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 kept climbing in February to 2.95%, but by the end of March fell back to 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 Strategic Income Fund returned negative 0.19% (I shares), outperforming the Bloomberg Barclays U.S. Universal Bond Index, which delivered negative 1.41%, and the Blended Index, which returned negative 1.38%.

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 concern for investors.

Specifically, market participants appear focused on 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 mixed spending and housing data, synchronized global growth appears sustainable and the general economic environment remains benign.

In The Portfolio

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. The Bloomberg Barclays U.S. High Yield Bond Index posted a loss of 0.86%, its first quarterly decline since a 2% loss in the fourth quarter of 2015. High-yield issues fared better than the 2.32% loss for its high-grade U.S. Corporate Bond counterpart, primarily due to the shorter duration and higher coupons of the high-yield index.

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 and HY corporates relatively uninspiring and not ripe for wholesale buying at these levels (see Chart 1). Unfortunately, assetbacked 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.

Option-Adjusted Spreads

Over the quarter, the front end of the 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 active, relative value managers like ourselves.

Volatility has presented opportunity in select names that we have been following, but that we had generally passed on or remained light in due to the tightness of spreads. The combination of higher rates and higher credit spreads has resulted in below-par prices in many names, resulting in better convexity around potential calls and better loss, given default metrics. Opportunities were not incredibly abundant, however, we identified several opportunities to add dislocated corporates at a notable dollar price discount compared to the recent past. Some of the names added during the first quarter included Aramark, Ball Corp., Iron Mountain, B&G Foods, Sirius XM, Hanesbrands, Virgin Media, and HCA Inc. The volatility during the quarter also provided for more opportunities to improve risk/reward within certain capital structures or swapping one credit for another. During 2017, we removed a notable amount of volatility from the portfolio, so now we have the option to be opportunistic without moving the portfolio towards aggressiveness. While there has been opportunity to add some potential return, and thus volatility to the portfolio, the market valuations are still fairly demanding at this later stage of the expansion/credit cycle. Therefore, we are likely to remain defensive going forward.

We generally think inflation will move higher, given a stronger economy and solid labor market. The U.S. tax reform bill creates fiscal stimulus on the one hand and a deeper federal budget deficit on the other, and will certainly add to inflationary pressures. But 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, we have favored investing behind the U.S. consumer, whose balance sheet has notably improved since 2008–2009. As alluded to above, this has meant senior-most tranches of asset-backed securities, grouping consumer loans, auto loans, and student loans. These tend to be short-lived assets that rapidly build upon already strong credit enhancement.

Executing effectively in the context of Thornburg Strategic Income Fund's broad mandate for providing income and total return without depending on an individual asset class (be it high-yield corporates, asset-backed securities, mortgages, etc.) can be valuable. We try to combine those individual, diverse opportunities into a moderate-risk, moderate-reward portfolio that we believe can solve a number of investor challenges.

Lastly, we want to highlight the promotion of Christian Hoffmann to Strategic Income Fund's portfolio management team. Christian joined Thornburg in 2012 as an analyst and was promoted to associate portfolio manager in 2014. During his tenure, he has made substantial contributions to the fund's performance through his excellent credit analysis and investment ideas as well as his overall thoughts and leadership in navigating credit and fixed income markets. This promotion recognizes this past success and demonstrates our complete confidence in his ability to create even greater shareholder value in the future as a member of the management team. Congratulations Christian.

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

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