Riskier credit sectors once again outpaced government bonds in October as interest rates rose on the back of a strong economy and despite mild inflation readings.
[ibd-display-video id=2488746 width=50 float=left autostart=true]Rates across the board ticked up, with the 10-year U.S. Treasury note finishing the month at 2.38%, up five basis points. The economy continued its expansionary path as several readings came in strong, such as consumer spending, consumer confidence and construction spending. However, core inflation at 1.3% remained well below the Fed's target of 2%.
Taxable general domestic bond funds rose an average of 0.29% in October, while U.S. diversified equity funds advanced 1.7%, according to preliminary Lipper Inc. data.
Income-generating funds showed the best performance, with loan participation, multisector income and flexible income funds gaining 0.56%, 0.27% and 0.42%, respectively, during the month. They're up 3.08%, 5.6% and 8.4% year to date.
Government-debt-related funds all declined in October. General U.S. Treasury funds shed 0.15%, GNMA funds 0.08% and U.S. mortgage funds 0.03%. Spreads tightened during the month, resulting in a positive return of 0.35% for high-yield funds, and 0.23% and 0.3% for A and BBB rated corporate debt funds.
"The major theme has been the potential for tax cuts and with that, the potential for better growth in the economy, which has led to slightly higher rates, tighter credit spreads and equities at record highs," said John Bredemus, head of capital markets at Allianz Investment Management. "On the other side of that is this continued low-inflation environment."
Non-U.S. bond mutual funds also posted losses in October. Emerging-market local-currency ones dropped 2.22%, trimming their yearly gain to 10.49%. Hard-currency ones only ticked down 0.1% as the dollar strengthened a bit, topping off their year-to-date return at 9.7%. International income funds fell 0.42% for a yearly gain of 6.62%.
"There is something we haven't seen since 2010, when the world was coming back from that bad recession of 2008-2009, and that is synchronized growth," said James Swanson, chief investment strategist at Massachusetts Financial Servicesand lead investment manager of MFS Diversified Income fund ( DIFAX ). "We really haven't seen the eurozone, Japan, the emerging-market countries and the U.S. doing this well all at the same time. And growth is associated with higher interest rates."
The Bank of England raised its benchmark interest rate to 0.5% from 0.25% on Nov. 2, the first increase in over a decade, but signaled that further rate increases will be very gradual. Meanwhile, the European Central Bank has agreed to further slow its bond buying from 60 billion to 30 billion euros per month starting in January as the eurozone is experiencing its fastest growth since the debt crisis 10 years ago.
So, with global economic growth firing on all cylinders, what could derail the current state of capital markets?
"Central bank policy is the most often cited reason that the market would turn down," said Mark Hackett, chief of investment research at Nationwide. "Currently, the Fed and ECB are patient, but a significant upturn in inflation could change things. Inflation across the globe has picked up, but is not yet cause for caution. It needs to be closely watched, though."
MFS' Swanson expects the yield curve to further flatten and growth to slow down somewhat in 2018. But the baby boomer demographics call for higher demand for fixed-income assets, which should be supportive of bonds globally. "So I'm not worried about a bond blowout, but in the near term, short-term rates have further to go up," noted Swanson.
He favors the seven-to-10-year part of the yield curve for government bonds, which he recommends owning for safety. "I don't think you make money; I think you just collect your coupon on that," he said.
Within fixed income, he likes high-grade investment-grade corporate bonds, mostly in the U.S. He believes they are a nice alternative to equities, which are very expensive now. He's not in favor of high yield, primarily due to the lower quality and low compensation for the extra risk.
"It can be a volatile market," he said of high yield. "If we go into a recession, that market on average goes down 26%, and that's a bond market. So, I don't think that's a safe place to be right now."
Within investment grade, he likes energy and health care. He's also constructive on select structured products such as collateralized mortgage obligations, asset-backed bonds and collateralized loan obligations, where he says one can find pockets of opportunity. Due to the long duration of Treasury inflation-protected securities, Swanson is slightly underweight TIPS as those securities will be hurt as rates rise.
Municipal bond funds ended October with flat to slightly negative returns. Swanson believes munis are still a good alternative to taxable bonds for people in high tax brackets as they provide similar yields. "The key to the muni market is being selective, because there are some very bad credits when you look at state GO's within the U.S. or individual project-type deals- some of them are very risky."
Read The Bond Mutual Fund Roundup For September And The Third Quarter
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