A Period of Relative Calm for Bond Funds

The third quarter of 2017 was a relatively uneventful one. Although short-term yields ticked up slightly, U.S. Treasury yields across the maturity spectrum finished the quarter remarkably close to their levels as of June 30.

The yield on the 10-year Treasury fell for the first two months of the quarter and bottomed in September amid escalating tensions. However, it then rose sharply and finished the quarter at 2.33%, a modest 2 basis points higher than its level at the end of June. A relatively hawkish tone from the Fed, coupled with the release of the Republican tax plan, was credited for helping to buoy expectations for economic growth and higher rates.

Stable bond yields translated into modest gains for investors in investment-grade bonds. The Bloomberg Barclays U.S. Aggregate Bond Index finished the quarter with a 0.85% gain, while the intermediate-term bond Morningstar Category posted a 0.88% gain. Gains on low-yielding, short-term debt were the most muted, leaving funds in the various short-term bond categories as laggards for the quarter; the long-term government category also fell to near the bottom of the list following losses in September. Meanwhile, the quarter was generally rewarding for riskier funds, especially those with exposure to emerging-markets local-currency debt, which continued its strong run, and high-yield bonds.

Fed Update The Federal Reserve did not raise short-term rates in the third quarter but did make news in September with the announcement that it would start to reduce its holdings of mortgages and U.S. Treasuries in October by reducing its reinvestment of principal payments. The plan, which includes a cap on the total volume of mortgages and Treasuries that will be allowed to roll off in any given month, had been well-telegraphed ahead of the meeting. Although chairwoman Janet Yellen acknowledged that inflation remains below the Fed's 2% target, the Federal Reserve also left open the possibility of a rate hike later in the year. As of Oct. 4, the Fed futures market priced in a roughly 75% chance of a December rate hike.

Emerging Markets Still a Bright Spot

Emerging-markets bonds have had a strong run so far in 2017, and that trend continued in the third quarter. Emerging-markets currencies also generally strengthened, with a few exceptions, driving gains for funds with exposure to local-currency bonds, including

Corporate Bonds Continue Their Run

Corporate credit has enjoyed strong returns since hitting bottom in early 2016, and that trend continued in the third quarter, despite a bout of modest volatility in August. Investment-grade corporate bonds had a solid quarter, while high-yield fared even better. The spread on high-yield bonds widened early in the quarter but finished September tighter than its level at the end of June. This tightening indicates that investors require less yield to take on the credit risk in junk bonds and helped buoy prices and returns within the high-yield bond category. That group posted the third-best gain in the fixed-income universe. Funds with relatively large allocations to energy-related fare did particularly well over the quarter.

The equity markets flourished, helping to drive strong returns in funds with large investments in convertible bonds and common stock.

Municipal Bonds Like their taxable cousins, municipal bonds posted a modest gain over the quarter, with the Bloomberg Barclays Municipal Bond Index up 1.06% over the period. After a solid July and August, the increase in broad market yields and strong supply made for modest losses in September. High-yield muni bonds generally fared a bit better, with the Bloomberg Barclays High Yield Muni Index up 1.5%.

But not all of the muni market's riskiest bonds did equally well. Illinois-related names benefited from an end to that state's budget impasse in early July. However, bonds issued by Puerto Rico fell sharply following Hurricane Maria's devastation of the territory. As a result, performance across the high-yield muni group varied considerably.

More Market Outlooks

Stock Market Outlook: China Rebalancing Presents Winners and Losers

Credit Market Insights: A Solid Quarter for the Bond Markets

Basic Materials: Valuations Propped Up by Shaky China Fundamentals

Communication Services: Smaller Rivals Call the Shots in U.S. Wireless

Consumer Cyclical: Tepid Mall Traffic Could Constrain the All-Important Holiday Season

Consumer Defensive: Valuations More Reasonable After Third-Quarter Retreat

Energy: All Roads Point to Oversupply in 2018

Financial Services: Banks Can't Rest Easy

Healthcare: Stock Selection Key as Valuations Rise

Industrials: Worldwide Growth Is Resilient, But Valuations Look Full

Real Estate: Enter With Caution

Technology: Valuations Painting Overly Rosy Scenarios

Utilities: Valuations Still Running Out of Control

M&A Outlook: High Prices Impede Dealmaking in the U.S.

Private Equity Outlook: Larger Funds, Larger Deals

Venture Capital Outlook: Exits Come Into Focus as Valuations Continue to Climb

U.S. Stock Funds: Steady as She Goes

International-Stock Funds: The Beat Goes on