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Bond Funds Hold Their Own in the First Quarter

Despite a Fed rate hike, most fixed-income funds have posted gains so far this year.

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The bond markets enjoyed a relatively benign opening to 2017, with many fixed-income funds enjoying modest gains after a rocky fourth quarter of 2016. Although the Fed hiked rates for only the third time in more than 10 years, all fixed-income Morningstar Categories were in positive territory over the first quarter.

Risk On
The riskiest bonds outperformed sharply, with particularly strong performances coming from funds in the emerging-markets bond and emerging-markets local-currency bond categories. Gains in the Mexican peso, which had struggled since 2015 and plunged following the U.S. election, helped buoy many funds, despite continued tension between Mexico and the United States. Other key emerging markets, including Brazil--which has encouraged investors with recent reforms--and Russia, also surged. World-bond funds with significant exposure to emerging-markets debt, including  Templeton Global Bond (TPINX), benefited from that strength.

Corporate debt was another winner for the quarter. The convertibles category flourished thanks in part to solid returns in the equity markets. Meanwhile, despite a modest loss in March, the high-yield bond category enjoyed healthy gains, as default rates continued to decline. Funds that buy common stock, including  Fidelity Capital & Income (FAGIX), were among the biggest winners. In a continuation of a trend in place for much of the past year, the riskiest bonds, which carry credit ratings of CCC or lower, led the pack.

Muni Rebound
Municipal-bond funds were among the biggest losers in the fourth quarter of 2016 but turned in a solid opening quarter in 2017 against the backdrop of limited supply. Those gains came despite continued uncertainty for municipal investors surrounding tax reform, which could include changes to tax rates. As in the taxable universe, riskier funds prospered, with high-yield muni funds posting the strongest gains. Tobacco and corporate-backed municipal bonds rallied sharply, benefiting funds such as  PIMCO High Yield Municipal Bond (PHMIX).

All Quiet on the Long End of the Yield Curve     
By the time the Federal Reserve hiked rates in March, the markets had widely priced in the move and, as a result, the reaction was relatively muted. Notably, yields on intermediate- and long-term bonds barely budged over the quarter after seeing a sharp increase in the second half of 2016 that accelerated in the weeks after the election. The yield on the 10-year finished the quarter at 2.4%, down just a few basis points from where it finished 2016. That, combined with an increase in short-term yields, which are most sensitive to Fed policy, led to a flattening of the yield curve.

Relatively stable rates supported modest gains for many investment-grade bond categories. The Bloomberg Barclays U.S. Aggregate Bond Index returned 0.8% for the quarter, while the intermediate-term bond category gained 1.1%. Within this group, funds with sizable allocations to credit (including non-investment-grade bonds, which the index does not hold), and even non-U.S. dollar currencies, flourished. Winners included  Loomis Sayles Investment Grade Bond (LSIIX) and  Western Asset Core Plus Bond (WACPX), for example; both held allocations to the Mexican peso as well as stakes in junk bonds. Long-term bond funds, which were among the biggest losers in the fourth quarter of 2016, also posted modest gains.

Conservative Funds--and Agency Mortgages--Bring Up the Rear
The biggest laggards for the quarter were the most conservative funds, including those in the short-term government and ultrashort bond groups. It's not unusual to see these funds, which typically offer the lowest yields in the bond fund universe, at the back of the pack. Still, all but a handful of funds in these categories finished the quarter with gains.  

Agency mortgage funds also posted particularly anemic gains over the quarter. Mortgages have benefited in recent years from steady purchases from the Federal Reserve as it reinvests principal paydowns in its mortgage stake. Investors are keeping a close eye on any changes to this policy as the Fed moves to tighten monetary conditions. 

For all category trailing returns through the previous day, visit the Fund Category Performance page

Sarah Bush does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.