Third Quarter Returns

At first glance, total returns through the third quarter would suggest a very good year for most sectors of the bond market. The YTD returns are 9.2% for the Treasury market and a whopping 23.4% for the 30-year bonds. Virtually all of those returns, however, were achieved in the first quarter when the full impact of the virus on the economy became evident. Since then the Treasury market has returned only 0.6% and the bond has returned -1.5%. Portfolio performance has been excellent only if Treasuries were sold at the end of the first quarter.

Corporates show the opposite pattern of returns–negative returns in the first quarter but goods returns since then. Investment grade returns are only 6.6% YTD, but 11.1% over the second and third quarters. For high yield, returns were steeply negative in QI but are 14.3% since then. Muni market returns have been less volatile–slightly negative in QI and a return of 3.9% since then.

TIPS have performed very well, with a modest 2% return QI and solid returns of 4.2% and 3.3% in Q2 and Q3. In the process, they have become expensive versus the nominals. Perhaps PMs recognized that fact in September, as TIPS recorded a return of -0.2% in the month. TIPS will continue to benefit from the inflation adjustment of close to 2%, but going forward, additional price gains are unlikely.

Price gains are probably unlikely in most other sectors in the quarters ahead. Treasury yields appear to have begun a very slow uptrend because the economy is growing and more Fed easing is unlikely. Corporate spreads have room to narrow some, but future returns will be primarily coupon income. Muni-to-Treasury yield ratios remain unusually generous, so the muni market could withstand an uptrend in Treasury yields. A blue wave on election day is expected to result in higher tax rates and, thus, boost the demand for munis. But, with yields already so low, any benefits might be limited. In the past, economic trends have been far more important to the muni market than tax law changes.

Investors who need portfolio income should heed the advice presented in the latest Barron’s. Look to leveraged funds such as REITS and closed end bond funds and/or high dividend equities. If the Fed intends to keep the fed funds rate near zero indefinitely, why not take on leverage? One should, however, be cautious when choosing REITS, as the outlook for commercial real estate is extremely uncertain.

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