The fixed income market continued its winning streak through the second quarter as the asset class generated solid returns and was the beneficiary of money which flowed from U.S. equity funds. Investors sought the relative safety of fixed income securities as concerns grew regarding the pace of economic growth and the impact that negative interest rates had on inflation expectations. This flight to safety combined with a continuing search for yield provided a tailwind for bonds.
Volatility spiked at the end of June with the vote by the U.K. to leave the European Union. This outcome was a surprise to many as late surveys suggested the “stay” vote would carry the day. While several of the longer-term impacts from the vote to leave the union remain uncertain, expectations for economic growth within the U.K. were revised downward. Investors responded in an aggressive move to reduce the risk levels of their portfolios, and increased allocations to fixed income pushed yields down quickly across the globe. U.S. rates fell sharply and the yields on many government bonds outside the U.S. slipped further into negative territory. At the end of June, there were nearly $12 trillion in government bonds that were selling with negative yields — a 12% increase from just the previous month. For comparison, this is nearly as much as the $15.4 trillion in outstanding U.S. Treasury and agency bonds. Of the bonds that comprise the BofA ML Global Government Bond Index that have yields below zero, an astounding 74% have yields lower than 1% suggesting that the high safety and liquidity of government bonds are unusually appealing to investors at this time.
All major sectors of the fixed income market posted positive returns over the first quarter as yields fell and credit spreads narrowed. Bonds with more duration or interest rate sensitivity performed better than those that had less duration. Likewise, bonds with greater credit risk or lower credit ratings tended to outperform corporate bonds with higher credit ratings as some investors took on credit risk in their search for higher yields. The broad Barclays U.S. Aggregate Bond Index gained 2.21% over the quarter, taking the year-to-date return to 5.31%. Bonds rated Baa, on the lower end of securities considered to be investment grade, gained 4.30% in the quarter while AAA rated bonds rose 1.67%. Very long duration bonds with maturities greater than 10 years returned 6.55% for the quarter and an impressive 14.33% for the last six months. These long maturity bonds benefited from the large decline in interest rates on the long end of the yield curve driven by weaker economic indicators such as the disappointing employment reports for May and June along with meeting minutes suggesting the Federal Reserve will be hesitant to raise rates.
U.S. inflation expectations have also fallen which had an outsized impact on the interest rates of longer maturity bonds when compared to shorter maturity bonds. The combined effects of weaker growth and inflation expectations have caused the U.S. yield curve to flatten significantly. The difference in yields between 10-year U.S. Treasury bonds and 2-year U.S. Treasury bonds fell to 0.89% at the end of the second quarter. This is the lowest level since the credit crises and a drop of 0.16% in just the last quarter.
Despite economic concerns, investors were generally still willing to take on risk within their fixed income invests in a search for yield. Corporate bonds of intermediate maturity returned 2.24% in the quarter, while safer U.S. Treasury bonds of similar maturities gained only 1.28%. High yield bonds performed even better than did investment grade corporate bonds with a return of 5.52%. Sovereign bonds outside the U.S. fared better than did Treasuries taking the return for global treasury bonds to 4.05%. Emerging market bonds which include some corporate bonds gained 6.47% over the last three months.
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