What a way to end a year. As the third quarter was ending, it seemed everyone was expecting yields to continue the slow ascent for the final three months of 2018. The Federal Reserve had just raised the overnight fed funds rate for the third time in September and a rate hike at their final meeting in December was all but a certainty. Bond investors were also thinking about and planning for further rate increases in 2019. That lasted for a few weeks into the fourth quarter, but as it turned out, many were unprepared for the bond market’s quick about-face and the ensuing rally that lasted until year-end. While the shortest and longest Treasury note maturities were volatile, by year-end the largest moves were seen in the intermediate range, with 5 to 10-year maturities dropping over 50 basis points from the 2018 highs of early November. December alone was the impetus for many of the investment grade intermediate bond indexes to finish the year in positive territory.
Inflation expectations plummeted in the fourth quarter as oil and gasoline prices fell. The yield curve of 2-year to 10-year Treasury securities finished the year at 19 basis points, down from 24 basis points at the end of the third quarter and keeping the potential for a recession on everyone’s mind. And the Federal Reserve did raise short rates for the fourth time at its December meeting, which at the time had lost some if its “as expected” and felt more like “as required.” That put the fed funds rate at 2.25%-2.5% to finish 2018. While the market is pricing in a small chance for further rate increases, the Fed is anticipating two rate hikes this year. We believe it will wait until at least its June meeting while assessing further economic data on inflation and unemployment.
For the quarter, the Bloomberg Barclays U.S. Aggregate Index, the broadest bond market index, advanced 1.64%, putting the index flat for the entire year. Of that fourth quarter performance, 1.84% was December alone. This was a remarkable turn from an almost entirely negative year and something repeated in most of the other indexes.
The Bloomberg Barclays Intermediate U.S. Government/Credit Index, our benchmark, returned 1.65% for the fourth quarter, helped by 1.34% in December. For the year, the index returned 88 basis points. That positive performance in the index was due to the over-weight to Treasury securities. The risk-off trade in the bond market overwhelmed demand for Treasuries but took a toll on corporate debt. The Bloomberg Barclays Intermediate Corporate Index finished the year negative 23 basis points even though it was positive in the fourth quarter. Long maturity bonds dragged down performance for the year in the broad corporate index even further. The Bloomberg Barclays U.S. Corporate Index returned -.18% for the fourth quarter and finished 2018 -2.5%. Not to be outdone was the Bloomberg Barclays U.S. Corporate High Yield Index which lost 4.5% in the fourth quarter – almost half of that in the month of December. The High Yield Index, which was positive entering the final quarter, ended 2018 -2.08%.
In our Q2 Investment Strategies newsletter, I wrote how high yield was “bucking the trend’ with positive returns but we were “cautious” longer term. High yield bonds (AKA junk bonds) are very susceptible to large price swings. Equity selling, lower commodity prices, and reduced liquidity were just the ingredients of a recipe for disaster. For that reason, throughout the quarter we have been increasing the overall quality of our clients’ fixed income portfolios by reducing non-investment grade bonds.
But what about investment grade corporate debt? Reducing lower rated debt and adding to our government bond allocation began a re-positioning of our clients’ portfolios as we move through the late cycle domestic economy. The fourth quarter was a return to a more normal risk/reward environment when it paid to hold higher quality corporate securities and we believe that theme will continue throughout 2019. Rest assured we are not giving up on the corporate bond market. Our strategic fixed income allocation for total return portfolios has 50% allotted to corporate bonds and that is a slight over-weight to our benchmark. We value the incremental income of non-Treasury securities as a powerful influence for long-term performance. At the same time, we want to be defensive against credit downgrades if the global economy slows more than anticipated.
Switching gears to the tax-exempt bond market, the Bloomberg Barclays Quality Intermediate Municipal Index returned 1.72% for the fourth quarter and 1.51% for all of 2018. A rough start to 2018 due to tax law changes going into effect put the municipal bond market in quite a hole to start the year. Throughout the year though, the influences of lower new issue supply, high taxable equivalent yields (especially for states like NY, NJ and CA) and improving credit fundamentals brought retail demand back into the market. And like most other high-quality fixed income sectors, the November/December rally provided the strong finish and positive return across all maturities. Revenue bonds outperformed general obligation bonds in 2018 due to the incremental income as well as being a smaller portion of new issue supply during the year.
As we look to the new year in the municipal bond market, net supply is always a focus for the first few months as maturities and calls outweigh new issuance. With the lack of any tax reform scheduled to begin 2019, a healthy start to the year is expected. We anticipate issuance in 2019 to be similar in size to 2018, roughly $350 billion, while seeing more new money deals and less refunding. A bipartisan bill to fund infrastructure to boost spending on roads and bridges may add some much-needed supply to that sector, though compromise in Congress seems a distant possibility. Nonetheless, we continue to look for opportunities in A-rated revenue bonds and AArated general obligation bonds.