Interest Rates Soared in the First Quarter, Crushing Fixed-Income Returns

All major Morningstar fixed-income fund categories fell in 2022’s first quarter as interest rates soared. The Federal Reserve officially raised short-term interest rates by 25 basis points in March for the first time since December 2018, after hinting it would do so for several months. The Bloomberg Aggregate Bond Index, a proxy for the U.S. bond market, fell 6.1%--its worst quarter in almost 40 years--while the average intermediate core bond Morningstar Category fund lost slightly less: 5.9%.

Owing to the rate hikes, the prospect for more rate increases, and the inflation pressures exacerbated by the war in Ukraine, the 2-year U.S. Treasury yield spiked by almost 125 basis points during the quarter, more than doubling from 0.73% on Dec. 31, 2021, to almost 2.32%. The 10-year U.S. Treasury yield rose more than 50 basis points to 2.34%, which flattened the spread between the two yields from 70 basis points at 2022’s start to a low of 2 basis points at quarter-end. The 30-year fixed-rate mortgage rate rose more than 1 full percentage point to 4.37%. Consequently, floating-rate leveraged loan funds were the top performers, while the bank loan category slipped a modest 0.6% in the quarter, a bit deeper than the S&P/LSTA Leveraged Loan Index’s 0.1% decline. One of the indexes with the shortest duration, the Bloomberg US 0-3 Year Corporate Index, was the period’s next best performer, though it lost 1.9%. Long-duration U.S. Treasury funds fared the worst, plunging 10.6% on average.

At least one large fixed-income manager expects inflation and interest-rate risk to persist. At its Cyclical Forum in March, Pimco decided to keep the duration of its strategies modestly short of their benchmarks, owing to the risk that inflation continues to exceed expectations and central banks continue tightening more than expected. The firm also plans to underweight investment-grade corporates and focus on resilient, liquid issuers. Some sectors of the securitized market offer more credit quality relative to corporate credit, the firm said.

Rising Rates Wallop Returns

With inflation expectations rising for the second consecutive quarter, U.S. Treasury Inflation-Protected Securities outperformed nominal Treasuries; the Bloomberg U.S. TIPS Index slumped only 2.9% for the quarter, while the Bloomberg U.S. Treasury Bond Index posted a 5.6% loss. PIMCO Real Return PRTNX fell 3.1%, slightly more than the TIPS index.

Rising rates did not spare AAA rated securitized bonds. The Morningstar U.S. MBS Index fell 5.3%, similar to the Treasury and Municipal indexes’ declines. The Morningstar U.S. Asset-Backed Securities Index, which consists mostly of auto and credit card loans converted into bonds and has a much shorter duration than the MBS Index, dropped by only 2.7%. Strategies that had more money in these securitized sectors, primarily intermediate core and core-plus, performed better in the quarter but still lost money. Mortgage-heavy DoubleLine Total Return DBLTX finished the quarter in its peer group’s top quartile but still dropped 4.8%.

Credit-sensitive strategies also suffered. Credit-related yield spreads widened for corporate bonds in all ratings categories during the quarter, with BBB rated spreads widening by 50 basis points, and high-yield credit spreads widening by over 100 basis points. The Bloomberg U.S. Investment Grade Corporate Index plunged 9.1%, while the Bloomberg U.S Corporate High Yield Index fell only 5.5% over the period. Morningstar U.S. High Yield Bond funds lost less on average: 3.9%. The investment-grade index dropped more than the high-yield index because its much-higher duration makes it more sensitive to rising rates. Fed language promoting a more-aggressive rate-raising plan stoked high-yield investors’ fear of a large economic growth decline later in 2022 and 2023, which would hurt profitability for many high-yield issuers. Fidelity Advisor High Income Advantage FAHCX lost 4.9% in the quarter, less than most high-yield bond peers, thanks to its higher-credit-quality profile.

Leveraged loan funds were the quarter’s top performer as investors embraced the strategies' floating-rate coupons, which increase with interest rates. Widening credit-related yield spreads still took a toll on the sector, though. The most popular benchmark, the S&P/LSTA Leveraged Loan Index, declined 0.1%. T. Rowe Price Floating Rate PRFRX modestly underperformed that index, sliding 0.4%, owing to the benchmark’s larger helping of higher-quality BB rated loans.

Muni Returns Are Also Dismal

The abrupt rise in rates also hit the muni market, with the average Muni National Intermediate fund losing 6.0%, slightly better than the Bloomberg Municipal Bond Index’s 6.2% loss for the quarter and matching U.S. Treasuries’ losses. However, some of the decline is because of trading environment weakness that occurs in the first quarter of most years as many investors pay their tax bills by selling muni holdings. Historically, the second- and third-quarter trading environments can be stronger, so munis could improve relative to U.S. Treasuries later this year. For longer-term investors, the relative value of long-dated muni yields improved after rising more than 100 basis points during the quarter. According to Bank of America, 10-year and 30-year muni yields have risen to 90% of their comparable U.S. Treasury yields, making them relatively cheap compared with taxable-bond yields. The Western Asset Intermediate Term Municipals SBLTX had top-quartile performance, but investors still lost 5.2%.

Investors in lower-quality muni credit funds also felt the pain of higher rates, with the Bloomberg High Yield Municipal Bond Index falling 6.5%. BlackRock High Yield Municipal MAYHX, historically a consistently top-quartile high-yield fund, fell 8.1% for the quarter in part because of its overweighting in lower-rated bonds.

Higher rates also dampened new issuance. For the quarter, muni sales were $82 billion, down 17% from the same period in 2021.