Fed Tightens Policy Amid Rising Inflation
U.S. interest rates continued to march higher during the second quarter, as the Federal Reserve raised short-term interest rates by 50 basis points on May 4 and 75 basis points on June 15. As the quarter ended on June 30, U.S. Treasury rates with maturities of two, five, 10, and 30 years each rose between 67 and 69 basis points from the end of the first quarter, a highly unusual parallel increase in the U.S. Treasury yield curve over a very short period.
All major Morningstar fixed-income fund categories are on pace to lose money for a second consecutive quarter. For the year to date as of May 31, 2022, floating-rate bank-loan funds lost the least, with the S&P/LSTA Leveraged Loan Index losing 2.8%. T. Rowe Price Floating Rate RPIFX, which has a Morningstar Analyst Rating of Gold, modestly outperformed that return with a decline of just 2.6%. Investors are attracted to these funds because the bonds’ interest rates reset every one to three months and are collateralized with a company’s assets. With inflation at levels not seen in almost 40 years, U.S. Treasury Inflation-Protected Securities held up better than nominal Treasuries and placed second among fixed-income categories, with a 3.0% drop. Gold-rated Vanguard Short-Term Inflation-Protected Securities Index fund VTAPX benefitted from its shorter duration mandate (a measure of interest-rate sensitivity) relative to its peers and finished in its Morningstar Category’s top decile.
Other sectors fared much worse. The Bloomberg U.S. Aggregate Bond Index, which comprises U.S. Treasuries, agency-backed mortgage-backed securities, and investment-grade corporates, fell 8.9%. Widening credit spreads played a bigger role in the index’s negative return than surging interest rates. The Bloomberg U.S. Treasury Index lost 8.3%, less than the Aggregate Index, while investment-grade corporate bonds were the largest detractors, shedding more than 13%. The noncyclical industries of cable/satellite and domestic telecom, and the cyclical metals/mining industry were the biggest losers. Noncyclical paper/packaging and consumer products, and the cyclical automotive industry did relatively better. Consequently, because of the relative safety provided by AAA rated securitized bonds, the Bloomberg U.S. MBS Index outperformed both the aggregate and treasury indexes, falling 7.3%. Bronze-rated Guggenheim Total Return GIBIX lost 10.9% for the year to date, 200 basis points worse than its Bloomberg Aggregate benchmark, and ranking in the category’s lowest decile. The fund massively overweighted credit risk, with an 87% allocation to credit and liquidity-sensitive sectors, versus 59% for the benchmark, as of May 31, 2022.
High yield was one of the better performing fixed-income asset classes, with the ICE BofA U.S. High Yield Constrained Index falling 7.7%. The investment-grade index dropped more than the high-yield index because its higher duration—8.7 versus 4.5 years—made it much more sensitive to rising rates. However, current corporate credit fundamentals remain strong. In high yield, buyers started to add credit risk in higher-quality BB rated issuers in May as nominal yields became attractive owing to the combination of rising rates and widening credit spreads. Since fears of a recession are dominating news headlines, investors are mostly avoiding single B and CCC rated issuers.
Emerging-markets bond funds suffered the sharpest decline relative to other asset classes so far in 2022, as the rally in the U.S. dollar relative to emerging-markets currencies has sunk bond prices for issuers of U.S. dollar-denominated bonds. Year to date through May 31, 2022, the JPMorgan EMBI Global Index fell 15%, its worst five-month performance since 1994.
Bronze-rated Invesco Total Return Bond ETF GTO has struggled with lowest-quartile performance for the year to date as of May 31, 2022, because of out-of-benchmark allocations near 10% in both high-yield and emerging-markets debt. This exchange-traded fund has often had top-quartile performance relative to its intermediate core-plus bond Morningstar Category peers over the past several years.
Muni Returns Were Also Painful for Investors
Rates also continued to rise in the muni market, with the yield on two-year AAA rated bonds rising 14 basis points to 1.97% between the end of the first quarter and June 27, 2022, and the yield on 10-year AAA rated bonds rising 32 basis points to 2.79%. The Bloomberg Municipal Bond Index lost 7.5% for the year to date as of May 31, 2022, which was less than U.S. Treasury, high-yield, and investment-grade corporate bonds’ losses. Similar losses in many muni strategies pushed investors toward the doors; they have redeemed more than $80 billion so far in 2022, exceeding other recent big outflow years in 2020, 2018, and 2013. Higher rates have also dampened new issuance, with muni sales down 14% from the same period in 2021 to at $189 billion.
The second quarter historically has been a stronger trading environment and that has held true this year. Muni funds posted their first monthly gain of 2022 in May and their first week of inflows since February. Large muni fund managers Pimco and BlackRock both expect the sector to benefit from seasonal strength in June, July, and August. During these months, issuance has historically been lower than the cash flowing into muni funds from calls, coupon payments, and maturities. This could provide a tailwind for munis relative to taxable-bond sectors. However, widening credit spreads could hinder any rebound. The extra yield that investors are demanding for single A and BBB rated issuers relative to AAA rated issuers is the most since early 2019. As the risk of a recession continues to rise, credit spreads could widen further, despite any credit-quality concerns with municipalities at this time.
Some municipal portfolio managers see opportunities in the market volatility. Muni strategies with robust management teams and sophisticated tools have stood up well against peers in their respective categories in both strong and turbulent muni markets. Vanguard’s attractively priced intermediate muni funds, Fidelity Intermediate Municipal Income FLTMX, and T. Rowe Price Summit Municipal Intermediate PRSMX, each lost less than their median rival as of June 27, 2022. The same holds true for these firms’ funds in the muni-national long category as well as T. Rowe Price Tax-Free High Yield PRFHX, which fared better than its average peer in the high-yield muni category.