3rd Quarter 2018

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During the third quarter, the Bloomberg Barclays U.S. Aggregate Bond Index delivered a 0.02% return, bringing year-to-date losses to 1.60%. Over the same period, Thornburg Limited Term Income Fund returned 0.36% (I shares), outperforming the U.S Aggregate Bond Index and its benchmark, the Bloomberg Barclays Intermediate Government/Credit Index, which returned 0.21%.

The third quarter of 2018 began with more-dovish-than-expected minutes from the previous U.S. Federal Reserve monetary policy committee meeting and ended with less-hawkish-than-expected Federal Open Market Committee (FOMC) projections. As central banks move away from ultra-accommodative monetary policies, dependence on forward guidance as a market influence has grown increasingly important. While the Fed has eliminated some forward guidance, Chairman Jerome Powell continues to guide markets through the “normalization” process in post-meeting press conferences, which, in a new development, will be held at every FOMC meeting beginning in 2019. The European Central Bank (ECB) and Bank of Japan (BOJ), meanwhile, have increased their communications as well.

U.S. 10-year Treasuries traded in a narrow range around 2.90% through the first two thirds of the quarter before spiking to 2.97% on rumors Japan was about to change its quantitative easing (QE) program, highlighting the importance of global central bank actions and market reactionary functions. The BOJ introduced forward guidance and a flexible trading band for 10-year Japanese government bonds (JGBs) on July 31. Governor Haruhiko Kuroda explained that it’s necessary to restore some market functionality and liquidity to JGBs. Later in the quarter, ECB chief Mario Draghi spoke about plans to stop expanding its €2.4 trillion quantitative easing program—though maintaining securities reinvestment—and promoted greater risk-sharing among member states through an integrated European banking and fiscal system. As we have mentioned in previous communications, an important feature in today’s marketplace is a changing landscape for global central bank accommodation and the resultant market gyrations that follow.

The U.S.’s 4.2% annualized second-quarter economic growth appeared to have had little immediate effect on the market, as it was widely anticipated. Other economic data during the third quarter appeared mixed, but generally suggested continued above-trend growth. Perhaps most notably, despite trade war rhetoric and an ongoing negative political environment, both business and consumer confidence remain strong. Non-farm payrolls have grown at a decent 185,000 per-month average over the last three months. Wages continue to increase, albeit at a moderate pace, causing no major impact to inflation. The biggest question facing the economy is if the jump in economic growth is sustainable. We have our doubts.

Tax reform has certainly given a boost to after-tax consumer and business income. Consumer spending has jumped and even corporate investment has picked up in 2018. That said, future growth will now be measured relative to a higher base, creating a more difficult hurdle. Meanwhile, leverage in all three major sectors (government, corporate, and consumer) is becoming more expensive to service with higher rates. Going forward, it will be challenging to find additional spending power in an already indebted economy to fuel future growth. Perhaps higher capital expenditures and reduced regulation are the missing links to higher productivity growth and the start of a virtuous cycle, but given continual disappointments in this cycle thus far, we remain skeptical.

Given economic growth, the Fed increased its target range in late September. Over the quarter, rates moved higher with the two-year Treasury increasing 29 basis points (bps) to 2.82% while the 10-year increased 20 bps to 3.06%. Thus, the curve, not unexpectedly, flattened over the period. With the unemployment rate likely below its natural level and inflation near target, it appears the Fed will stay on its monetary tightening path and increase the target rate again in December, and another three to four times in 2019. The Fed says it will remain data dependent. But should the U.S.- China trade conflict begin to impact the real economy significantly or emerging market difficulties bleed into developed markets, perhaps we’ll see an extended pause in monetary tightening. However, this Fed seems to be less inclined to deviate from its tightening program. Any data that would cause a deviation would have to be quite meaningful in nature and unlikely to come from gyrations in the S&P 500 Index.

Toward the end of the quarter, we bought some seven-to-10-year U.S. Treasuries (USTs) in Limited Term Income to move duration back into the low 2.90s, given the move in rates. The duration of the portfolio had fallen a bit with the passage of time and repayment of bonds, as well as some selling of credit duration. We’ve periodically taken advantage of the bounce higher in rates to move duration of the portfolio closer to the middle of our longer-term range of 2.5 to 3.5 years. We also bought some USTs in Thornburg Low Duration Income Fund to move duration from 1.2 to 1.4 as two- to three-year UST rates also moved higher throughout the quarter. Overall, we still don’t see great value in pure duration risk, but given our underweight position, as compensation for duration improved, we decided to slightly reduce our underweighting.

Corporate leverage remains at elevated levels across the credit spectrum, despite some improvement in recent quarters, thanks to strong revenue and cash flow growth. Investment-grade spreads recovered somewhat during the third quarter. Per Bloomberg, investment-grade spreads reached 124 basis points in late June 2018, up from a low of 85 basis points in February, following higher rates combined with a few months of heavy new issue supply. But new supply declined notably in July and August, and while September was a very large supply month, spreads rallied back to roughly 105 basis points. Bids across corporate sectors remain strong, but considering our questions around the path of growth going forward, credit selectivity is of upmost importance.

We continue to favor investing in securities backed by the cashflows of the U.S. consumer. That said, consumers are re-leveraging their balance sheet largely via unsecured borrowing (student loans, personal loans) and via autos. Spreads in many of the asset-backed securities (ABS) sectors we’ve found attractive have gotten tighter. In turn, we’ve become even more selective with consumer ABS. We’re finding value in senior tranches of non-agency mortgage-backed securities we are buying. Essentially, we are moving more into secured consumer loans (i.e., secured by houses). In our view, our place in the capital structure reduces our credit risk and the underlying borrowers’ incentives/ability to refinance controls prepayment activity, making for an attractive opportunity, given the limited convexity risk.

In general, we still prefer to be short and defensive, believing we’ll see more attractive buying opportunities down the road.

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

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