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1st Quarter 2017 Income and U.S. Government Bonds Commentary

By: Thornburg Investment Management
Harvest Exchange
May 4, 2017

1st Quarter 2017 Income and U.S. Government Bonds Commentary

Markets across the globe continued to climb the proverbial wall of worry during the first quarter of 2017. The yield on the 10-year U.S. Treasury remained range-bound during the period, ultimately moving lower by 0.05%. Both investment-grade and high-yield corporate spreads tightened during the quarter, with the Bloomberg Barclays U.S. Corporate Investment Grade Index option adjusted spread (OAS) falling approximately 0.05% and the Bloomberg Barclays U.S. Corporate High-Yield Index OAS declining 0.26%.

Corporate investment-grade issuance set a record, yet, as evidenced by the declining spreads, the market remained strong despite increased supply. Both investment-grade and bank loan funds experienced significant inflows during the quarter, supporting the broader market. With respect to high yield, equity market hesitation during the first weeks of March proved a headwind leading to outflows, while gradually higher trending equity markets helped keep returns in solidly positive territory.

The market continues to appear yield hungry although skittish around rates, as the Federal Reserve (the Fed) made a widely anticipated hike to short-term rates in March. Fourth quarter 2016 company financial results appeared to satisfy market participants, and credit metrics deteriorated at a slower pace. These trends look like they will continue in the second quarter of 2017. While we believe fundamentals are still relatively attractive, we remain skeptical that current spreads adequately reflect weaker absolute credit metrics. Broadly speaking, investor complacency remains the status quo despite risks under the surface. The U.S. still faces very real debt challenges; student debt, auto debt, and commercial real estate come to mind when thinking about potential pockets of instability going forward.

Most investors will agree that quantitative easing (QE) from central banks around the world has been fantastic for both depressing risk-free yields and compressing risk-assets spreads. What then, is the ultimate result of the inevitable unwinding? The truth of the matter is that no one out there truly knows, and while we believe it can be completed in an orderly fashion—that is to say we are unlikely to repeat taper tantrums—we ultimately sit at low overall yields leading to lower expected returns on a go forward basis. Said another way, if QE was a tailwind over the last few years, then negative QE should be a headwind going forward.

Recently, risk markets have benefited from what some call the "Trump trade," and although we viewed this optimism as largely due to hope, there were several underlying reasons to believe in. Sentiment and hard data had been strong to start the year, however, it appears to be weakening as of late. We’ve not seen any sizable pickup in realized economic activity, so either it may never actually be achieved, or we won’t see much activity until there is positive and clear movement on the political front. It’s too early, of course, to say that the market’s hope in policy-driven growth was misplaced, but the political environment remains notoriously difficult to navigate as evidenced by the failed repeal of the Affordable Care Act. Next on the political agenda appears to be something that will matter to markets an order of magnitude more than health care—taxes. Our view is that some level of reform will ultimately be accomplished. However, it will be less than what market participants currently anticipate. Without health care reform, revenue neutral tax reform becomes significantly more tenuous. Add in further difficulties in implementing a generally negatively viewed Border Adjustment Tax and the image of everything being completed as expected becomes even murkier.

While this may not paint the rosiest of images for the investment environment we all currently face, that hasn’t prevented us from continuing to deliver attractive results for our investors. Clients know well the deep level of research we conduct when analyzing individual credits. However, they may be less aware of how we also carefully consider the changing political/economic/social paradigms when we invest.

In deciding where to deploy client capital, we ultimately discern how likely something will happen, what will happen, over what time period, and what the market is currently pricing in. While we clearly follow day-to-day developments when positioning the portfolios to meet their goals over time, we step back and consider the longer term.

What this Means for the Portfolios

The first quarter saw minimal volatility across most high-quality fixed income assets. As noted above, investment-grade corporate spreads essentially ended the quarter where they began, moving downward only 0.04%. U.S. Treasury securities broadly saw decreasing volatility, as well. This in spite of the Fed raising rates. The net result of these calm seas was relatively few compelling opportunities for value-conscious investors such as ourselves.

In general, we remained disciplined and defensive regarding interest-rate risk. Depending upon the mandate, we added modest exposure to relatively short-term floating-rate bonds. Where appropriate, given each portfolio’s guidelines, these additions came by way of various structures, including asset-backed securities and corporates—the common link being that, regardless of structure, they were backed by high-quality assets.

Apart from our overall belief that compensation for undue interest-rate risk is broadly not available across fixed income markets, there were select opportunities to add longer-term, high-quality bonds to the portfolios. Be it through policy rate increases or the unwinding of its balance sheet, the Fed does have the potential to tighten domestic monetary conditions. As this occurs, it is possible that such a phenomenon can cause the economic cycle to turn, leading to headwinds. Given our philosophy of balancing risk exposures across the portfolios to perform across multiple macro outcomes, we used brief periods of higher longer- term rates during the quarter to add small amounts of longer-dated, defensive, high-quality assets to the portfolios. These assets would likely perform well should yield curves flatten as a result of economic softness.

Across the portfolios we added modest mortgage-backed securities exposure. In all instances these were high-quality short-term bonds. Additionally, they were structured to limit the potential range of pre-payment or extension risk outcomes, giving us confidence in their likely weighted average life. Lastly, in keeping with the theme of defensive positioning, we ended the quarter with cash balances towards the higher end of their historical ranges, which we stand ready to deploy should opportunities present themselves.

Thank you for investing with us in Thornburg core bond funds.

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Originally Published at: 1st Quarter 2017 Income and U.S. Government Bonds Commentary