Short-Duration: Key Driver In Fixed Income Q1 Performance

EXECUTIVE SUMMARY

Fixed income funds realized a return of positive 0.50% on average during the first quarter of 2024, marking their second straight quarterly gain and fifth plus-side quarterly return in their last six.

Taxable bond funds (+0.58%) outperformed tax-exempt bond funds (+0.27%) for the fourth time in five quarters. Both taxable and tax-exempt funds ended 2023 on a high note. In Q4 2023, taxable bond funds returned their highest quarterly return since Q2 2020, while tax-exempt bond funds reported their second largest quarterly return on record (trailing only Q3 2009).

Looking at active management against passive, Q1 2024 had actively managed fixed income funds (+0.54%) outperform their passive (-0.04%) counterparts. Actively managed taxable (+5.55%) and tax-exempt (+3.62%) have both outperformed passive on a trailing-one year basis as well-passive taxable and tax-exempt returned a positive 3.59% and 2.61%, respectively.

Overall, markets fared well during the first quarter of 2024, with both equity and fixed income funds realizing positive returns after closing last year with their largest quarterly gains since Q4 2020 and Q3 2009, respectively. Market participants are getting on board with the notion that the Federal Reserve will keep rates higher for longer until the Fed is confident inflation is moving down to 2% on what Fed Chair Jerome Powell referred to as a “sustained basis”.

But what defines “sustained?”

Powell has reiterated his need to see consistent, positive economic data before any rate cuts take place. Powell and Federal Open Market Committee (FOMC) have highlighted that the U.S. is still seeing strong growth, job gains, and relatively low unemployment all despite tighter monetary policy.

Does the data agree?

First let’s look at jobs. Total nonfarm payrolls employment increased by an unexpected 303,000 jobs in March, up from a revised February gain of 270,000. For reference, the trailing 12-month average currently sits at (+231,000). The unemployment rate (3.8%) and number of unemployed people (6.4 million) fell slightly in March. The average unemployment level from 2014 to 2019 was 7.5 million, meaning we are below pre-pandemic levels. Along with job increases, we continue to see hourly earnings grow-over the past 12 months the average hourly wages have increased by 4.1%, with earnings growing 0.3% month over month. Let us not forget California’s minimum wage hike, which will likely cause annual earnings growth to increase in the future-the law went into effect April 1 for fast food workers and is effective for healthcare facility employees starting June 1 of this year.

With the 6.4 million unemployed, there are 8.8 million job openings as of February – the average number of openings from 2014 to 2019 was 6.1 million. Maybe we are simply in a different era of the job market where remote openings take longer to fill or just stay on the market longer. In Powell’s own words, the job market is in a “very unusual situation.”

Next let’s examine growth. Real gross domestic product (GDP) increased at an annual rate of 3.4% in the fourth quarter of 2023, a strong reading despite decelerating from Q3’s 4.9% rate. The change in annual levels of real GDP from 2022 to 2023 was positive 2.5%, whereas we only saw 1.9% growth from 2021 to 2022. Through the first three months of the year, we have seen broad-based equity market indices report strong gains-the S&P 500 (+10.56%), Nasdaq (+9.11%), DJIA (+6.14%), and Russell 2000 (+4.81%) all saw positive Q1 returns. Fixed income markets have been on a different path. Broad market indices were down in Q1-the FTSE U.S. Broad Investment Grade Bond Index (-0.84%) and Bloomberg Municipal Bond Index (-0.39%) both declined over the three months starting 2024. Despite the drawback in Q1, fixed income markets are poised for a strong 2024 given the macroeconomic landscape-more on this in the final word section.

Finally, let’s comb through inflation data. The Bureau of Labor Statistics released its latest Consumer Price Index (CPI) report on March 10 showing a hotter than expected increase in prices across the economy. CPI rose 3.5% in March from a year earlier, after growing 3.2% and 3.1% in the prior two months. Core-CPI, excluding food and energy, rose 5.7% year over year. Energy and shelter play significant roles in the overall price index calculation. The energy index increased 2.1% over the previous 12-month period, marking the first annual increase this index has reported in more than a year. The shelter index grew 5.7% since last year, although this reading was higher than expected, it’s been on a very slow decline since last March’s year-over-year growth of 8.2%. On the day of the CPI print, the 10-year Treasury note observed its largest single-day climb since September 2022 as it ended the day at 4.56%.

