U.S. bond markets suffered along with equities in October as interest rates continued to rise. In addition, volatility from emerging markets filtered through to U.S. corporate and high yield bonds.
X"October saw a return of volatility," said Kevin Akioka, fixed-income senior portfolio manager at American Century Investments. While volatility was outside the U.S. for most the year, in October, U.S. credit and mortgages started to react to that volatility. That resulted in a widening of yield spreads vs. Treasuries, he added. Akioka also comanages $4.3 billion American Century Diversified Bond Fund (ADFIX) and $397 million American Century Short Duration (ACSNX).
"It's almost like U.S. credit sectors were decoupled (from emerging markets)," he said. "But in October we saw a recoupling of U.S. credit markets and some mortgages." Also, "The tariff news is affecting perception and risk tolerance. It's going to be a while for the actual impact to start to hit corporates and the bottom line, but what it brings to the market is uncertainty."
Bond Fund Scoreboard
General U.S. Treasury funds shed 1.44% during the month. That brought their year-to-date loss to 5.07%, according to preliminary Lipper Inc. data. Corporate debt A and BBB rated funds fell 1.28% and 1.36%, respectively. That expanded their YTD losses to 3.49% and 3.46%. High yield slid a bit more, falling 1.58%. But these funds still kept a slightly positive YTD return of 0.17%.
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On the shorter-end of the yield curve, short U.S. Treasury funds rose 0.07%. That lifted their YTD gain to just 0.51%. Meanwhile, Treasury inflation-protected securities funds also lost ground, giving up 1.35% in October for a YTD loss of 1.97%.
By comparison, the average U.S. diversified stock mutual fund declined 7.91% in October, while the S&P 500 fell 6.94%.
What overall bond fund performance has done to investors' mood can be seen in recent ETF fund flow figures. Fixed income ETFs, where 38 consecutive months of inflows had swelled assets under management to $630 billion, in October posted outflow for the first time since 2015, totaling just shy of $3 billion out, says Mathew Bartonlini, head of SPDR Americas Research at State Street Global Advisors.
"What we've seen so far for the year, is that the bond market has produced a negative return of close to 2%," said Celso Munoz, portfolio manager at Fidelity Investments and co-manager of $32.5 billion Fidelity Total Bond Fund (FTBFX). "And if you look historically, the frequency of negative returns has actually been fairly small within the bond market. If you look at the modern bond era, since the mid-1970s, there's only been about a handful of periods where we've seen negative returns on a calendar basis."
Interest Rates: Time To Buy Bonds On Dip?
After these historical negative returns, the bond market produced larger returns that more than offset the prior losses, he points out. Also, in terms of yields, as a starting point, the bond market is better positioned now than pre-2008 as yields are higher now. Therefore, Munoz recommends viewing bonds as a core part of one's portfolio.
"An interesting thing for October is that we haven't seen a flight to quality, or a strong interest in U.S. Treasuries," said Ford O'Neil, lead manager on Fidelity Total Bond and various other bond funds. "Often, when stocks are falling, there's a concern for a potential recession around the corner. And at the same time when you get yields falling and spreads widening, that's obviously a validation that you might be moving from late-cycle to recession. And we've not seen any of that type of behavior in the fixed-income markets."
He points out that as the equity markets have been "re-rating," meaning that the overall price-to-earnings ratios have been falling. We haven't seen a significant change in the macroeconomic outlook for the coming months or 2019.
Fidelity's Munoz expects U.S. economic growth to be fairly modest. Therefore he doesn't see a very big upward move in interest rates. In addition, O'Neil points to the long-term secular trend of increased "de-risking" of assets by retiring baby boomers and the resulting higher demand for bonds. This should add downward pressure to bond interest rates.
Three Or Five Hikes In Interest Rates?
While the market expects three more hikes in interest rates, the Federal Reserve led by Jerome Powell is talking about five: "That's going to be really one of the more interesting debates over the coming 12 to 18 months, to see whether the market's right or the Fed's right," said O'Neil.
Yvette Klevan, managing director of Lazard and portfolio manager on the Lazard's Global Fixed Income team, has been looking for select opportunities in higher-quality, fundamentally strong countries outside of the U.S. She also has an eye out for "rising stars" in the U.S., i.e. high-yield bonds that get upgraded to investment grade. Internationally, she finds Eastern Europe attractive, with countries such as Poland, the Czech Republic and Hungary, as well as Chile in South America.
"We can buy local bonds (in those countries), hedge them back to U.S. dollars and enhance the yield because of the differentials in interest rates," she said.
American Century's Akioka has been selling off price-rich parts of U.S. investment-grade credit. "With spreads tight in a lot of sectors, there's not a lot of room for error nor reason to have a huge overweight to a lot of the rich sectors," he said.
Instead, he's been buying asset-backed securities, commercial mortgages and nonagency collateralized mortgages. "Now is the time to be very selective," Akioka said.
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