The third quarter of 2015 was marked by heightened market volatility and investor risk aversion. Concerns over slowing economic growth out of the emerging markets and its impact on the global economy led to a collapse in commodity prices, a stronger U.S. dollar, an equity market correction and a “flight to safety” by investors. In the end, heightened global risk factors caused the Federal Reserve’s ("Fed’s”) long-anticipated “liftoff” from zero to be postponed again in September, despite recognition of an improving economic trajectory for the U.S.
Amidst this backdrop, the shape of the yield curve flattened, as yields on intermediate- to long-term maturities declined more than those on the short end of the curve. Yields steadily trended lower over the quarter, driven by questions about economic strength, equity market valuations and the Fed’s decision to postpone the liftoff in interest rates. By the end of the quarter, the yield on the 10-year U.S. Treasury dropped to 2.04% from 2.36% on June 30.
U.S. fixed-income securities generally posted positive, but modest total returns. The Barclays U.S. Aggregate Bond Index (“Barclays Aggregate”), the proxy for the broad investment-grade U.S. fixed income market, rose 1.23% for the quarter. Both Treasuries and corporates rose for the quarter, with Treasury securities leading gains amid widening credit spreads for corporates. In general, higher quality fixed income securities outperformed lower quality, and longer-duration securities outperformed shorter-duration.
All domestic sectors of the Barclays Aggregate delivered positive returns, while Yankee bonds (U.S. dollar-denominated bonds issued in the U.S. bond market by foreign entities) declined. This decline is partially attributable to the strong U.S. dollar during the quarter, which would be a headwind for foreign entities that have to repay loans in U.S. dollars. The strong U.S. dollar has buffeted returns, particularly for longer dated Yankee bonds this year, and remains a concern for many emerging market economies that have witnessed their currencies collapse in value over recent months.
Non-U.S. fixed income also fared much better than their equity counterpart, as the Barclays Global Aggregate ex-U.S. Index posted a 0.64% return. Just as in the U.S., developed market yields fell broadly on global growth concerns, due to weakness in emerging markets, despite evidence that fundamentals in the developed world remain favorable. Emerging Market debt suffered from the drop in commodity prices, and the JPMorgan Emerging Market Global Bond Index fell 2.04%. Of particular note, the loss of investment-grade status for Brazil, and consequently some of its corporates, resulted in forced selling and contributed to broader risk-off sentiment.
Characteristic of the risk-off character of the third quarter, high yield securities performed very poorly, dropping 4.88% according to the Merrill Lynch High Yield Cash Pay Index. High yield bonds suffered from outflows and intensified risk aversion, and price moves were exacerbated by pockets of poor market liquidity. In particular, energy and mining-related securities experienced a notable weakness, dragging down the broader index and accounting for the vast majority of defaults (although default rates remain low on a historical basis).
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