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 leg 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 $60 billion in the first quarter and $30 billion in the last three months of 2017. The Fed expects 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. Recep Erdogan, Turkey's re-elected president, effectively took control of the Central Bank of the Republic of Turkey and installed his son-in-law as chief economic policy maker. In Europe, Italy's anti-establishment left- and right-wing populist parties managed to form a government after March elections. Italian government bond yields jumped, though markets calmed as the Five Star–Lega coalition tamped down historical criticism of the euro and demands for sovereign debt relief. 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 Barclays U.S. Aggregate Bond Index delivered a negative 0.16% return, bringing year-to-date losses to negative 1.62%. For the second quarter 2018, Thornburg Strategic Income Fund returned 0.21% (I Shares), outperforming the Bloomberg Barclays U.S. Universal Bond Index, which delivered a negative 0.27%, and in line with the Blended Index, which returned 0.22%.

Over the first half of 2018, Thornburg Strategic Income Fund returned 0.02% (I shares), beating the both the Bloomberg Barclays U.S. Universal Bond and the Blended Index, which sank 1.67% and 1.16%, respectively, in the period.

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% annual 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 securities or commercial mortgage-backed securities spaces. Still, as bottom-up, relative value investors, we identified a number of individual opportunities and selectively added to our portfolios.

Interestingly, U.S. high yield proved both resilient and fragile. Although portfolio outflows rose to a total $18 billion in the first half of the year, the Bloomberg Barclays U.S. High Yield Bond Index advanced 1.03% in the second quarter, bringing the first half return to an above-water 0.16%. Muted default rates and shrinking supply proved supportive. New high yield issuance declined 23% for U.S. dollar paper and fell 15% for global sales. Issuers understand the market isn't as wide open as in 2017. Absolute rates are higher, and many companies looking to borrow are finding favorable conditions in the leveraged loan (bank loan) market. Also, the visible issuance calendar is light.

Default rates should remain subdued for the near-term given solid economic growth and strong earnings estimates. Although high-yield credit spreads loosened marginally recently, they remain tight relative to history. Spreads may resume a grind tighter so investors could be rewarded in the short term for assuming a “risk-on” posture. Certainly, lower- quality credit has outperformed this year, as CCC returned 3.17% in the January- through-June period. Nonetheless, our portfolio is light in lower-quality holdings, as we're focused on stories that can generate a reasonable outcome in a variety of macroeconomic conditions.

We take risk when we are paid to take it. We remain cautious around credit spread duration and this later-cycle market environment. While we don't expect a near-term credit market swoon, cycles can turn rapidly and mini-implosions can happen intra-cycle. High-yield energy in 2015 and low-grade retail in 2016 bear this out. We remain biased toward less cyclical credits and those with near-tomedium term catalysts. In the meantime, should dislocations in one market segment or another occur, perhaps due to a less-balanced supply-and-demand dynamic, we stand ready to deploy capital. In fact, on an incremental basis we already have, albeit in more defensive ways. Strategic Income's cash position declined one percentage point in the second quarter to 10.8%. We found more opportunities in the collateralized mortgage obligation and corporate bond spaces, and increased our exposure to AAA credits a full percentage point.

We're cognizant of 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 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 seven-year and 10-year 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 10-year/two-year 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 precedes 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 remain prudent around risk exposures in the portfolio. 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 prefer 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 also increased in price.

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 highyield 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.

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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