During a quarter in which the multitude of volatility-inducing market headlines seemed to run on a continuous loop, investment grade bonds proved relatively resilient, as returns were flat to slightly positive during the April through June time period. This comes despite a rate increase by the Federal Reserve, another in its series of well telegraphed steps down the path to policy normalization, and also despite a tick-up in inflation to levels more consistent with the Fed’s target of 2%. However, the uncertainty surrounding issues such as global economic growth, trade policy and the indebtedness of emerging economies (just to name a few) has created an environment where the “safe” nature of high quality bonds is in favor. And now that short-term interest rates are off of rock bottom levels, investors are once again reasonably well compensated for investing in fixed income, which we haven’t been able to say for many years now.
2Q18 Index Returns ICE/BAML Intermediate Index Returns (1-10 Yr)
The Fed Funds rate was near 0% from 4Q08 to 4Q16, an abnormally low level for an extended period of time. While this measure helped stimulate the overall economy, it was not good for investors with money in the bank or for fixed income investors looking for income. But times are getting better as the Fed Funds rate target is now 1.75% - 2.0% and projected to go higher. If the Fed’s expectations come to fruition, the Fed Funds rate could be around 3.0% by the end of 2020. With longer rates having risen early in the year and now stabilized, the environment we have described previously as the “sweet spot” for bond investors may be upon us, where short-term bonds are producing more income and longer-term bonds are holding steady.
Municipals are leading all sectors of the investment grade market this year after a tax-reform induced bout of volatility at the end of 2017. The tax reform bill that passed late last year is reducing the supply of municipal bonds, as the new law eliminated the ability for municipalities to issue advance refunding bonds on a tax–exempt basis. Less supply with steady demand has created a favorable technical backdrop. This, coupled with generally strong credit quality (absent a few problem children), is driving our expectation for the positive trend to continue as we move through the second half of 2018.
As in Q1, corporate credit spreads widened in Q2, which means investors are now demanding more yield compensation to lend money to corporations. Less demand from overseas buyers, concerns around trade policy and stretched balance sheets have all been contributing factors to the spread widening and, thus, the underperformance. While spreads are now more attractive than they were just a few months ago, and though we are finding some opportunities in short-maturity corporates, we believe the corporate volatility will likely continue, and as such are continuing to position portfolios conservatively.
Our outlook for the second half of the year is not too dissimilar from our expectations coming into the first half. The Fed is likely to continue raising the Fed Funds rate, domestic and geopolitical headlines will continue to influence markets and investors will continue to assess just how much longer this economic cycle has to run. But against this backdrop bonds can still do well, and with interest rates now higher, income production will rise, which could help them perform even better moving forward.
Sources: ICE/BAML Indices