It was a volatile third quarter for credit markets.
Interest rates continued to experience significant volatility in the third quarter with the benchmark 10-year U.S. Treasury bond beginning the quarter at 1.49%, dropping to 1.19% by early August and then rallying to close the quarter at 1.52%. This tug-of-war was due to several ongoing issues and makes the future movement in interest rates difficult to gauge.
The decline in rates in July was largely driven by concerns about the economic recovery as the Delta variant spiked and many states and municipalities imposed renewed COVID restrictions. Investors were also concerned that we had reached “peak” economic growth in the second quarter and economic growth would naturally slow from there.
The ensuing rally in interest rates was fueled by news that the Federal Reserve would begin tapering their $120 billion monthly purchases of bonds – one of the extraordinary measures enacted by the Fed to counter the economic pressure from COVID shutdowns. My colleague Jason Rodnick covers what this could mean for various asset classes in his excellent article titled “Quantitative Easing, Tapering, Liftoff, and Rolloff”. The Fed also indicated in their September meeting they could begin raising interest rates as early as 2022.
Also leading to the rapid increase in rates in September was data showing inflationary pressures continuing to persist, particularly due to significant bottlenecks in the global supply chain and increased demand for goods and services. Many investors had predicted the spike in inflation would be short-lived, but it appears this inflationary pressure will likely continue into 2022 until these supply disruptions are worked out.
As of this writing, COVID is on the decline in 47 of 50 states. This should lead to a pickup in economic activity as people become more comfortable returning to some sense of normalcy. So, there is a strong argument to be made that interest rates will continue to creep up from here as investors discount stronger economic growth going forward.
On the other side of the coin, global interest rates (both nominal and real) are still decidedly negative in many countries around the world (including real interest rates in the U.S.). So as U.S. interest rates offer some of the best nominal yields around the world today, many foreign investors continue to buy U.S. bonds for higher relative yields, keeping a lid on rates.
It will be interesting to see how this interest rate dynamic plays out, but in the meantime, we continue to be generally negative on the fixed income asset class. For the quarter, it was a mixed bag from a total return standpoint. The average total return on U.S. bonds was up slightly in the third quarter, but still negative for the year. Total returns for junk bonds, U.S. agency bonds and Treasuries all increased slightly, while total returns for municipal bonds declined. Corporate bonds remained largely unchanged for the quarter.