The personal consumption expenditures (PCE) index-the Fed’s preferred measure of inflation-saw a deceleration (to +0.3%) during February-March data is available at the end of April. February’s decrease followed an unexpected jump in January (+0.4% month over month). The 12-month change in PCE moved up slightly to 2.5%-one year ago this figure was 5.2%. Annual core-PCE, excluding food and energy, fell to 2.8% from 2.9%-last year it stood at 4.8%. Both PCE and core-PCE, while slowly improving, are still substantially above the Fed’s long-term target of 2.0%. In Powell’s speech on April 3, he warned that, “Reducing rates too soon or too much could result in a reversal of the progress we have seen on inflation and ultimately require even tighter policy to get inflation back to 2%.” His speech gave zero indication of near-term rate cuts.

Where does that leave us?

Well, with a growing economy, relatively healthy labor market, and stickier inflation, the “longer” in “higher for longer” may actually be extending past the market’s expectations. But anything can happen- even rate hikes-we must not forget it is an election year, geopolitical tensions are high, and the U.S. government is facing record levels of debt service costs.

In the fund markets, there are a few key stories that have carried over from the end of the year which we will be following throughout 2024:

Investors sitting in cash

Money markets continue to see inflows-Q1 inflows total $24.8 billion bringing the total assets under management to nearly $6.0 trillion (Figure 1).

FIGURE 1: QUARTERLY MONEY MARKET FLOWS ($BIL)

Although it is the seventh straight quarter of net new capital, inflows have decelerated-each of the last five quarterly inflows were greater than $160 billion, with an average of $234.6 billion. The market’s outlook has turned slightly more optimistic with rates projected to be more stable and future downward moves more gradual. This has led investors toward active tactical, passive broad-market, and overall strategies targeting the intermediate part of the curve. The opportunity cost of remaining in cash is becoming too high. If we look at the history of how fixed income macro-classifications performed in the subsequent 12-month period following peak interest rates, we see money market funds lagged in each of the last four instances (Figure 2).

FIGURE 2: LIPPER TAXABLE FIXED INCOME MACRO-CLASSIFICATIONS, 12-MONTH TOTAL RETURN (%) FOLLOWING PEAK RATES

Securities and Exchange Commission’s (SEC) response to asset managers seeking permission to launch ETF share classes CBOE Global Markets was the latest firm to do so, joining big players in the space such as Fidelity, Morgan Stanley, and Dimensional Fund Advisors. The mad rush of filings is taking place as investor preference for the ETF wrapper increases, but more importantly Vanguard’s patent on this specific structure expired last May. Asset managers have taken other avenues to enter the ETF market and grow their footprint such as launching a clone of their flagship mutual fund or converting their mutual fund to an ETF. Each method comes with its own challenges, but none are anticipated to affect the landscape more so than the potential (and likely) approval of allowing firms to provide ETF share classes.

Active ETF market continuing to grow

In Q1 2024, we saw 89 launches (32 fixed income) of active ETFs following record quarters in Q3 2023 (97, 44 fixed income) and Q4 2023 (110, 33 fixed income). The majority of these came in the Lipper Option Arbitrage/Option Strategies Funds (OS) classification. In the last three quarters there were 34, 37, and 35 new OS ETFs launched in the market. These funds are often structured in a way that will lag a bull market, generally do well in a sideways market, and outperform in a bear market. Since fund companies try to launch new products that not only realize positive returns but also meet existing demand, this should give you an indication as to what issuers believe a large part of the market is forecasting.

Newly Issued Debt

Over the past three months, the marketplace saw quarter-over-quarter increases in the proceeds amount for newly issued investment grade corporate, high yield corporate, and leverage loan debt (Figure 3).

FIGURE 3: QUARTERLY NEWLY ISSUED DEBT, PROCEEDS AMOUNT + OVER SOLD ($BIL)

Investment grade corporate debt recorded its second largest quarterly issuance total and largest issuance total to start a calendar year. It also saw the largest percentage quarter-over-quarter growth since Q1 2009.

High yield corporate and leverage loan debt also posted strong levels as they reported their highest issuance totals since Q4 2021 and Q2 2022, respectively.

The stated years to maturity on newly issued investment grade corporate debt has diverged from historical averages, with growing levels in the intermediate range-there was a greater percentage of total issuance with maturities of six to 11 years, highlighting where market demand and opportunity converge.

Fixed Income Quarterly Flows

Lipper’s Q1 2024 fund-flow numbers, generated from Global Fund Flows [FUNDFLOWS] application in LSEG Workspace, showed fixed income investors were net buyers of fund assets for the quarter, adding $177.4 billion-marking the largest quarterly intake since Q1 2021. This was also the fifth straight quarterly inflow for fixed income funds.

The trend toward the ETF wrapper is not as prevalent in the fixed income space as it is with equity funds-Figure 4.

