The U.S. Federal Reserve elected to maintain rates in May 2018 but followed up with a 0.25-point rise in June, continuing a trajectory of tighter monetary policy that began at the beginning of 2016.
Over the second quarter, the yield on the 10-year U.S. Treasury oscillated between 2.7% and 3.1%, driven by expectations of rising inflation and continued concerns over growing U.S. government debt. The 10-year U.S. Treasury ended the quarter at 2.9%, above its 2.5% starting point for the year.
In general, yields on short- to intermediate-term bonds increased more than those on long bonds, contributing to a flattening of the yield curve. As of June 30, the difference between the 30-year and five-year tightened to 25 basis points at the end of the period from 42 basis points at the quarter's start.
Meanwhile, demand for longer maturities in the United States remained strong, with a modest drop in those yields, particularly in May. Stubbornly low yields on longer-maturity bonds have stoked anxieties over the possibility of an inverted yield curve in the near future, a potential indicator of a forthcoming recession. U.S. Treasury Inflation-Protected Securities delivered 0.77% on a wave of increased inflation expectations. The U.S. dollar strengthened against the euro and the yen over the quarter.
ECB Takes Action But Politics Upsets
In June, the European Central Bank reiterated that it would pare back its quantitative easing slowly but surely. However, fiery geopolitical arguments across the eurozone did little to bolster the continent's market outlook. Pressures on Italian banks and a surprise collapse of coalition talks to form a government, which drove a dramatic sell-off in Italian government bonds – 10-year Italian government bond yields moved from a low of 1.7% to a high of 3.2% during May, didn't help either.
Meanwhile, the Bank of Japan continued to grapple with underwhelming inflation numbers. Given a backdrop of rising rates and geopolitical tensions, the Bloomberg Barclays Global Aggregate Bond Index lost 2.78% during the second quarter, relative to the first quarter's 1.36% rise. The index's underlying corporate-credit component was a detractor. Whereas the Treasury portion was a contributor, benefiting from the drop in yields from mid-May.
How Did Global Bond Funds Fare?
The global-bond Morningstar Category lost 3.77% for the quarter. Funds with shorter duration and heavier U.S. dollar exposure were among the better performers for the quarter. For example, M&G Global Macro Bond, which has a Morningstar Analyst Rating of Silver, produced a 3.34% return with biases to that profile. In contrast, Bronze-rated Invesco Bond, with 7.1 years of duration and low exposure to the US dollar, lost 4.03%.
The Bloomberg Barclays Global Aggregate Corporate Index lost 0.45%, less than its first-quarter 1.41% drop but motivated by similar dynamics, including rising interest rates, bellicose U.S. threats around trade, and a strengthening dollar that has made the hedging costs for foreign buyers unpalatable.
Trade War Raises its Head
In May, the U.S. imposed steel and aluminium tariffs of 25% and 10%, respectively, on its allies, contributing to counteractions and heightened uncertainty surrounding the direction of the global economy. Meanwhile, the ICE Bank of America Merrill Lynch Global High Yield Index lost 0.14% for the second quarter, though lower credit tiers outperformed higher credit tiers, signalling that broad confidence in credit markets remains healthy. The energy sector benefited from rising oil prices, which were coaxed upward following expectations of reduced supply given the U.S. departure from the Iran nuclear deal in early May.
The West Texas Intermediate crude-oil price rose to around $70 at the end of the quarter, up from around $60 at the period's start. The global corporate-bond, EUR corporate-bond, and GBP corporate-bond Morningstar Categories lost 0.75%, 0.64% and 0.19%, respectively, for the second quarter in their base currencies. Generally, funds with lower duration versus their benchmarks and/or peer group had an advantage.
For example, within the GBP corporate-bond category, Silver-rated BlackRock Corporate Bond ran an underweight duration and credit risk stance compared with its benchmark, and most peers, and produced a 0.3% return for the quarter.
In contrast, Gold-rated Fidelity MoneyBuilder Income, with an effective duration of 7.7 years, lost 0.35% for the quarter. Within the global high-yield category, funds with greater exposure to the lower-quality credit tiers outperformed. Bronze-rated AXA WF Global High Yield Bonds generated 0.29%, given its larger exposure to CCC rated credits. This was well above the global high-yield bond category's 0.95% loss. Whereas high-yield options that were more conservative but more rate-sensitive generated weaker returns, such as the 1.83% loss for Bronze-rated AB FCP I Global High Yield.
Mounting Pressure on Emerging Markets
Emerging markets came under even greater pressure in the second quarter, owing to the stronger U.S. dollar and negative headlines in a handful of countries, including Argentina and Turkey. Local-currency emerging-markets debt experienced the swiftest sell-off for the period. To illustrate, Neutral-rated funds PIMCO GIS Emerging Local Bond and Investec GSF Emerging Markets Local Currency Debt slid by over 11%; Silver-rated iShares J.P. Morgan EM Local Government Bond also lost 11%.
Funds with a preference for hard-currency debt, which held up somewhat better for the quarter, such as Bronze-rated MFS Meridian Emerging Markets Debt, fared better. That fund was down 3.8%. Global-bond funds with emerging-markets currency exposure were hit harder as well: Silver-rated Legg Mason Brandywine Global Opportunistic Fixed Income was down 7.3% owing to its heavy helpings in the Mexican peso and Malaysian ringgit.
