4th Quarter 2017

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Near the end of 2016, interest rates jumped significantly following the election of President Trump. Higher yields were fueled by expectations of faster economic growth and rising inflation as a result of policies projected to be put in place by the new U.S. administration. Many expected yields to continue to rise throughout 2017. Interestingly, the yield on the 10-year U.S. Treasury remained below 2017 starting levels for most of the year, and ended the year roughly unchanged from where it started. Markets remained sanguine with regards to risk in the fourth quarter of 2017, with renewed optimism inspired by developments surrounding U.S. tax reform.

In our view, U.S. fiscal stimulus (e.g. the tax bill)—while short-term positive– could potentially result in inflation. But perhaps more important in the long run is the fact that the tax bill immediately increases the U.S. fiscal deficit. If growth doesn’t pick up on a sustainable basis, then that deficit increase will become long-lasting. In previous commentaries, we mentioned government balance sheets as an area of concern going forward. While we generally believe a simpler, more-efficient tax structure would lead to improved growth, we are not yet certain that is what we will see. Indeed, though lower tax rates will provide short-term stimulus, we have not been convinced that our current system was significantly improved.

To be sure, there are a lot of reasons to be optimistic in 2018. However, due to the asymmetric nature of returns within fixed income and low levels of risk compensation, it pays to keep safety of principal top of mind. In our view, the largest risk to markets in general is the removal of policy accommodation by most major central banks around the world. The Federal Reserve Board (Fed) is shrinking its balance sheet and raising its policy rates, the European Central Bank is tapering its purchases, and even the Bank of Japan has signaled that 0% interest rates won’t last forever. Despite central banks taking punch out of the punchbowl, general macroeconomic and market indicators point toward loose financial conditions. This may embolden central bankers and allow them to potentially remove stimulus at an increased pace. No one on Earth has a road map for what is to come, but it is certainly reasonable to suggest that at some point this will be a headwind to asset performance even if the global economy strengthens further from here.

Fed Chair Janet Yellen raised rates one final time while at the helm during the fourth quarter. Now, markets look toward the transition to incoming chair Jerome Powell. We expect the transition to go smoothly and the Powell-led Fed to be a potentially more hawkish continuation of the Yellen regime. With New York Fed President William Dudley and board member Stanley Fischer also departing, there are multiple posts in transition within the Fed. While the large number of new members mostly appear benign, it remains another potential source of volatility in 2018.

Inside the Portfolio

Investment-grade spreads tightened slightly over the fourth quarter, with brief moments of volatility caused by heavy supply and knock-on effects from brief wobbles within the high-yield complex. Option-adjusted spreads are now at post-crisis tights (lower than summer 2014 levels) and are not that far from pre-crisis (2004–2007) tights. Compensation for risk continues to grind tighter despite the appearance of some weak credit metrics, though deterioration has somewhat stabilized. We will be watching to see if spreads can continue to tighten in the face of reduced liquidity from the world’s central banks. In the meantime, we remain conservatively positioned in credit, given unattractive compensation levels.

We continue to prefer short floaters (1–3 years), given expected Fed rate hikes and for the shorter credit duration. Overall, our generally conservative positioning in credit is not really about credit ratings, though there has been some migration to higher credit rungs within Thornburg Limited Term Income Fund. Rather, it’s about the assets that generate the cash flows behind the bonds we purchase. For example, we prefer less cyclical businesses, such as utilities. In our view, business models are often more informative than credit ratings during times of stress.

Despite the previously mentioned deterioration in some consumer loans markets, we remain constructive on the state of the consumer, and, as we’ve mentioned in previous commentaries, we’ve been executing on that view with asset-backed securities (ABS). Generally, we favorably view the structural enhancements provided by many of the ABS we’ve purchased (senior, shortdated, with amortization, etc.). However, spreads have tightened notably in this market as well. While we continue to invest in this area, we have become even more selective as the cycle rolls on.

We have increased Thornburg Limited Term Income Fund’s exposure to mortgages, both agency backed and prime jumbo. In both cases, we perceive the credit risk to be minimal and are more focused on the convexity profile of purchases with a close eye on structural enhancements and the incentive profile of underlying borrowers. We believe the convexity risk is quite limited and, as such, the spreads being offered provide attractive compensation relative to corporates and some ABS credit.

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.

 

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, visit the Prices & Performance page.
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Source of data: Factset, BBH, Confluence, Bloomberg—unless otherwise stated Date of data: 31 December 2017—unless otherwise stated

Investments carry risks, including possible loss of principal. Portfolios investing in bonds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. Unlike bonds, bond funds have ongoing fees and expenses. Investments in mortgage-backed securities (MBS) may bear additional risk. Investments in the Fund are not insured, nor are they bank deposits or guaranteed by a bank or any other entity.

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