For fixed income investors, the spotlight remained on the central banks during the third quarter as financial markets globally were calm compared to the previous quarter and equities hit new highs. Central banks’ commitments to maintaining or even expanding their simulative monetary policies came under scrutiny as the Federal Reserve clearly announced their desire for another rate hike in the fourth quarter. The Fed’s comments, along with a “comprehensive review” by the Bank of Japan, contributed to the rise in sovereign interest rates, which dampened the returns of several fixed income sectors during the quarter.
The vote in favor of Brexit at the end of June surprised the market, but the rise in volatility it injected into the fixed income market was short-lived. Indeed, the U.K. fixed income market snapped back from a brief sell-off and was among the best-performing among the developed markets in the third quarter in local currency terms. The relative strength of the dollar against the pound weakened the returns of U.S.-based investors, however. The weakness of the pound during the quarter was something of an outlier as, on the whole, the conversion of returns back to the dollar favored U.S. investors due to the dollar’s depreciation relative to both the euro and the yen.
The broad fixed income market provided a mixed bag of moderate returns in an environment of mildly rising rates of the third quarter. The broad Barclays U.S. Aggregate Index gained 0.46% for the quarter on the strength of corporate bonds within the index. Despite falling to a record low of 1.36 in July, the yield on the U.S. Treasury 10-year bond gained 12 bps to reach 1.61% by the end of September as concerns grew regarding the potential slowing of central bank stimulus. The greater sensitivity to rising rates of longer-maturity Treasury bonds caused them to underperform shorter-maturity bonds. Still, Treasury bond sectors with two years' maturity or longer lost value during the quarter.
Corporate bonds, which typically exhibit more credit risk than Treasury bonds, rose in value along with equity prices as investors sought exposure to less interest rate-sensitive investments. Although each corporate bond sector in the Barclays U.S. Aggregate Index gained in the quarter, bonds with lower credit quality ratings materially outperformed safer bonds that have higher ratings. Indeed, the total return Baa bonds was 184 bps higher than AAA-rated bonds for the quarter. Additionally, the credit spread or the yield above Treasury bonds demanded by investors to hold riskier corporate bonds fell to the lowest level since the second quarter of 2015.
The low interest rate environment continues to drive investors to riskier bonds in their search for yield. As a result, high yield corporate bonds continued to shine in the third quarter. With a three-month return of 5.55%, high yield corporate bonds actually surpassed the strong return of the S&P 500® Index by 170 bps (Bloomberg Barclays U.S. Aggregate Credit — Corporate — High Yield — 2% Issuer Cap Index). In a similar vein, yield-seeking investors drove the prices of emerging market sovereign debt 3.73% higher in the quarter.
Although the yield premiums of investment grade corporate and high-yield bonds are low by historical comparisons, default rates remain below the long-term averages, and they continue to provide meaningful gains in yield relative to the extremely low yields available from the sovereign bonds of developed nations. As economic growth projections are being revised downward, the willingness of central banks to attempt to spur spending and investment via low interest rates will continue to hold the focus of fixed income investors.
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