Higher levels of volatility led the fixed income market on a roller coaster ride through the first quarter. Although all major market sectors posted positive returns and yields fell only moderately over the last three months, simply comparing the beginning and ending values doesn't tell the full story of the intra-quarter volatility.
Investor sentiment suffered through the first part of February as fear of recessions in the U.S. and Chinese economies grew. In response, China moved to support its currency while the European Central Bank along with the Bank of Japan took interest rates into negative territory in an effort to spur consumer demand. Although the degree to which the actions of these central banks will increase demand remains to be seen, investor sentiment experienced a sudden and significant boost. This in turn drove prices on riskier bonds sharply higher. The impact is evident when comparing returns in high yield or below investment grade corporate bonds to intermediate Treasury bonds. High yield bonds lost 1.61 percent in January as equity prices fell and economic concerns rose, while Treasury bonds gained 1.63 percent. The situation began to change in the second week of February following the aggressive actions of central banks, and high yield bonds outperformed Treasury bonds by 1.01 percent over the full quarter.
The Federal Reserve was less aggressive, although it too moved to a more defensive stance in the quarter. After voting to keep interest rates unchanged, the Federal Open Market Committee (FOMC) announced a 50 percent reduction in the number of interest rate hikes they anticipate making this year.
U.S. fixed income securities posted positive returns over the full quarter. The Barclays U.S. Aggregate Bond Index ("Barclays Aggregate"), the proxy for the broad investment grade U.S. fixed income market, gained 3.03 percent for the quarter. The primary driver of fixed income returns during the quarter was duration or interest rate risk, as rates fell during the quarter and the yield curve flattened modestly. Thus bonds with longer durations outperformed shorter-duration bonds. Treasury inflation-protected securities returned 4.46 percent during the quarter as the five-year break-even inflation rose slightly. The mortgage-backed security sector generated a more moderate return of 1.98 percent, while asset-backed security bonds gained 1.36 percent, driven by strong performance from the utility and credit card sectors.
Non-U.S. fixed income outperformed domestic securities as interest rates in Japan and Europe fell sharply in response to rate cuts by their respective central banks. Declining rates outside the U.S. pushed the Barclays Global Aggregate Bond Index 5.90 percent higher during the quarter. Returns from emerging market bonds were slightly higher than developed market bonds with a return of 5.94 percent.
Investment grade corporate bonds recovered late in the quarter to outperform Treasury bonds with a return of 3.97 percent. The majority of this outperformance was driven by the longer duration of the corporate sector rather than a narrowing of the credit spread or the yield premium of these bonds over Treasury bonds. High yield or below investment grade corporate bonds suffered losses early in the quarter but came roaring back to generate a return of 3.35 percent as the economic outlook brightened.
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