Like much else, fixed income markets were dominated by the coronavirus pandemic in the first quarter. While the COVID-19 crisis is far from over, we expect that second-quarter bond market performance will be dominated as much by the path of central bank and government policies around the world as by the path of the coronavirus.
During the first quarter, as the coronavirus spread around the globe and containment efforts partly shut down economic activity, investors rushed into U.S. Treasuries at the expense of nearly every other asset class. Prices rose and yields fell sharply, with one- and three-month Treasury bill yields sinking below zero at times. In contrast, prices of many other bonds dropped. The riskier the bond, the larger the price drop.
Treasury bond returns were strong in Q1, but returns for riskier bonds declined
Source: Bloomberg. Q1 2020 returns are from 12/31/2019 through 3/31/2020, while 2019 returns are from 12/31/2018 through 12/31/2019. Returns assume reinvestment of interest and capital gains. See disclosures for indexes used. Indexes representing the investment types are: Treasury Bonds = Bloomberg Barclays U.S. Treasury Index; Core Bonds = Bloomberg Barclays U.S. Aggregate Index; Securitized Bonds = Bloomberg Barclays Securitized Bond Index; TIPS = Bloomberg Barclays U.S. Treasury Inflation-Protected Securities; Municipals = Bloomberg Barclays Municipal Bond Index; Int’l Developed Bonds (x-USD) = Bloomberg Barclays Global Aggregate ex-USD Bond Index; IG Corporate Bonds = Bloomberg Barclays U.S. Corporate Bond Index; Emerging Market Bonds = Bloomberg Barclays EM USD Aggregate Bond Index; Preferred Securities = ICE BofAML Fixed Rate Preferred Securities Index; Bank Loans = S&P/LSTA Leveraged Loan 100 Index; HY Corporate Bonds = Bloomberg Barclays VLI High Yield Index. Past performance is no guarantee of future results.
The mixed performance in the fixed income markets in Q1 underscores some important lessons for investors:
1. The benefits of holding Treasuries for diversification from stocks. Highly rated government bonds posted positive returns, providing a valuable offset to the 20% decline in the S&P 500® index. Longer-term Treasuries produced the largest returns, which has historically been true during stock market declines. In contrast, riskier, more aggressive investments, like high-yield and emerging-market bonds, tend to be correlated with stocks and therefore don’t provide as much diversification.
2. The value of liquidity in times of market stress. Steep price declines for preferred securities and municipal bonds were, to a large extent, the result of low liquidity. Because these are smaller markets driven by individual investors, when there are significant outflows from mutual funds, it can exaggerate the drop in prices.
3. The importance of a risk premium. When investing in more aggressive fixed income asset classes, investors should earn extra yield compared to Treasuries of similar maturity to compensate for the added risk. For example, investing in bonds with higher credit risk—that is, the risk that the borrower will default on the debt by failing to make required payments—means that the higher the risk, the more yield an investor should receive as compensation. Prior to the selloff, yields for most asset classes were very low relative to Treasuries and long-term averages. This offered little compensation to investors for the risk, resulting in steeper losses than might otherwise have been the case.