2018 delivered a reality check to bond investors. Rising US interest rates, a strengthening dollar, escalating trade fears, and myriad geopolitical tensions further rattled markets at points throughout the year, which ended with a meagre single-basis-point return for the Bloomberg Barclays US Aggregate Bond Index.
The broad intermediate-term bond Morningstar Category lost 50 basis points for the year, though funds with less duration and more-tailored exposure to US Treasuries outperformed those with a significant overweight in corporate credit.
Four quarter-point rate hikes by the Federal Reserve – in March, June, September, and December – lifted the federal-funds rate to a 2.25%-2.50% range. Its large balance sheet still under scrutiny, the Fed continued to pare back its US Treasury and agency mortgage holdings, as well.
When riskier assets sold off in December, investors piled into intermediate-maturity Treasuries. The year-end volatility also stoked speculation of an impending yield-curve inversion, and the possibility of a follow-on recession, as the spread between two- and 10-year Treasuries tightened to 11 basis points in mid-December from 78 basis points in February.
Nowhere were anxieties more palpable than in the corporate credit markets. The prior two calendar years generated healthy returns, underpinned by low interest rates and relatively muted volatility. Many expected the late-2017 passage of US corporate tax reform to boost earnings and provide a counterweight to looming interest-rate hikes.
That Goldilocks outcome proved elusive in the bond markets. With the size of outstanding US corporate debt, according to the Securities Industry and Financial Markets Association, having nearly doubled to $9.0 trillion from $5.5 trillion a decade earlier, balance sheets looked more vulnerable in the face of aggressive Fed tightening.
Against this backdrop, investors in corporate credit became jumpy. Investment-grade corporate bond toppled 2.5%, while corporate high-yield slipped a less-dramatic 2.1%.
The high-yield bond category looked worse on average, with a 2.6% drop in 2018, but it was marked by a range of outcomes. Less duration and more-differentiated security selection worked in favour of some funds.
Europe, Japan and Emerging Markets
Across the world, tightening monetary policy is on the horizon but remains a challenge in the face of anaemic global growth. In Japan, inflation is nowhere as high as its target, while the situation in Europe is hampered by political tensions. Britain's economic uncertainty is still simmering over Brexit.
Emerging markets debt also faced challenges. Despite a heated economy, Turkey's central bank refused to raise interest rates, and its currency plummeted roughly 30% relative to the US dollar in the third quarter, before capitulating with a rate hike in September. Argentina was running a large current-account deficit, and creditors became impatient over the course of 2018. Ultimately, the International Monetary Fund stepped in with a bailout package in September, but by the end of the year, the Argentine peso lost half its value relative to the US dollar.
The Bloomberg Barclays Global Aggregate Index lost 1.2% for 2018, while the US-dollar-hedged version of the benchmark fared better given the strengthening dollar and delivered a 1.8% gain. Funds with significant non-US currency exposures and emerging-markets debt allocations were at a disadvantage.
