Soaring U.S. interest rates reduce bond fund yield

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All major categories of Morningstar fixed income funds except the bank loans group fell for a third straight quarter in the three months to September and remained on pace in what could be the worst year for bond fund investors..

Rising US interest rates squeezed returns for bond fund investors. The Federal Reserve raised short-term rates by 75 basis points each at its July and September meetings, pushing the overnight interest rate, or the rate at which banks lend to each other, by 300 basis points above what it was in January.

This caused bond yields to rise and prices to fall across the fixed income market. As of September 30, 2022, the yield on two-year Treasury bills had jumped 130 basis points to 4.22%, a level not seen since 2007. The 10-year Treasury yield rose 84 basis points at 3.83%, its highest point. since 2010. Broadly diversified fixed-income funds that typically serve as the backbone of investors’ fixed-income portfolios, represented by the Morningstar Core Intermediate Bond category and funds like Vanguard Total Bond Market ETF (NDB)– fell about 4.7% in the quarter and was still on pace with its worst year in decades, down 14.6% through September 30.

Dynamic bank loans

Rate trends hurt all bond fund categories, but the average bank loan fund gained 0.8%, slightly better than the Morningstar/LSTA leveraged loan index, which was stable for quarter and down 3.2% year to date. until September 30. Fidelity Floating Rate High Income Fund (FFRHX), who earns a Morningstar Analyst Rating of Silver, gained 1.7% in the quarter and matched the benchmark year-to-date loss, finishing in the top decile of its category in both periods.

These funds attract investors when the Fed raises rates because bank loans are backed by a company’s assets and their interest payments reset every one to three months.

High Yield Highlights

High-yield funds also held up relatively well. The category average slid 0.8% in the third quarter and fell 13.5% for the year to September 30. The ICE Bank of America US High Yield Index fell 0.7% for the quarter and 14.6% for the year to date. Gold-Rated BlackRock High Yield Bond (BHYIX) slid 0.4% for the quarter and 14% for the year to date due to an overweight in lower quality CCC-rated issuers. The fund ended the quarter in the top third of its peer group, but in the middle of the pack for the first nine months of 2022.

The market did not spare high quality corporate bonds. The average corporate bond fund in the Morningstar category fell 4.7% for the quarter and 17.9% for the year. The category’s longer duration (a measure of interest rate sensitivity) than that of the high yield group detracted from results. Diversification and a conservative portfolio took some of the edge off Vanguard Intermediate-Term Investment Grade, rated Bronze (VFIDX)which beat nearly two-thirds of its corporate bond peers in the quarter and more than four-fifths for the year, while losing 4.2% and 15.7% respectively.

table of the best rated bond funds in the third quarter of 2022 in their categories

Inflation protection provides little

Inflation-linked bonds couldn’t do much as inflation hit 40-year highs and the Fed hiked rates to fight it. Morningstar’s category of inflation-protected bonds fell as much as the broader bond market during the quarter and ended the nine months down 11%, as these bonds are extremely sensitive to rate changes. Again, keeping the duration short helped a bit. Gold Rated Vanguard Short Term Inflation Protected Securities Index (VTAPX) limited losses to 2.6% for the quarter and 4% for the year to date and beat more than 90% of its inflation-protected bond peers.

sore core

Loomis Sayles Investment Grade Bond rated silver (LIGRX) lost 3.4% in the quarter and 13.3% for the year to date, but beat its benchmark Bloomberg US Aggregate Index and most of the Morningstar core-plus intermediate category. The fund’s large overweight in securitized bonds, a relatively short duration and a cash holding of 9.8% helped. Morningstar’s large core and core plus mid-tier categories fell 4.7% and 4.4%, respectively, for the quarter and were both down around 14.7% for the year to date.

The Bloomberg US Aggregate Bond Index, a common indicator of core and core-plus funds that includes US Treasuries, mortgage-backed securities and investment-grade corporate bonds, fell about 4 .7% during the quarter. The benchmark is now down 14.6% year-to-date. Widening yield spreads played a bigger role in the index’s losses than soaring interest rates.

Dollar damage

Emerging market bond funds also lost money for a third consecutive quarter in 2022. The sharp rally in the US dollar against emerging market currencies has sent down bond prices for dollar-denominated bond issuers. Americans. Year-to-date, the JPMorgan EMBI Global Index has fallen 22.2%. The silver-rated TCW Emerging Markets Income TGEIX took it on the chin, falling nearly 6% in the quarter and more than 23% for the year to September and ranking in the bottom third of the emerging markets bond group.

table of the worst performing bond funds in the third quarter of 2022 in their categories
– source: Morningstar Analysts

Municipal exodus

Municipal bond rates also continued to rise. Yields on two-year and 10-year AAA-rated bonds reached 3.07% and 3.26%, respectively, leading the Bloomberg Municipal Bond Index to lose 12.1% for the year to date at 30 september. Rowe Price Tax-Free Income (PRTAX) lost 13.2% year-to-date, more than the benchmark, while still ranking in the top quartile of the national Morningstar long category.

Similar losses in many municipal strategies have investors rushing for the doors this year. Morningstar’s U.S. municipal bond category group saw $77.6 billion in releases in 2022 through August, more than other major release years, such as 2013. Nuveen High Yield Municipal Bond (NHMRX) fell 4.9% in the quarter and is now down 18.9% year-to-date, landing at the bottom of Morningstar’s U.S. Municipal High Yield category. The fund’s longer duration, particularly an overweight to bonds maturing in 22 years or more, detracted the most.

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