Lessons From QI

The pattern of first-quarter bond market returns suggests a few lessons. One is to avoid long durations.  Here are the returns by maturity segment:

1-5 years      Corp. -0.8%   Treasury  -0.6%  Hi Yield  -0.23  Muni -0.10%

10 years+    Corp. -2.2%   Treasury  -3.15%  Hi Yield -2.8% Muni –1.6%

While even the 2-3-year sectors suffered negative returns in the quarter, returns were far worse for maturities 10-years and longer.

Another lesson is to stay with the weaker credits.  High yield corporates continued to outperform investment grade corporates and Treasuries.  BBB corporates did not have a great quarter, but they did outperform the single A credits.  BBB munis outperformed the stronger credits by approximately 25 basis points.  The only sectors to post positive returns were high yield munis and CCC corporates.

Lesson three is to not rely on a flattening of the yield curve to “protect” the longer maturities.  The 2-year to 30-year spread narrowed by 10 basis points, but that was not sufficient to prevent steeply negative returns from the 30-year bonds.

Lesson four is that TIPS  do not “protect” against negative returns when the Fed is tightening.  Yes, they outperformed nominal Treasuries, with a total return of -1.02% for the quarter versus -1.21% for the nominal Treasuries.  But investor clients who think TIPS should perform well when inflation is expected to increase will be unhappy with negative returns.

Lesson five might be to mind the fundamentals.  The economy is at full employment, the funds rate is rising and Treasury borrowing is building.  These are not positive fundamentals for the bond markets–especially for the long durations.  Credit sectors can continue to outperform as long as a recession appears unlikely.

On that point, there is now some talk about the economy slowing enough to keep the Fed on hold.  But, we have seen  weaker economic data in the first quarter of almost every year for the past ten years.  Those data have not been precursors of slower growth.  The ISM manufacturing index released yesterday suggested good GDP growth.  The new orders component stayed above 60, a very strong level.  The most likely scenario is still a funds rate 50 to 75 basis point higher at year-end.  In that event, the pattern of returns for all of 2018 could mimic the Q1 patterns.

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