1st Quarter 2018

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The first quarter of 2018 marked the return of volatility from the muted levels experienced throughout 2017. As volatility rose, asset returns became highly correlated to the downside, catching many investors off guard. In January alone, the U.S. 10-year Treasury bond yield jumped 31 basis points (bps), and by the end of March stood at 2.77%. During the quarter, the Bloomberg Barclays U.S. Aggregate Bond Index delivered a negative 1.46% return, reminding investors of the potential perils found in longer duration, core bond indices. Over the same period, Thornburg Limited Term Income Fund returned negative 0.44% (I shares), outperforming the Bloomberg Barclay's U.S. Aggregate Bond Index and its benchmark, the Bloomberg Barclays Intermediate Government/Credit Bond Index, which returned negative 0.98%.

In a tumultuous quarter, the S&P 500 Index gave back all the gains from the best January in 20 years, returning negative 0.76%. Volatility, as measured by the CBOE Volatility Index (VIX), spiked in early February as investor fears over suddenly increasing inflation gripped markets. Leveraged VIX exchange-traded-note products quickly exacerbated the issue as the popular short volatility trade of 2017 unwound. Equities sold off roughly 10% over nine days before rallying as fears subsided. Treasury yields remained elevated throughout the quarter as potential changes to monetary policy from the new chairman of the Federal Reserve, Jerome Powell, were a top of mind concern for investors.

Specifically, market participants appear focused on any signs of inflation acceleration and what that might do to the pace of Fed, Bank of England, European Central Bank (ECB), and Bank of Japan tightening. Statements from former Fed Chairwoman Janet Yellen's last meeting earlier in the quarter were more hawkish than anticipated, and Powell's first Humphrey-Hawkins performance came off a bit hawkish as well. But, not so conclusively hawkish that markets pushed the yield curve sustainably higher. Despite acceleration concerns, sub-target inflation continues to provide the Fed, ECB, and other developed-market central banks enough wiggle room to move slowly. However, economic output gaps have shrunk back to neutral levels, and most notably, unemployment rates continue to fall such that the U.S. and various European economies are at or near full employment. Although we've recently experienced some weaknesses in spending and housing data, synchronized global growth appears sustainable and the general economic environment remains benign.

In Portfolios

Over the quarter, investment-grade (IG) and high-yield (HY) corporate bond markets eventually followed the stock market's lead and sold off. IG corporates reached a post-crisis low in spread in mid-January (about 85 bps), which equaled the pre-crisis low reached in 2007. The rate-driven selloff pushed spreads about 20 bps wider on average, making the market marginally more interesting. As such, we found a few more opportunities to deploy capital over the period. Of course, spreads are still generally tight (see Chart 1).

Option-Adjusted Spreads

General economic conditions are good, which should provide runway for earnings and cash flow to improve going forward. Additionally, credit metrics have stabilized and in some sectors improved. That said, leverage generally remains at highly stretched levels. High leverage combined with historically tight spreads ultimately leaves IG corporates relatively uninspiring and not ripe for wholesale buying at these levels. Unfortunately, asset-backed securities (ABS) spreads are also quite tight these days, so we remain highly selective in terms of both corporates and consumer driven ABS additions to portfolios.

Over the quarter, the front end of corporate credit curve experienced a bit more widening on average than the rest of the curve. However, due to the impact of duration, additional spread widening doesn't necessarily mean worse price performance when compared to longer ends of the curve. Recent tax reform and corporate repatriation of cash imply less need by companies to invest in high-quality (IG) corporates. Two-to-three-year bonds appeared the most impacted, though some paper out to five years showed additional weakness. Where there is weakness, there is often opportunity for fundamental managers like ourselves. We identified several opportunities to pick up dislocated corporates in short maturities during the volatility. But again, we are coming from very tight levels so selectivity remained key. The long end of the curve held up better with a seemingly strong bid from pension funds, life insurers, and other long-duration buyers, which shifted allocations from equities to fixed income to better match liabilities as all-in yields reached attractive levels.

We've kept duration relatively short within portfolios for a while now, and, over much of last year, we continued to shorten on the margin. Over the last 10 years, for example, our Limited Term Income Fund's duration has ranged from 2.5 to 3.5 years and at the end of 2017 duration sat at 2.5 years. In addition to holding shorter duration fixed-rate bonds, we also have around 20% of the fund in floating-rate product to benefit from U.S. Fed increases. This year, as U.S. Treasury rates moved up, we have increased duration somewhat to around 2.75. We are not looking to make a large rate bet here, rather, as duration risk has become more attractively priced, we have increased our exposure to it.

In Thornburg Limited Term U.S. Government Fund, we purchased 10-year very low convexity agency mortgages in 2017 at roughly 40 bps to Treasuries. These instruments recently tightened to approximately 28 bps to Treasuries, and we have sold in favor of holding pure Treasuries and not convexity. Additionally, we've had opportunity to purchase loans where the underlying rate resets higher four times for a total of 1% over next year. These increases will flow through to the coupon on the bonds—thus offsetting up to four additional rate hikes by the Fed, somewhat insulating portfolios. Going forward, we may look to potentially raise duration into higher rates.

We generally think inflation will move higher, given a stronger economy and solid labor market. The U.S. tax reform bill (fiscal stimulus) and related deficits will certainly add to inflationary pressures. However, given how competitive global labor and product markets are, we do not expect inflation to spiral notably higher. In terms of positioning, stronger economic growth continues to give us confidence to hold a decent amount of credit currently, though we have lowered risk exposures in the portfolio over time as risk compensation has declined. Generally speaking, we have favored investing behind the U.S. consumer, whose balance sheet has notably improved since 2008–2009. As alluded to earlier, across portfolios, this has meant senior most tranches of asset-backed securities, backed by consumer loans, auto loans, and student loans. These tend to be short-lived assets that rapidly build upon already strong credit enhancement. However, these assets have increased in price as well, and so we have pivoted somewhat to mortgages, specifically those where the credit risk is low, such as agency-backed MBS and jumbo prime. Given the structure and/or borrower incentives, we believe the compensation for the convexity is relatively 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.

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