FUNDMARKET INSIGHT REPORT THOMSON REUTERS LIPPER RESEARCH SERIES FIXED INCOME SUMMARY QUARTER-END ANALYSIS

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1 FUNDMARKET INSIGHT REPORT THOMSON REUTERS LIPPER RESEARCH SERIES FIXED INCOME SUMMARY QUARTER-END ANALYSIS MARCH 2016 Dovish Fed Sends Bond Funds Flying Higher EXECUTIVE SUMMARY When the Federal Reserve met March 15 and 16 and once again declined to raise interest rates (dot plots now show it plans to raise rates just twice in 2016, not four times as initially expected) the surprisingly dovish tone caught many investors and Fed watchers off guard. After all, this had been a Fed that wanted to take a firm line on inflation. But the Fed was also in a tough spot, trying to reconcile the bits of inflation that pop up from time to time with the pieces of economic languor floating around. But the real story of the quarter happened on February 11 when Janet Yellen gave her semiannual testimony before Congress and indicated the Fed may not seriously consider any rate hikes in the near future. She said financial conditions in the United States have recently become less supportive of growth and that she does not expect the FOMC is going to be soon in the situation where it is necessary to cut rates. Bottom line: things aren t going well enough to raise rates, and they re not going bad enough to cut them. Big Rebounds Abound! The year started with a bang for Emerging Markets Local Currency Funds, which rocketed 9.04% as commodity prices bounced off recent lows. General U.S. Treasury Funds also proved resilient, gaining 5.39%. The largest fixed income group, the $546-billion Core Bond Funds group, ended Q1 with a gain of 2.71%. Dollar weakness also helped developed economies, and International Income Funds (+5.23%) emerged as a clear winner. Munis followed the Treasury markets to nice quarterly returns, led by High Yield Muni Debt Funds (+2.07%) and California Muni Debt Funds (+1.80%). Munis followed the Treasury markets to nice quarterly returns, led by High Yield Muni Debt Funds (+2.07%) and California Muni Debt Funds (+1.80%). To that point the quarter had gone terribly bad for equities (and conversely very well for many noncorporate bond sectors): we had experienced the worst start to a year in the history of the Dow, volatility was spiking, the dollar continued to climb, and commodities had bottomed out. But the old saw about markets hating uncertainty was still true, and shutting down the conversation about changing rates in either direction turned out to be exactly what market participants wanted to hear. Authored by: JEFF TJORNEHOJ HEAD OF LIPPER AMERICAS RESEARCH LIPPER, DENVER 1

2 As seen in Figure 1 below, Thomson Reuters Lipper s General U.S. Treasury Funds classification was among the quarter s top performers, gaining 5.39% as yields on the ten-year note sank from 2.25% at the end of Q to touch 1.63% on February 11 (the height of the market panic ). It then retraced to 1.98% over the next 30 days and finally found another rally to finish Q1 at 1.78%. The beginning of January saw just a 10% probability that 2016 would pass without another rate hike, and at mid-quarter those low odds suddenly seemed the smartest money in the room. On February 11 a turning point for many assets the Fed funds futures market suggested the odds of a March rate hike were zero and that of June were just 3%. Today, June odds are closer to 20% as global economic conditions seem to have improved over the past few months. While Short U.S. Treasury Funds (+1.06%) was expected to lag in a broad rally, the relatively explosive gains made by Treasury Inflation-Protected Bond Funds (+3.53%) were surprising, given the protracted losses the group had endured. Unlike other Treasury-related groups, Inflation-Protected sustained a solid rally for March (+2.09%). The breakeven rate for TIPS had trended lower since July 2015, from 1.91% to 1.36% in early February; at quarter-end it had rallied back to 1.61% as wage gains data for March showed the inflation concerns voiced recently by the gold market might have been finding their way into the broader consciousness. FIGURE 1 LIPPER FIXED INCOME FUND CLASSIFICATION RETURNS, FIRST QUARTER 2016 Source: Thomson Reuters Lipper 2

