After posting solid gains in the first quarter, fixed income markets generally took a step back in the second quarter. The period was full of action, with foreign events in particular gaining market attention. While events out of China and Greece concerned markets and led to “risk off” periods and increasing global yield volatility, the backdrop was generally not favorable for fixed income assets. Positive economic news out of the U.S., including a rebound in economic growth and continued strong employment gains, led to expectations for higher short-term interest rates and increased expectations for future inflation, which is negative for fixed income assets. In addition, a dramatic repricing of risk and shifting expectations in the European markets caused a spike in long-term rates in those markets that also served as a catalyst for higher rates in the U.S. as well.
The Barclays U.S. Aggregate Bond Index (“Barclays Aggregate”), the proxy for the broad U.S. fixed income market, fell 1.68% for the quarter, more than reversing gains in the first quarter as U.S. Treasury rates ended the month higher. The Treasury yield curve steepened modestly, as longer-dated yields rose notably higher than shorter-dated yields.
All sectors of the Barclays Aggregate generated negative returns in the second quarter with the exception of asset-backed securities, which generated a modestly positive return of 0.17%. The corporate sector was the weakest-performing sector, dragged down by declines in the industrial and utility sectors. Across sectors, the lower the credit quality and the longer the duration, the worse the performance was. Outside of the Barclays Aggregate, however, high yield fixed income securities (that is, fixed income bonds rated below investment grade) performed better, managing to hold their gains from the first quarter to lead performance amongst fixed income sectors for the year (Barclays U.S. Corporate High Yield Index up 2.53% year-to-date).
Longer-term interest rates, specifically 10-year government debt yields, rose across the globe as signs of stronger growth and somewhat higher core inflation led global investors to sell longer-duration bonds. The 10- and 30-year Treasury yields began the quarter at 1.92% and 2.54% and ended at 2.35% and 3.12%, respectively. Long-duration government bonds were the worst-performing sub-asset class, with the 30-year Treasury plunging -10.44% for the quarter after returning an astonishing 29.4% in 2014.
Looking abroad, while the sell-off in longer-term interest rates in the U.S. was acute, for European markets it was extreme. A powerful, year-long rally in German bonds brought the 10-year yield all the way down to an intra-day low of 5 basis points on April 17. This move occurred just three weeks into the ECB’s quantitative easing program and represented a massive overreaction. Once signs of strength in the eurozone economy surfaced, the “bubble” burst and bonds sold off aggressively with the yield rising 101 basis points, reaching a high for the quarter of 1.06% on June 10 – a breathtaking move. Europe represents a good example that investors need to stay cognizant of valuations and understand the risks imbedded in the instruments they are purchasing – even when issued by AAA sovereign governments.
In conclusion, the Federal Reserve is anticipated to finally lift its policy rate off of zero later this year after more than six long years of a zero interest rate policy. Monetary policy divergence therefore will likely continue to play out, as other key central banks (ECB and Japan) continue to aggressively pursue quantitative easing agendas. Movements in interest rates may place pressures on various market sectors, and the impact to global fixed income markets to a period of increasing interest rates is uncertain. For the remainder of the year, we anticipate that rates, along with volatility, are moving higher and that this will increase the potential for market dislocation events. Investors need to be prepared for more swings in sentiment and valuations as markets adjust to new realities. At GuideStone, we believe patient, long-term investors will continue to be rewarded by practicing prudent global diversification and employing experienced active fund managers who possess proven risk-control expertise.
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