FIGURE 4: QUARTERLY FIXED INCOME FLOWS: MUTUAL FUNDS VS. EXCHANGE TRADED FUNDS

Fixed income ETFs attracted $84.6 billion where conventional fixed income mutual funds added $92.8 billion during the first quarter. This was the forty-first consecutive quarterly inflow for fixed income ETFs while mutual funds have only seen three quarterly inflows over the last nine quarters.

Actively managed fixed income funds posted inflows of $75.6 billion, their first quarterly inflow in three. The top three Lipper classifications to see active inflows were Core Bond Funds (+$24.2 billion), Multi-Sector Income Funds (+$15.7 billion), and Core Plus Bond Funds (+$8.0 billion). The largest quarterly outflows from active fixed income funds came from Short Municipal Debt Funds (-$1.2 billion), Inflation Protected Bond Funds (-$593 million), and GNMA Funds (-$504 million).

Passively managed fixed income funds realized $101.8 billion of net inflows in Q1. The three top Lipper classifications to receive passive inflows were Core Bond Funds (+$41.7 billion), General U.S. Treasury Funds (+$11.8 billion), and Corporate Debt Funds BBB- Rated (+$11.7 billion). The largest outflows during the quarter from index-linked funds came in Short U.S. Treasury Funds (-$7.8 billion), Emerging Market Hard Currency Debt Funds (-$2.4 billion), and Short U.S. Government Funds (-$2.1 billion).

Performance Overview

Thirty of the 51 Lipper fixed income classifications ended the first quarter with gains-all 51 posted a plus-side return in Q4.

Each of the 51 classifications underperformed their Q4 return-General U.S. Treasury Funds (-10.00%) and Emerging Markets Local Currency Debt Funds (-9.19%) saw the largest quarter-over-quarter loss.

The top-performing Lipper classifications throughout Q1 were Flexible Income Funds (+3.37%), Loan Participation Funds (+2.29%), Emerging Markets Hard Currency Debt Funds (+1.94%), High Yield Funds (+1.64%), and Global High Yield Funds (+1.61%).

General U.S. Treasury Funds (-1.80%), General U.S. Government Funds (-1.31%), Emerging Markets Local Currency Debt Funds (-1.03%), Intermediate U.S. Government Funds (-0.96%), and International Income Funds (-0.81%) closed the quarter as the worst – performing classifications.

Lipper’s 51 fixed income classifications each fall under one of the eight fixed income macro-classifications.

Seven of the eight reported Q1 gains-General Domestic Taxable Fixed Income (+1.30%), Alternative Bond Funds (+0.95%), and General Municipal Debt Funds (+0.76%) were the top three.

The three-bottom macro groups during the quarter were Government/Treasury Funds (-0.33%), Single State Municipal Debt Funds (+0.02%), and National Municipal Debt Funds (+0.21%). All eight macro- groups underperformed their Q4 returns.

Government/Treasury Funds Summary

Treasury yields rose during the first quarter with larger gains seen at the short part of the curve-the two- (+8.99%), three- (+10.50%), five-year (+9.87%) have led the way. Since the end of 2022, the tail ends of the curve have seen the largest percentage growth-the two- (+11.84%) and 30-year (+10.44%).

FIGURE 5: TREASURY YIELD CURVE: CHANGES OVER THE LAST THREE YEARS

Government/Treasury Funds posted a negative 0.33% return on average over the quarter, its third sub-zero performance over the last four quarters. This macro-classification has been the lowest performer of the eight fixed income macro-groups in four of the last seven quarters.

The best-performing classifications under this macro-group were our shorter duration classifications: Short U.S. Treasury Funds (+0.73%), Short U.S. Government Funds (+0.50%), and Inflation Protected Bond Funds (+0.20%). These three classifications were the only to realize positive returns in Q1 and were the bottom three performing classifications during Q4. Despite being the laggard of the group to end the year, Short U.S. Treasury Funds are the only classification under this macro-group to see six straight quarterly gains.

The three bottom Lipper classifications under Government/Treasury Funds were General U.S. Treasury Funds (-1.80%), General U.S. Government Funds (-1.31%), and Intermediate U.S. Government Funds (-0.96%). It has been a tough stretch for longer duration government/Treasury funds- General U.S. Treasury and General U.S. Government Funds were the bottom two performing classifications during both Q2 and Q3 of 2023.

The small bright spot came in Q4 when General U.S. Treasury Funds logged their largest quarterly return since Q1 2020, and General U.S. Government Funds saw their second largest quarterly return on record.

