The third quarter was characterized by the carry-over of economic momentum from the second quarter, as states continued to lift restrictions to reopen their economies. Perhaps it was no surprise that some of the hardest hit and most economically sensitive areas of the fixed income market benefited.
As shown in the LPL Chart of the Day, the sectors of the fixed income market widely considered to be “risk on” outperformed, such as high yield, bank loans, and emerging market debt:
Further, these sectors typically carry lower interest-rate sensitivity than other segments of the fixed income universe. While Treasury yields remained broadly flat during the quarter, the return of economic growth pushed many investors to position for a rise in yields, increasing the attractiveness of these sectors. Despite the strong quarter, however, the brutal environment during the onset of the COVID-19 pandemic has left these sectors playing catch-up to their investment-grade counterparts for the year.
“With economic growth returning during the third quarter, we expected the risky corners of the fixed income market to perk up,” said LPL Financial Chief Market Strategist Ryan Detrick. “Nevertheless, as the rate of growth following the initial rebound in the economy tapers a bit, there may be some additional volatility in these sectors.”
As we noted in our blog, Low Treasury Yields Present a Challenge, low Treasury yields also present a challenge for investors as the deflationary shock that characterized the early months of the pandemic subsided and inflation expectations normalized. Since nominal Treasury bonds presented very little income to investors while carrying greater interest rate risk as a result, we saw a strong environment for Treasury Inflation-Protected Securities (TIPS) in the third quarter as they outperformed their nominal counterpart.
Not to be left out, municipal bonds also fared well in the third quarter, outperforming Treasuries as well as the broader Bloomberg Barclays US Aggregate Bond Index. High-yield municipals fared the best—given the index’s exposure to revenue bonds—as economic momentum lifted the attractiveness of the sector. While a fourth stimulus bill remains elusive, investors expect additional stimulus will have some funding for state and local governments, perhaps raising the attractiveness of municipal bonds.
Looking forward into the fourth quarter, we continue to prefer high-quality fixed income exposure as the rate of economic growth has tapered, and further uncertainty around the path of the recovery could limit the attractiveness of the riskier segments of the fixed income market.
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