Investor sentiment changed rapidly in the fourth quarter and led to a very volatile and stress filled quarter for markets of all types. For fixed income investors, the volatility brought a bid back to bonds after several quarters of rising rates. As the debate continues regarding monetary policy, trade negotiations, economic growth and changes in Washington, we anticipate unsettled markets to continue in 2019. While we think the current market reaction has been overdone, we are mindful of the fundamentals as we approach the later stages of the Fed rate normalization process.
Treasury yields navigated a fairly wide range during the quarter as the market’s view on Federal Reserve Bank (Fed) monetary policy shifted significantly. Beginning the quarter at 3.06%, the 10-year Treasury traded just above 3.23% in early October (and again in early November) before closing the year at 2.68%. The two-year Treasury note was also well travelled, beginning the quarter at 2.82%, peaking at 2.97% in early November and closing the year at 2.49%. The sudden shift resulted in positive quarterly returns in most bond indices, pulling some out of negative territory for the full year.
The volatility began in early October when Fed Chairman Jerome Powell indicated that monetary policy was still accommodative and that we remained a long way from a neutral Federal Funds rate. This hawkish tone pressured interest rates across the yield curve higher in October and November as investors anticipated multiple hikes into early 2020. Both the equity markets and the White House expressed displeasure with that view, the latter in a quite unconventional and public fashion. While the Fed pressed on with an additional rate hike to a range of 2.25%-2.50% and reiterated its balance sheet reduction plan at their December Federal Open Market Committee (FOMC) meeting, they struck a more cautious tone by lowering their expected number of rate hikes to reach a new and currently lower view of neutral. The less hawkish tenor of December’s Fed statement paved the way for the steep decline in yields headed into year-end.
In our view, the bond market appears to be premature and overly anxious in its concern regarding an imminent recession. While a more cautious approach by the Fed -- and perhaps a lower end point for the Fed Funds rate -- is possible, an examination of forward rates suggests that Treasury yields are now priced for no additional rate increases in 2019 and increasing odds of an actual rate cut in 2020.
In 2018, the best place to invest in corporate bonds was on the front-end of the curve. Shorter-term corporate bonds significantly outperformed longer-term corporate bonds in 2018 for several reasons. Despite the flattening of the yield curve, the move higher in interest rates and widening of credit spreads was enough to cause negative total returns in the longer-end of the corporate bond market. In addition, the flow of funds into investment grade credit mutual funds/exchange-traded funds (“ETFs”) was very large over the past few years. While money flows into longer-term products have slowed, and in some weeks been negative in the latter half of 2018, there continue to be flows into shorter-term credit products. This helped drive demand for shorter-maturity corporate bonds, which led to outperformance in that part of the curve.
The domestic bond market is currently facing conflicting signals. On the positive side, revenue and earnings growth remain favorable due to a stable U.S. economy and benefits from the new tax law. Earnings growth is expected to moderate in 2019 but should still be positive. On the negative side, leverage has been rising at domestic companies and much of the proceeds have gone for shareholder-friendly initiatives including share repurchases, dividend increases and M&A activity. While likely down slightly from 2018 levels, new investment grade issuance in 2019 is expected to be substantial as companies have large debt maturities over the next few years that will need to be refinanced. Foreign trade/tariff issues, weakness in Europe/Italy, Brexit issues and a lack of unity in the U. S. Government all are potential wild cards that could continue to impact credit spreads.
If the domestic economy continues to expand in 2019, albeit at a slower rate than in 2018 as we expect, we will continue to focus on the 2-5 year range as the flat yield curve is not rewarding taking additional duration risk. In addition to higher quality corporate bonds will anticipate adding to taxable municipal bond holdings when attractive as well as agency mortgage-backed securities when attractive.
Bonds are subject to certain risks including interest-rate risk, credit risk and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in the report constitute the authors’ judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Madison Scottsdale is the Insurance Asset Management Division of Madison Investment Advisors, LLC © May 30, 2018.
“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC, and Madison Investment Advisors, LLC, which also includes the Madison Scottsdale office. Madison Funds are distributed by MFD Distributor, LLC. Madison is registered as an investment adviser with the U.S. Securities and Exchange Commission. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer, and is a member firm of the Financial Industry Regulatory Authority.
Madison Investments shares all personnel and resources at their Madison, Wisconsin location. Statistical data is for the consolidated Madison organization. The Madison organization consists of its holding company, Madison Investment Holdings, Inc. and its affiliates: Madison Asset Management, LLC; Madison Investment Advisors, LLC; and Hansberger Growth Investors, LP. Asset information presented includes non-discretionary assets. Refer to each entity’s Disclosure Brochure for more information.