond ACCHX, which has often taken more BBB credit risk than its corporate bond category peers, rebounded strongly over the quarter with a 10.1% result.
High-yield bond markets saw a broad recovery in both issuance and spreads as investor optimism for a “V-shaped” recovery outweighed fears around growing downgrade and default rates. Bonds which had previously been slammed by the impact of government-mandated shutdowns, including airlines and energy-related credits, saw significant price appreciation over the quarter. Though the price of oil (West Texas Intermediate) briefly went negative in April amid the worst of the Russo-Saudi oil price war, oil prices saw their strongest quarterly gain in 30 years from around $20 at the end of March to nearly $40 at the end of June. Silver-rated Diamond Hill Corporate Credit DHSTX, which held a large conviction-driven stake in Danish oil-services company WELTEC at the beginning of the quarter, benefited from this recovery and posted a top-quartile (against distinct high-yield bond category peers) 11.1% gain.
Floating-rate loans, too, saw a broad recovery over the quarter, with the S&P/LSTA Leveraged Loan Index posting a strong 9.7% return. Investor interest, however, remained muted with the prospect of rate hikes far away in the horizon, and bank-loan funds continued to see grievous outflows over much of the quarter.
Munis Play Catch-Up Amid Worrying Pandemic Data Whereas corporate credit began to post breathtaking recovery figures in April, both investment-grade and high-yield munis took longer to bounce back amid fears over the impact of government-mandated shutdowns on various issuers. Both investment-grade and high-yield munis suffered losses over the month of April, as investor skepticism over local shutdowns outweighed normalizing issuance and spreads. Over the remainder of the quarter, support from the Federal Reserve via its Municipal Liquidity Facility and optimism over the pace of reopenings drove renewed investor appetite for tax-exempt issues, propelling the Bloomberg Barclays Municipal Index to a respectable 2.7% gain over the quarter. Lower-rated BBB munis slightly outperformed higher-quality munis and high-yield munis, represented by the Bloomberg Barclays High Yield Muni Index, fared better with a 4.6% result as spreads came down significantly from March highs.
As riskier munis eventually rallied across the market, players which have focused more on mid- to low-quality had an easier time of things in the second quarter. Bronze-rated Western Asset Intermediate-Term Muni SBTYX, which has often taken more BBB exposure than its muni national intermediate category rivals, posted a strong 3% return.
Emerging Markets Reemerge Amid Global Bond Rally Central banks around the world, including the European Central Bank, introduced similar quantitative-easing programs and rate cuts to those rolled out by the Federal Reserve, helping boost investor sentiment in both developed and emerging markets. Japanese sovereign bonds, often held as a safe-haven asset, declined in value while riskier Italian and Spanish sovereigns reversed some of their losses from the first quarter. The world bond category also posted a stronger quarterly result (6%) than the world bond USD-hedged category (4.7%) due to the U.S. dollar's decline over the quarter. Gold-rated Dodge & Cox Global Bond DODLX, which materially underperformed its world bond category rivals during the depths of the March sell-off due in part to its concentrations in emerging markets and depreciating currencies such as the Brazilian real and Mexican peso, surged past most peers over the second quarter with an 11.4% gain.
Emerging-markets bonds posted strong results amid a rebound of risk assets. The JPMorgan Emerging Markets Bond Global Diversified Index, a broad basket of hard-currency emerging-markets sovereign debt, climbed by 12.3% over the quarter--this was a strong reversal of fortune from the quarter prior, when the index plummeted 15%. That said, not all markets saw strong rebounds. Political and social turmoil in Brazil, for example, contributed to a depreciation of the Brazilian real over the quarter. Gold-rated Templeton Global Bond TGBAX, a strategy that has long favored emerging-markets local debt and held a large stake in Brazilian bonds, lagged many of its nontraditional bond category peers with a 0.1% return. It also lagged the JPMorgan Emerging Local Markets Index Plus, which tracks a sampling of emerging-markets local currencies; that index posted a 3.4% bounce for the quarter after declining 8.8% the previous quarter.