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The Second Quarter in Bond Funds

A respite from rising rates.

Spring bloomed in more than one place in the second quarter of 2021, with fixed-income markets turning in a solid performance following a rocky first quarter. The bond market was buoyed by weak to mixed economic signals, including retail sales reports that fell short of expectations and disappointingly slow job creation. These indications that the ongoing economic recovery might have hit a speed bump drove yields lower and prices higher.

As a result, long bonds generally outperformed while short-maturity bonds lagged. The Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for typical U.S. core bond exposure, gained 1.8% for the second quarter after losing 3.4% last quarter. Despite the reversal in bond yields, two themes from the first quarter held. One is the stretch for yield as investors favored more aggressive sectors, and the second is inflation, as the Consumer Price Index continued to surge, up 5% year-over-year through May 2021. That led to strong performance for sectors including high-yield bonds and Treasury Inflation-Protected Securities.

Rate Reversal

Interest rates generally declined through the quarter in response to a variety of mixed or disappointing data surrounding the ongoing economic recovery. After rising 81 basis points in the first quarter, the yield on the 10-year Treasury note fell roughly 30 basis points in the second quarter and sat at 1.4% at the end of June.

In the face of rising inflation and a bumpy economic recovery, the Federal Reserve remained steady throughout the quarter and kept short-term interest rates near zero. In their June meeting, Fed members indicated that they expect to begin hiking short-term rates in 2023; and even though May's 5% CPI number was the highest 12-month increase since 2008, they reaffirmed their belief that current inflation is transitory. At the same time, investors reacted to rumblings that the Fed might soon begin to taper its bond-buying program. In response, the yield curve flattened as short-term rates jumped while longer-term yields held steady or declined. This further contributed to long bonds' relative outperformance for the quarter.

As a result, funds with a longer duration--and thus more interest-rate sensitivity--than peers and their benchmarks generally outperformed. Examples within the intermediate core and core-plus bond Morningstar Categories included Western Asset Core Bond WATFX and PGIM Total Return Bond PDBZX, which gained 2.2% and 3.1%, respectively, for the second quarter, topping most of their category peers.

Meanwhile, the rate reversal also impacted mortgage-heavy funds. Falling rates generally drive an increase in prepayment risk, which can weigh down mortgage bond returns. After holding up relatively well in the first quarter, funds like Fidelity Advisor Mortgage Securities FIKUX and Putnam Mortgage Securities PUSYX trailed their respective core bond and core-plus bond peers in the second quarter.

Compounding Credit

The rally in yields also drove performance in more credit-sensitive parts of the market. While high-yield corporate bonds outperformed investment-grade corporates in the first quarter, the more rate-sensitive investment-grade cohort benefited from falling yields and outperformed in the second quarter. For example, the Bloomberg Barclays U.S. Corporate Bond Index gained 3.6%, while the Bloomberg Barclays U.S. Corporate High Yield Index returned a still-respectable 2.7%. Despite this recent reversal, high-yield bonds are ahead of their investment-grade counterparts for the year to date because the latter suffered heavily in the first quarter.

Within the high-yield category, funds with elevated exposure to lower-rated credits and/or equities proved to be the best performers, consistent with the prior quarter. Indeed, the Bloomberg Barclays U.S. High Yield Ca to D Index gained 12.5% in the second quarter after a 14.6% rip in the first quarter. While this slice of the market is typically less liquid and doesn't often appear in open-end funds, its performance still speaks to investors' demand for yield and risk.

The top performers in the high-yield category included Fidelity Capital & Income FAGIX, which gained 4.1% in the second quarter partly because of its roughly 20% allocation to equities. Laggards included explicitly short-duration offerings, like Shenkman Capital Short Duration High Income SCFIX, as well as funds that go short Treasury futures to hedge duration, such as First Trust Tactical High Yield ETF HYLS.

The changing rate dynamic also impacted bank-loan returns, which benefit from rising rates but generally lag when rates fall. The S&P/LSTA Leveraged Loan Index only gained 1.5% for the quarter. Convertible bonds, hybrid securities that combine debt and equity characteristics, continued to benefit from the continued upswing in equities, although they enjoyed more modest gains than they did in the first quarter. For example, the ICE Bank of America U.S. Convertible Index was up roughly 3.6% in the second quarter.

Global Gain

Falling U.S. interest rates and an uneven American economic recovery led to a weakening of the U.S. dollar relative to a basket of currencies over the quarter, which buoyed unhedged strategies over hedged strategies. For example, the unhedged Bloomberg Barclays Global Aggregate Index gained 1.4% in the second quarter, while the hedged version only gained 0.9%. One of the best performers in the quarter was BrandywineGLOBAL Global Opportunities Bond GOBSX, which returned 2.5% thanks to both a variety of non-U.S.-dollar exposure and a helping of credit-sensitive assets. A similar theme played out across emerging-markets bond funds, although the hedged/unhedged divergence was less pronounced there.

Infrastructure Week

The major news story in the muni market was the potential passage of an infrastructure bill, with a bipartisan version approaching approval near the end of the quarter. The proposed bill would invest $1.2 trillion into roads, bridges, tunnels, and a variety of other projects and initiatives, possibly fueling a flood of muni-bond issuance.

Municipal bonds also benefited from both falling rates and the reach for yield. The Bloomberg Barclays High Yield Municipal Bond Index returned 3.8% for the quarter, outperforming every sector except for long-term Treasuries and the junkiest parts of the corporate market. High-yield munis tend to have a longer duration than high-yield corporate bonds, which makes them very sensitive to swings in interest rates. BlackRock High Yield Municipal MAYHX remains one of the top year-to-date performers in the category, gaining 4.9% in the second quarter following a 2.5% gain in the first quarter. Meanwhile, the investment-grade Bloomberg Barclays Municipal Bond Index returned 1.4% for the quarter.

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