Despite monetary and fiscal policy adjustments, bond markets remained steady for 2017, providing a subtle encore to the prior year’s risk-on fervor.
By Emory Zink | 01-09-18 | 06:00 AM | Email Article

Continued strength in the U.S. economy underpinned a slow but steady shift in the Federal Reserve’s monetary policy guidelines, including actions to reduce its balance sheet and to hike interest rates, despite stubbornly low inflation.

Emory Zink is a manager research analyst for Morningstar.

The economic optimism, further fueled by serious tax cuts in the United States and recovering oil prices across the globe, continued to support credit fundamentals, and led to another year of risk-on fervor.

The Bloomberg Barclays U.S. Aggregate Index, a proxy for expected typical core bond performance, delivered 3.5% for 2017, while the intermediate-term bond Morningstar Category generated 3.7% by comparison. Funds courting more risk, either from significant allocations to credit or emerging-markets debt, and with non-U.S.-dollar currency exposures to the euro or yen, had an advantage.

Monetary Policy Shifts Under Way, With Long-Dated Bonds Leading the Way
Three interest-rate hikes (March, June, and December) signaled the Federal Reserve’s improving confidence in the U.S. economy and resulted in a federal-funds rate that rose above 1% for the first time since September 2008, while long rates didn’t budge much.

Ultimately, the U.S. Treasury yield curve flattened, with the difference between the 10-year and two-year points steadily narrowing from 1.30% in January 2017 to 0.51% by the end of December. The yield on the 10-year U.S. Treasury served as a loose fulcrum—it started January at 2.45%, fluctuated between a range of 2.05% and 2.62%, and ended the year roughly where it began at 2.40%.

Subsequently, the short end of the curve lifted in parallel in anticipation of a more active Fed, rewarding short-term bond funds with significantly less duration (a measure of interest-rate sensitivity) than their typical category peer; the short-term bond category returned 1.7% for the year. The longest-maturity bonds saw yields drop modestly, a function of steady demand, preemptively priced-in rate hikes, and persistently low inflation expectations. As a result, the long-government bond category gained 8.4%.

Early in 2017, the Federal Reserve communicated that it would begin paring back its balance sheet in October by reducing the reinvestment of principal payments on securities that it acquired through quantitative easing. Unlike the raucous taper tantrum of 2013, this announcement and subsequent policy initiation was implemented with minimal volatility to underlying U.S. Treasury and agency-backed mortgage pass-through markets, with these sectors gaining an albeit modest 2.3% and 2.5%, respectively.

Robust Appetites for Credit Continued
Following 2016’s bullish credit markets, there was a general sentiment that credit spreads—the additional yield investors in corporate bonds get to compensate for default risk—couldn’t tighten much further. Still 2017 saw continued strength in riskier bonds.

Oil prices, which dropped beneath $30 a barrel in February 2016, ravaging many energy-related names, continued a steady ascent throughout 2017, reaching nearly $60 a barrel by year-end. That contributed to further rebounds in the prospects of oil-related companies and oil-producing countries alike.

Further, the Federal Reserve’s slow and steady monetary policies extended an already-heated credit market, with the Bloomberg Barclays U.S. Corporate High Yield Index and U.S. Investment Grade Corporate Index returning 7.5% and 6.4%, respectively. The lowest-quality bonds continued to flourish in a market hungry for yield, and bond funds with significant allocations to CCC rated debt were rewarded accordingly.

Aggressive offerings in the high-yield category include  Fidelity Capital & Income , which can hold equities and handily topped its peers with an 11.7% gain for 2017, as well as  BlackRock High Yield , which overweighted CCC securities and contributed to the fund’s 8.2% return.

Within the densely populated intermediate-term bond category, funds with greater exposures to credit, as well as emerging-markets holdings and currency flexibility, such as  Western Asset Core Plus Bond , were among the biggest winners.

Central Banks Across the Globe Contend With the Dollar While Geopolitical Risks Continue to Mount
Emboldened by continued U.S. economic growth, the U.S. dollar appeared poised to strengthen for much of 2017, but continued accommodative monetary policies by European and Japanese central banks kept the dollar behind. The market returns on the euro and yen versus the U.S. dollar were 13.9% and 3.5% for the year, respectively, while the Bloomberg Barclays Global Aggregate Ex USD Index generated a 10.5% gain that was well ahead of the 3.5% of its U.S. Aggregate counterpart.

Negative yields continued to persist amongst the typical culprits, including the five-year German bund and Japanese government bonds, though overall negative-yielding debt stock decreased from 2016.

Ultimately, funds with heavier exposures to commodity-driven countries and companies, such as Brazil and Petrobras, as well as broad currency flexibility, bounded to the front of the world-bond category, with  Prudential Global Total Return  posting a particularly strong gain of 13.6% for the year.

Still recovering from painful losses in 2013, 2014, and 2015, local-currency emerging-markets bond indexes bounced back in 2016 with an 11.7% return and did even better in 2017, generating a 15.2% gain. Hard-currency emerging-markets indexes had a good, though not quite as impressive year with a 9.3% return, despite tricky political situations in Venezuela, Turkey, and Russia. But rising oil prices continued to benefit many commodity-driven emerging-markets contributors, except for Venezuelan debt, which defaulted and sank by 34% for the year.

Geopolitical risks remained a serious concern throughout 2017—including tensions related to North Korea’s nuclear threats—yet broad economic projections remained optimistic. The International Monetary Fund anticipated 3.6% global growth for 2017, followed by 3.7% for 2018.

Municipals Held Steady, Despite Policy Anxieties
The Bloomberg Barclays Municipal Bond Index delivered 5.5% return despite uncertainty surrounding tax and health care policy. During a lengthy though ultimately unsuccessful campaign to repeal and replace the Affordable Care Act, the healthcare sector experienced some anxiety. This was followed by the tax overhaul passed in early December that lowered the corporate tax rate from 35% to 21% and eliminated the tax exemption on advanced refunding bonds.

A wave of advanced refunding issuance was swiftly brought to market before the law was enacted at the start of 2018, and that, coupled with continued strength in demand for municipal securities, lifted the index to its second-highest monthly return for the entire year that December.

Against the backdrop of generally strong performance for muni debt, prices on already troubled Puerto Rico bonds plummeted in the wake of Hurricane Maria. 2017 was a year that rewarded funds with appetites for non-investment-grade securities—as exhibited by the broad high-yield municipal category return of 7.4%, ahead of the municipal-national intermediate category’s 4.6%—and in particular those that managed to simultaneously steer clear of Puerto Rico, such as  Nuveen Intermediate Duration Municipal Bond .

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Emory Zink does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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