3 TREASURY FUNDS SUMMARY As shown in the chart below (Figure 2) the yield curve rallied hard from two years on, which helped long-duration fund groups such as General U.S. Treasury Funds (Wasatch-Hoisington U.S. Treasury Fund advanced 9.18%!). The two-/ten-year spread narrowed from 1.21% to an intra-quarter low of 0.95% on March 8 before it widened a bit to end Q1 at 1.05%. Yields on the two-year note touched a low of 0.64% on February 11 and ended at 0.73%, while ten-year notes trended similarly, starting at 2.24%, hitting 1.63% on February 11, and giving ground to wind up at 1.78% by quarter-end. FIGURE 2 TREASURY YIELD CURVE Source: U.S. Department of the Treasury 3

4 CORPORATE AND MORTGAGE-BACKED BOND FUNDS SUMMARY As in the previous quarter, higher-rated credits tended to outperform lowerrated, but unlike for the previous quarter it would be a stretch to describe Q1 s performance as a flight to safety. In fact, all three credit-specific corporate bond fund groups had an excellent quarter as fears of energy sector-led junk bond contagion abated when oil prices rose and retail investors dove back into high-yield products (the fund-flows week ended March 2 turned out to have the largest weekly net inflows on record $4.7 billion! to high-yield mutual funds and exchangetraded funds). Furthermore, according to Thomson Reuters LPC, high-yield bond issuance was $18.8 billion for March for a Q1 total of $33.5 billion well below the $88.0 billion of issuance for the same quarter last year. That poor supply likely helped significantly fuel the rally. Options-adjusted spreads on the Bank of America Merrill Lynch US Corporate AAA were fairly active, widening from 75 basis points (bps) at the end of Q to 99 bps on February 11 before trending back down a bit to end Q1 at 79 bps. The same spread on the the Bank of America Merrill Lynch US Corporate BBB was even more active, widening from 241 bps to 303 bps on the same day before narrowing to 231 at the end of the quarter. The net effect was that Lipper s Corporate Debt BBB- Rated Funds classification gained 2.66% for March for a quarterly gain of 3.69%. Corporate Debt A-Rated Funds lagged a bit, gaining 3.32% for the quarter, while High Yield Funds (whose spreads came within a hair of the 900-bp mark) had a great rally for March (+3.54%) as it made up ground lost in January and February and ended Q1 with a gain of 2.26%. Mortgage paper lagged as U.S. Mortgage Funds delivered a Q1 return of 1.54% and GNMA Funds returned 1.33%. According to Fannie Mae, the single-family-home delinquency rate (those mortgages 90 days or more overdue or in foreclosure) reached its lowest level since mid Between low unemployment and a hot housing market, risk premia came off mortgages, which may limit their ability to outperform in the near-to-intermediate term. WORLD INCOME FUNDS SUMMARY The trade-weighted U.S. dollar index was flat (though quite elevated) for January, volatile for February, and trended down for March as it changed from at the end of December 2015 to at the end of March for its worst quarterly loss in more than five years. Alternative Currency Strategies Funds rallied 2.94% for March to earn 1.81% for Q1. Investors in developed markets saw International Income Funds gain 3.97% for March and 5.23% for the quarter, while the really big gains were reserved for those investors who either jumped into emerging markets debt at the right time or suffered through last year s steep losses: EM Hard Currency Funds gained 4.13% for March for a quarterly return of 4.53%, while EM Local Currency Funds rocketed 8.33% for March for a quarterly return of 9.04%. Commodity-related currencies of Australia, Canada, and Norway were notable gainers. MUNICIPAL DEBT FUNDS SUMMARY Muni fund investors had another solid quarter to lean back on; the average singlestate muni debt fund returned 1.47% for Q1 (better than Q s 1.36%) on a pre-tax basis or a tax-equivalent 2.26% for high-tax-bracket earners. Total muni bond sales by states, cities, schools, and others were just $96 billion for Q1 (down 7.5% from the same quarter in 2015), according to Thomson Reuters, which helped prop up the market. And with relative values (muni yield to comparable Treasury yield) near or slightly less than 100%, munis still looked attractively priced in spite of the rally. Investors continued to demand lower-rated muni paper, as evidenced by High Yield Muni Funds 2.07% quarterly gain (for a tax-equivalent return of 3.18%), although the muni market turned decidedly soft at the short end of the yield curve in March and seemed poised to remain that way, like their Treasury peers. 4

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