General Domestic Taxable Bond Funds Summary

Despite underperforming Q4 by 4.63%, General Domestic Taxable Fixed Income Funds finished the quarter returning a positive 1.30%, marking their fifth quarterly gain in the last six quarters. This macro-classification has been the leading fixed income macro group in four of the last five quarters.

FIGURE 6: Q1 2024 TAXABLE FIXED INCOME PERFORMANCE (%)

Flexible Income Funds (+3.37%), Loan Participation Funds (+2.29%), and High Yield Funds (+1.64%) were the highest-performing classifications of the macro-group. These top performers were the three laggards last quarter. Loan Participation Funds continued their hot streak with their seventh straight quarter of positive returns-one of three fixed income classifications to carry this active streak.

Corporate Debt A-Rated Funds (-0.72%), Corporate Debt BBB-Rated Funds (-0.25%), and General Bond Funds (+0.18%) were the lowest performing classifications under General Domestic Taxable Bond Funds during the first quarter of 2024. Each of these three classifications were among the top three performing to end 2023, as intermediate to long duration funds realized a brief yet significant return to the limelight in Q4. Corporate A-Rated and Corporate BBB-Rated Funds have now suffered three quarters of losses in four.

Short-Term Intermediate Corporate Bond Funds Summary

Short-Term Intermediate Corporate Bond Funds finished the first quarter with positive quarterly performance (+0.29%), marking their second straight quarter of gains. The macro-classification is coming off one of their best quarters on record producing a gain of 4.96%.

At the top of this macro-group during Q1 was Short High Yield Funds (+1.60%), Ultra-Short Obligation Funds (+1.44%), and Short Investment Grade Debt Funds (+0.97%). Short High Yield and Ultra-Short Obligation Funds are the other two fixed income classifications to record seven consecutive quarterly gains-along with Loan Participation Funds.

The bottom-performing Lipper classifications in this macro group were Core Bond Funds (-0.48%), Core Plus Bond Funds (-0.34%), and Short- Intermediate Investment Grade Debt Funds (+0.59%). Both Core Bond and Core Plus Bonds are coming off their largest quarterly return on average.

Spreads have continued to narrow during the first quarter with the FTSE High Yield Bond Index and FTSE USBIG Corporate Bond Index tightening by 20 and 11 basis points, respectively. Both indices have reported spreads below their five-year average and yields above their five – year average.

FIGURE 7: FTSE USBIG CORPORATE BOND INDEX OPTION-ADJUSTED SPREAD & YIELD TO REDEMPTION

FIGURE 8: FTSE HIGH YIELD BOND INDEX OPTION-ADJUSTED SPREAD & YIELD TO WORST

World Fixed Income Funds Summary

World Fixed Income Funds also reported their fourth positive return over the past five quarters as they saw an average gain of 0.41%. The macro-classification realized its fifth largest quarterly return of all time to end 2023 and the largest since Q2 2009.

Emerging Markets Hard Currency Debt Funds (+1.94%), Global High Yield Funds (+1.61%), and Global Income Funds (-0.66%) finished at the top of this macro-group with thanks to a strong dollar. Emerging Markets Hard Currency Debt Funds have seen five positive quarters over the prior six, while leading this macro-classification in four of those six periods. Emerging Markets Local Currency Debt Funds (-1.03%) and International Income Funds (-0.81%) suffered the greatest losses over the three months kicking off 2024.

Alternative Bond Funds Summary

The Alternative Bond Funds macro group returned a positive 0.95%, after seeing their fourth largest quarterly return on record in Q4. The macro group has realized five gains over the last six quarters, while being one of the top three macro-classifications in all but one quarter over the last year.

There are only three fixed income classifications under this macro group-Alternative Credit Focus Funds (+1.22%), Absolute Return Bond Funds (+0.83%), and Alternative Currency Strategies Funds (+0.16%). Technically the bitcoin spot ETFs and other cryptocurrency funds are in the Alternative Currency Strategies Funds, but we have excluded them in this fixed income report. This was the fifth quarter in six where all three classifications in Alternative Bond Funds have posted gains. Alternative Currency Strategies Funds are the only one within this macro-group to see six straight plus-side quarters.

Municipal Debt Funds Summary

Municipal Debt Funds recorded an average gain of 0.27% in the first quarter of 2024-marking their fifth positive return in six quarters. Twelve of the 20 municipal classifications realized plus-side returns during the quarter-Q4 had all 20 in the black the first time since Q1 2023.

FIGURE 9: Q1 2024 TAX-EXEMPT FIXED INCOME PERFORMANCE (%)

The macro groups under Municipal Debt Funds all had positive quarterly returns-General Municipal Debt Funds (+0.76%), National Municipal Debt Funds (+0.21%), and Single State Municipal Debt Funds (+0.02%) were in the black. All three macro-groups saw their second straight quarter of plus-side performance-General Municipal Debt Funds logged its fifth positive quarterly return in six.

