Despite monetary and fiscal policy adjustments, bond markets remained steady for 2017, providing a subtle encore to the prior year’s risk-on fervour.

Continued strength in the US 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.

The economic optimism, further fuelled 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 fervour.

The Bloomberg Barclays US Aggregate Index, a proxy for expected typical core bond performance, delivered 3.5 per cent for 2017, while the intermediate-term bond Morningstar Category generated 3.7 per cent 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

Three US Federal Reserve interest-rate hikes (March, June, and December) signalled improving confidence in the US economy and resulted in a federal-funds rate that rose above 1 per cent for the first time since September 2008, while long rates didn’t budge much.

Ultimately, the US Treasury yield curve flattened, with the difference between the 10-year and two-year points steadily narrowing from 1.30 per cent in January 2017 to 0.51 per cent by the end of December.

The yield on the 10-year US Treasury served as a loose fulcrum--it started January at 2.45 per cent, fluctuated between a range of 2.05 per cent and 2.62 per cent, and ended the year roughly where it began at 2.40 per cent.

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 1.7per cent for the year.

The longest-maturity bonds saw yields drop modestly, a function of steady demand, pre-emptively priced-in rate hikes, and persistently low inflation expectations. As a result, the long-government bond category gained 8.4 per cent.

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 US Treasury and agency-backed mortgage pass-through markets, with these sectors gaining an albeit modest 2.3 per cent and 2.5 per cent, 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 per cent and 6.4 per cent, 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.

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 were among the biggest winners.

Central banks contend with dollar, geopolitical risks

Emboldened by continued US economic growth, the US 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 US dollar were 13.9 per cent and 3.5 per cent for the year, respectively, while the Bloomberg Barclays Global Aggregate Ex USD Index generated a 10.5 per cent gain that was well ahead of the 3.5 per cent of its US 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.

Still recovering from painful losses in 2013, 2014, and 2015, local-currency emerging-markets bond indexes bounced back in 2016 with an 11.7 per cent return and did even better in 2017, generating a 15.2 per cent gain.

Hard-currency emerging-markets indexes had a good, though not quite as impressive year with a 9.3 per cent 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 per cent 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 per cent global growth for 2017, followed by 3.7 per cent for 2018.

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Emory Zink is a fixed income strategies analyst, manager research, Morningstar US. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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