How did the biggest bond funds perform in the third quarter?

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The biggest bond funds extended their losses into the third quarter as hopes that inflation would fall quickly and the Federal Reserve might slow its rate hikes were again dashed.

For some of the most widely held bond funds, the past three months marked the fourth consecutive quarter of losses. This includes the largest bond strategy for US investors, the Vanguard Total Bond Market Index VBMFX, which has never seen four straight quarters of losses in its 34-year history.

Vanguard Total Bond fell 4.68% in the third quarter, bringing its year-to-date loss to 14.65% and its 12-month loss to 14.74%.

As with the stock market, the third quarter began with a relief rally. Bond funds that invest in corporate debt securities rallied as recession risk appeared lower. Corporate bonds are considered vulnerable in times of recession, which could make it difficult for some companies to repay their debts.

The Vanguard Intermediate-Term Corporate Bond Index VICBX was approaching gains of 4% for the quarter in mid-August, but by the end was in negative territory by around that amount as inflation raged and interest rate hikes continued.

The hardest hit was iShares iBoxx Investment Grade Corporate Bond ETF LQD. The fund was one of the worst performing corporate bond funds this year. It invests in longer-term bonds than the average fund in the category, which hurt the fund when interest rates rose. The fund lost 21.24% in the third quarter of this year.

Funds that invest in longer-term bonds suffer when interest rates rise because the fixed payments of those bonds become less attractive as new bonds are issued with higher interest rates. Stuck to hold these bonds for longer periods, their prices fall when yields rise. One way to measure this is to calculate a bond’s duration, which measures in years how sensitive a fund is to interest rate increases.

“The average duration of the fund tends to be in the highest quartile of its category, standing at 8.7 years in July 2022. This has hurt its performance when interest rates rise, including since beginning of the year through July 2022,” writes Morningstar Associate Manager Research. analyst Lan Anh Tran. Over the year, corporate bond funds fell more than the average for mid-tier core bond funds. The average corporate bond fund is down 17.92% compared to the average decline of 14.67% for mid-tier core bond funds.

The Vanguard Total International Bond Index VTIFX outperformed US-focused indexes early in the quarter, but ended down 3.25%. The fund invests in high quality non-US bonds, but reduces its exposure to currency fluctuations by using hedging strategies.

Funds that invest globally, but do not use hedging strategies to offset currency fluctuations, struggled as the US dollar hit a 20-year high against other currencies. The rising dollar hurts the value of non-US investments for US fund owners. On average, global funds that hedge local currency movements lost 6.04% in the quarter, while global bond funds hedged against the US dollar lost only 3.47%.

The Vanguard Short-Term Corporate Bond Index VSTBX was the best among the largest passive bond funds, losing just 1.96% in the quarter. The same credit dynamic played out among short-term bond funds, with the broader Vanguard VBISX short-term bond index falling slightly more with a loss of 2.13%.

Funds that promise inflation protection are not immune to the effects of rising yields on their prices, and those invested in longer-dated inflation-protected Treasuries have struggled. “Changes in the consumer price index will impact the price of a TIPS by adjusting its principal value, but an increase in interest rates can have an outsized impact on the price due to the duration profile longer,” Morningstar analysts explained in a March article. .

The $26.4 billion iShares TIPS Bond ETF posted a 5.20% loss for the quarter, bringing its year-to-date loss to 13.69%.

Chart showing third-quarter returns for the largest passive and exchange-traded mutual funds

The largest actively managed bond fund, the $119.5 billion PIMCO Income PIMIX, lost just 1.86%. (Returns are based on the performance of each fund’s oldest share class.)

Morningstar strategist Eric Jacobson wrote in May that “the strategy outperformed many multi-sector bond peers in the Morningstar category on rising global bond yields entering the year with a duration of 1 .15 years, much of which comes from a 5.5% exposure to inflation-linked bonds.

BlackRock Strategic Income Opportunities Fund BSIIX held the best among the largest bond funds. The fund lost 1.79%, although it still trailed its peers in the alternative bond category.

“Lead managers Rick Rieder and Bob Miller have made the most of the strategy’s headroom in a variety of market environments, including weak and strong credit markets as well as periods of rising and falling prices. interest rate,” Jacobson wrote.

In the mid-core bond category, the $68.6 billion American Bond Fund of America ABNDX fell 4.58% but held up better than its peers. Morningstar manager research analyst Sam Kulahan writes that “managers actively manage portfolio duration,” which is generally below the average for mid-tier core bond funds.

Although short-term bond funds fared better than most other groups, Lord Abbett Short Duration Income LALDX and Vanguard Short-Term Investment-Grade VFSTX both lagged.

Table showing third-quarter returns for top active bond mutual funds and exchange-traded funds

While equity funds still show gains over longer periods, 2022 has eroded what were once gains for longer-term investors. iShares Core US Aggregate Bond ETF AGG has lost 0.31% over the past five years.

Chart showing the long-term returns of the largest bond mutual funds and exchange-traded funds

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