The two top-performing non-single state tax-exempt Lipper classifications were High Yield Municipal Debt Funds (+1.60%) and Short Municipal Debt Funds (+0.39%)-both classifications have realized five plus – side quarters over the previous six.

The best-performing classifications under Single State Municipal Debt Funds were California Municipal Debt Funds (+0.32%), Other States Short-Intermediate Municipal Debt Funds (+0.16%), and California Short- Intermediate Municipal Debt Funds (+0.15%). These three classifications were the worst three single-state performing classifications during Q4. Yet another reversal of worst to best in fixed income quarter over quarter performance.

The three bottom-performing classifications under Single State Municipal Debt Funds were Other States Intermediate Municipal Debt Funds (-0.21%), New York Intermediate Municipal Debt Funds (-0.11%), and Other States Municipal Debt Funds (-0.10%). All three of these classifications have suffered three quarters of losses in the past four.

Final Word

Outside of Emerging Markets Hard Currency Debt Funds which saw nice gains thanks to a strong dollar, floating-rate and higher yielding funds were the top performers during the first quarter of 2024. These funds also reported strong returns to start 2023, that is until the Fed started to shift its guidance.

Floating-rate and higher yielding funds maintain a shorter duration than their equivalent fixed-rate and investment grade counterparts. They are less adversely affected by interest rate increases since a greater proportion of the investor’s income is received through coupon payments.

Despite the short-end outperforming, investors are looking elsewhere. No matter how you break down the fixed income fund universe, Passive vs. Active or Mutual Funds vs. ETFs, investors are targeting the intermediate part of the curve. You are able to see this through the top inflows by Lipper classification, but also by breaking down flows by average portfolio-level duration (Figure 10). The only key difference is that some actively managed funds focused on short duration structured credit saw inflows during Q1.

FIGURE 10: QUARTERLY FLOWS ($BIL) BY AVERAGE PORTFOLIO-LEVEL DURATION

With the hopes of stable to declining rates and continued strong corporate fundamentals, the market is looking to take advantage of locking in higher rates by accepting additional credit and duration risk. When an investor locks in higher yields, they not only secure higher interest payments but also receive greater price appreciation if interest rates start to decline-here the higher duration is working in the investor’s favor leading to less reinvestment risk.

As we have also noted above, investment grade issuance has hit record quarterly levels-of the newly issued investment grade debt during Q1, more than three-quarters have a listed maturity of three to 12 years and nearly half in the three to nine bucket. Corporate issuers are flooding the market with supply aiming to meet investor demand. On the issuer side, they view this as an opportunity to secure funding while there is strong liquidity. They also no longer see the benefits of waiting for rates to drop because: A) the path downward is looking longer and more gradual B) the tail-end risks that cause rates to come back up have increased.

If fund flows equal market demand, then total active funds and underlying bond issuance would be the supply side of this over-simplified equation. In this supply/demand chart, each side is experiencing an upward and rightward shift. But while the market is still widely forecasting interest rates decreases by the end of the year, the total number and start date of those rate cuts have taken a more hawkish outlook. In fact, there is growing sentiment (albeit small) of rate hikes if progress towards lowering inflation stalls. Any near-term rate hikes will obviously negate the benefits of locking in at today’s rates while cementing another win for short-duration.

---

Click here or the Download Full Report link in the upper right-hand column of this page to access the First Quarter 2024 Fixed Income FundMarket Insight Report: Short-Duration: Key Driver in Fixed Income Q1 Performance.

You can also view the Q1 Equity FMIR, which shows equity mutual funds and ETFs celebrated their fifth quarterly gain (+6.92%) in six, while posting its second straight quarterly plus-side return.

Source: LSEG Lipper. Data as of: 04/11/2024

©LSEG2024.AllRightsReserved.LSEG Lipper FundMarketInsight Reports are for informational purposes only, and do not constitute investment advice or an offer to sell or the solicitation of an offer to buy any security of any entity in any jurisdiction. No guarantee is made that the information in this report is accurate or complete and no warranties are made with regard to the results to be obtained from its use. In addition, LSEG will not be liable for any loss or damage resulting from information obtained from LSEG Lipper or any of its affiliates.

For immediate assistance, feel free to contact Lipper Client Services toll-free at 877.955.4773 or via email at [email protected]. For more information about Lipper, please visit our website at Financial Markets Infrastructure and Data or Lipper Alpha Insight | LSEG