The Bloomberg Barclays U.S. Aggregate Index, a proxy for core bond performance, lost 1.5% for the quarter—its first negative quarterly return in over a year—while the intermediate-term bond Morningstar Category was down a more modest 1.3%. Funds with limited exposure to investment-grade credit held up better, as did those with exposure to non-U.S securities, given a weakening dollar and more robust global growth projections. As interest rates continued their ascent, funds with lower duration, a measure of interest-rate risk, also benefited. The positioning of Loomis Sayles Investment Grade Bond (LSIIX) (with a Morningstar Analyst Rating of Gold), with its combination of lower duration, high-yield holdings, and non-U.S. credit and currency exposures, elevated its performance above 95% of unique intermediate-term category peers, as it gained a modest seven basis points for the quarter.
Monetary Policy Stays the Course
True to its communications, the Federal Reserve continued its policy of a slow but steady tightening of the money supply, even after a change to its chairmanship. After a quarter-point rate rise in December, Janet Yellen maintained the 1.25% interest rate for January before departing the Federal Reserve. Her successor, Jerome Powell, assumed chairmanship responsibilities on Feb. 5, and in his first Federal Open Market Committee address on March 21, announced another quarter-point rise in rates, citing continued strength in U.S. economic fundamentals as an impetus.
From the start to end of the quarter, the yield on the 10-year U.S. Treasury rose to 2.7% from 2.5%. The shape of the yield curve, as signaled by the difference in spread between 30 and two-year U.S. Treasuries, was malleable, with modest flattening in January, steepening in February, followed by more flattening in March. Throughout 2017, despite three rate rises, the longer end of the U.S. Treasury yield curve refused to budge, but that ended with 2018’s first rate move. Funds such as Wasatch-Hoisington US Treasury (WHOSX), with its 22-year duration, lost 4.3% over the quarter.
Expectations of higher inflation as well as the rising rate environment handicapped municipals, whose supply was significantly diminished given the glut of advanced refundings that were issued to front-run the implementation of tax reform in December. Mortgages also suffered lackluster performance because of the same factors, but GNMA securities in particular were singled out for instances of churn in underlying mortgage pools, as nine servicing companies were called out for unnecessarily encouraging veterans to refinance loans. The Bloomberg Barclays GNMA Index and Bloomberg Barclays Municipal Index lost 1.3% and 1.1%, respectively, in the first quarter.
No Shift in Credit Fundamentals
After delivering robust returns throughout 2017, the credit sector’s performance faltered in the first quarter of 2018, primarily due to rising interest rates. The lowest quality tier of the Bloomberg Barclays Investment-Grade Corporate Credit Index—BBB—has roughly doubled in size over the trailing decade, sitting near a high of 13.5% at the end of March 2018, and recent S&P research estimates the number of highly leveraged corporates at 37%, which is five percentage points higher than in 2007, however these signals haven’t deterred credit appetites. In March, CVS Health Corp (CVS) raised $40 billion in the third-largest corporate bond sale on record, as it attempts to finance an acquisition of Aetna (AET) before the end of the year. And the average option-adjusted spread on the Bloomberg Barclays Investment-Grade Corporate Index remained within a historically tight range, despite ending 2017 near a trailing-decade low.
Within U.S. high yield, iHeartMedia (IHRTQ) defaulted on $16 billion of debt, though its situation was widely anticipated and factored into pricing, while broader non-investment-grade corporate funds experienced outflows. But the Bloomberg Barclays High Yield Corporate Index only lost 1.5% for the quarter, relative to its Bloomberg Barclays Investment-grade Corporate Index counterpart’s 2.3% loss. These results signal that credit’s underperformance stemmed from interest-rate sensitivity, which is greater in higher-quality tiers, rather than from underlying credit fundamentals. For example, Silver-rated Vanguard Intermediate-Term Investment-Grade Bond (VFICX), which had one of the highest exposures to AAA rated securities relative to peers in the corporate bond category, lost 1.8% for the quarter, while high-quality core bond option Silver-rated Baird Aggregate Bond (BAGIX) also suffered commensurately relative to its intermediate-term bond options, losing 1.5% over the same period.Non-U.S.-Dollar-Denominated Debt Posted Attractive Returns
More accommodative policies by the European Central Bank and Bank of Japan contrasted with continued tightening at the Federal Reserve, which resulted in attractive performance for funds with select non-U.S. exposures. Five-year yields on government bonds from Germany, Japan, and the Netherlands inched downward throughout the quarter and ended in negative territory, while 10-year yields on each country’s government debt also inched downwards but remained positive.
Also of note, the U.S. dollar’s continued weakness reduced demand from foreign investors searching for yield in shorter-dated U.S.-dollar-denominated securities, as the costs of hedging increased. Beyond the boost from overseas currencies, global growth remained robust, with the Bloomberg Barclays Global Aggregate ex USD Index delivering 3.6%, its highest quarterly return in the trailing two years. Aided by strong country selection and under 20% in U.S. dollar exposure, Silver-rated BrandywineGLOBAL Global Opportunities Bond (GOBSX) topped the world bond category with a healthy 4.1% gain for the quarter.
Emerging-markets bonds, particularly those denominated in local currencies, also fared well due to the weakening U.S. dollar in January and higher oil prices. West Texas Intermediate crude oil surpassed $60 a barrel at the start of the year and remained above that point throughout the quarter. The JPM GBI-EM Global Diversified Index delivered 4.4% for the quarter, one of the most robust returns for a fixed-income sector over the period. Actively managed funds, such as PIMCO Emerging Local Bond (PELBX), delivered an entire percentage point of performance above that benchmark thanks to its heavier emphasis on better performers, including Brazil and Russia.