2nd Quarter 2018

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The first-quarter spike in volatility carried over into the second, though the downside correlation in asset returns diminished as performance dispersion intensified in the second quarter of the year. In early March, the 10-year U.S. Treasury yield stood at 2.73%, then climbed to a high of 3.11% by mid-May, only to fall back to 2.86% by the end of June. Although threats of trade wars garner more media headlines, monetary policy tightening in the U.S. and tapering of central bank asset purchases in Europe appear to be driving much of the choppiness in credit markets.

The U.S. Federal Reserve's balance sheet reduction continued apace, with redemptions of roughly $90 billion of Treasury and agency securities rolling off in the April-through-June period, up from around $60 billion in the first quarter and $30 billion in the last three months of 2017. According to the Feds own projections, they expect calendar 2018 redemptions of $229 billion in Treasury and $141 billion in agency securities, respectively. At the same time, it continues to gradually raise its benchmark interest rate, lifting the upper bound to 2% in June and widening the rate differential vis-à-vis other major central bank target benchmark rates. Despite worries about the U.S.'s current account and fiscal deficits, the dollar strengthened, with the U.S. Dollar Index (DXY) rising roughly 5% in the quarter.

Increasing U.S. rates roiled emerging market economies, raising the cost of dollar-denominated debt obligations and forcing politically painful hikes in domestic short-term target rates to slow capital outflows. Trade tensions between the U.S. and China ebbed and flowed, as they did with the U.S.'s neighbors and partners in Canada, Mexico, and the E.U. At least geopolitical tensions eased, with an unlikely summit between President Donald Trump and North Korea's Supreme Leader, Kim Jong-un. Overall, an eventful quarter with various pockets of opportunities to deploy capital across our strategies. While the strong dollar may be dampening foreign demand for U.S. paper, demand from U.S. institutional investors, such as pension funds and life insurers with longer-term liabilities, has picked up, judging by the rotational flows from equities into fixed income.

During the quarter, the Bloomberg Barclay's U.S. Aggregate Bond Index delivered a negative 0.16% return, bringing year-to-date losses to negative 1.62%. Over the same period, Thornburg Limited Term Income Fund returned 0.21% (I shares), outperforming the U.S Aggregate and its benchmark, the Bloomberg Barclays Intermediate Government/Credit Bond Index which returned 0.01%. Over the first half of 2018, Thornburg Limited Term Income Fund returned negative 0.24% (I shares).

General economic conditions have been largely strong, notwithstanding worries about a flattening U.S. yield curve. Second-quarter GDP is expected to roughly double the first-quarter's 2% pace of expansion, providing a nice runway for earnings and cash flow to continue improving. In fact, recent S&P 500 Index consensus expectations put sales growth this year at 10%, building on revenue growth that for the last five quarters marks the best series since the Financial Crisis recovery began.

Corporate leverage has increased notably, and other credit metrics—including interest coverage—appear to be a bit stretched. However, the general economic environment is currently benign due to recent earnings growth and lower debt growth. Overall, metrics have continued to stabilize and in some cases, improved. To be sure, the current market is not without risks. When the cycle turns, metrics will deteriorate from already stretched levels which warrants some defensive positioning. Investment- grade U.S. corporate bonds lost 1% in the second quarter, bringing the first half returns to a negative 3.27%. Yet credit spreads in the space remain quite compressed relative to history. They did widen about 14 basis points in the second quarter, and finished June around 37 basis points wider than their January low. Certainly not a wholesale buying opportunity, but there was a bit more to pick over.

Little meaningful spread movement was seen in the asset-backed security or commercial mortgage-backed security (MBS) spaces. Still, as bottom-up investors, we identified a number of individual opportunities and selectively added to our portfolios. Fund durations rose marginally during the quarter, but remain squarely in the shorter end of their ranges over recent years. About a fifth of our Limited Term Income Fund remains in floating-rate instruments to benefit from Fed hikes, while our purchases earlier this year of high-quality investment-grade instruments, featuring underlying rate resets higher, helped offset the impact of Fed tightening. We may continue to incrementally raise duration in the funds as monetary policy continues to tighten and the relative attractiveness of duration increases.

Nominal yield pick-up in rate spreads is also rather paltry, particularly given inflation risks. Over the quarter, inflation accelerated, with the headline hitting 2.25% and core (ex-food and energy) reaching 1.96%, consistent with the Fed's 2.0% target. In the June minutes of the Fed's monetary policy meeting, several participants argued that it was premature to conclude that the Fed had achieved its 2.0% target. While two-year and 10-year Treasury yields are the usual determinants of yield curve inversion, and constantly cited as a harbinger of recessionary forces, the tightening between the 7- and 10-year yield indicates curve inversion is a real possibility before year-end. Nonetheless, the June minutes revealed that several participants favor the spread between the Fed funds rate and Fed futures for economic guidance instead of the Treasury curve. The historical data may explain the preference. The 2-10 curve inverted in December 1998, May 1998, and January 2006. In each case, the S&P 500 Index peaked 19, 22, and 21 months later, gaining 33%, 40%, and 22% after the inversion. All in all, curve inversion usually precede recessions by 12–24 months, and in previous cycles the Fed was not a massive participant in yield curve shaping as it has been for the last decade.

Stronger economic growth still gives us confidence to hold a healthy amount of credit. Though we have lowered risk exposures in the portfolio over time as risk compensation has diminished, only now are we starting to realize increased spread compensation. We continue to like investing behind the U.S. consumer, whose balance sheets have improved since the financial crisis, though we would note that their aggregate borrowing has picked up slightly of late. We remain focused on the senior most tranches of asset-backed securities comprised of consumer loans, auto loans, and student loans, all short-lived assets that exhibit strong credit enhancement. We're selective, though, as these assets have increased in price. We have also continued the shift to higher-quality mortgages such as agency-backed MBS and jumbo prime, as we think the compensation for the convexity is attractive.

We continue to follow our central tenet of investing—seeking the best relative value in terms of risk and reward. Our 10-year results suggest this process works, and as such, we'll remain focused on executing it in the years to come.

Thank you for investing with us in Thornburg Limited Term Income, Limited Term U.S. Government, and Low Duration Income Funds.

Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The maximum sales charge for the Fund's A shares is 1.50%.

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