3rd Quarter 2017

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Markets began the year pricing in the benefits alluded to by the surprise victory of President Trump, as risk-asset prices and U.S. Treasury yields moved up notably. As the year has progressed, markets have continued to discount the possibility of meaningful fiscal stimulus and, therefore, a resulting reflation trade. Ten-year U.S. Treasury yields have declined meaningfully since their peak, and the two-year versus 10-year yield curve has flattened, suggesting that the market is suspicious with respect to potential future inflationary policy. Throughout 2017 and the third quarter, administrative gridlock caused market participants to doubt the administration's ability to meaningfully implement its agenda. However, towards the tail end of the third quarter, a combination of U.S. Federal Reserve (Fed) member comments and a flicker of hope around tax reform caused treasury rates to rise 0.15%–0.20% across the curve.

Meanwhile, risk assets continued to perform well during the quarter, although not in a straight line, due to North Korea tensions, missteps during the Charlottesville protests, and multiple hurricanes. The bottom line, however, is that stocks are up, high-yield prices are up, and investment-grade spreads are tighter. The U.S. dollar experienced broad gains immediately following the election of President Trump, but like Treasury yields mentioned above, the dollar has retraced its steps as the exuberance of the past few years appear to have subsided.

The U.S. economy continues to grow, and unemployment continues to fall while, somewhat mysteriously, inflation has barely budged. The Fed continues along the path of reiterating its belief that transitory factors are at play and will ultimately subside. However, certain members have publicly begun to question our broad understanding of inflation, suggesting traditional models, such as the Phillips Curve—an economic theory that inflation and unemployment have a stable and inverse relationship—may no longer apply. In some ways, this may be true. Today the Phillips Curve might need to be looked at on a global basis as today's workforce is more mobile than any time in history due to technological factors, such as the outsourcing of services. Given generally lax inflation, one might imagine the Fed, as well as other central banks, having plenty of cover to keep rates lower for longer. However, the Fed continues to raise short-term rates, perhaps with an eye toward taming ever-increasing risk-asset prices.

The Fed also recently announced the when, how, and why of its balance sheet reduction. The passive, maturity roll-off approach, has been well received by markets so far. An October start date to the roll-off begs several questions: Will everything remain calm as is currently expected by market participants? Can global financial markets handle a Fed balance sheet unwinding, and a potential European Central Bank (ECB) quantitative easing (QE) reduction simultaneously? If QE initiation in some way helped economies and markets, then isn't it reasonable to expect the withdrawal of QE to have marginally negative implications, even if implemented at a measured pace? We recently experienced an example of how intertwined global markets are when German 10-year bund yields increased from 0.25% to 0.60% and 10-year U.S. Treasury yields increased from 2.14% to 2.38%, due to comments made by ECB president Mario Draghi in late June. Still, markets remain sanguine around the balance sheet reductions. Yet, as the great QE experiment comes to an end, perhaps it is wise to be skeptical that the unwinding will go off without a hitch.

One factor at play that may impact how Fed policy, and markets for that matter, move forward is the fact that Chair Yellen's term at the Fed will come to an end in early 2018. President Trump has yet to name a successor and Yellen herself could potentially remain at the helm. Interestingly enough, when Yellen's term expires, there will be five open positions at the Fed including vice chair, as Stanley Fischer announced his resignation effective October 2017. While it's true that President Trump currently espouses the virtues of lower rates, markets have no guarantees that he will appoint a chair, vice chair, and three additional members who share his views. In a nutshell, the future leadership and overall composition of the Fed remains unknown at this time. This is a fact that has not received much attention from market participants in the form of perceived concern or volatility.

What this Means for the Portfolio

High-yield and investment-grade bonds performed similarly during the period with a few major differences. As an asset class, high yield has seen net outflows over the course of 2017 thus far, with week-to-week flows being quite volatile. If flows are any indication, investors may be expressing some skittishness around the asset class. That said, spreads continued to drift lower over the course of the quarter, buoyed by somewhat light new issuance in months other than September. However, similar to the issues faced across the fixed income landscape, true opportunities remain sparse.

Investment-grade spreads generally tightened over the quarter with corporations reporting decent revenue and earnings growth and flat to slightly better credit metrics. However, all was not smooth sailing for credit. Heavy new issue corporate supply in July and early August seemed to cause a bit of market indigestion despite continued solid inflows into investment-grade funds and strong demand from other investors. Spreads took another leg wider with the North Korea missile launch and reaction to the Trump administration's response to the Charlottesville incident, which led to rumors of tax-reform champion Gary Cohn's imminent resignation. That did not happen, and spreads ultimately widened about 0.10% before starting the reverse march back to about 1.0% at quarter end.

Given how tight spreads are generally, the 0.10% move wider didn't present a truly attractive buying opportunity. As a result, we continue to hold high levels of cash, which we are ready to deploy as meaningful opportunities present themselves without over-reaching for yield.

The consumer remains healthy as employment continues to increase, though debt levels continue to rise in areas such as student loans, auto loans, and unsecured debt. Asset-backed securities spreads have continued to tighten as well. However, we still favorably view the senior tranches of these assets as they are generally quite short-dated and well-structured to protect the top tranches from losses. Even here though, our activity has slowed, given spread tightening and overall compensation.

Over the quarter we have seen some opportunities in agency mortgages. Spreads have not tightened as much relative to other asset classes and have even moved wider in some cases. Ultimately, this may be the result of market worry over the Fed's plan to allow its balance sheet to run-down, including agency mortgage-backed securities. While the impact is certainly unknown, we believe it will be manageable in the context of our overall portfolios. Additionally, we believe current spreads in the marketplace are adequate compensation for the low level of convexity risk we are assuming, given the types of newly created non-agency mortgages, including jumbo, and seasoned collateral issues we are purchasing.

We continue to follow our central tenant of investing—seeking the best relative value in terms of risk and reward—and for now that continues to point to higher-quality instruments for the portfolio and a general posture of caution.

Thank you for investing with us in Thornburg Strategic Income Fund.

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 4.50%.

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