4th Quarter 2018

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Thornburg Strategic Income Fund returned negative 0.38% (I shares) in the quarter ended December 31, 2018, underperforming its Bloomberg Barclays U.S. Universal Index benchmark return of 1.17%. That brought the fund’s calendar 2018 return to 0.68%, which beat both the bench’s 0.25% decline last year as well as the 0.01% gain in the widely tracked Bloomberg Barclays U.S. Aggregate Index.

Markets & Economics

The last leg of 2018 represented a major shift in market sentiment across asset classes. The U.S. Treasury 10-year yield peaked in early November, but investor fears surrounding trade tensions, weakening global economic data, Brexit, and especially a hawkish U.S. Federal Reserve caused investors to shun risk assets as the year drew to a close. By the end of December, interest rates fell back toward their January lows. While global growth moderated in 2018, and we likely find ourselves in the latter stages of the economic cycle, things may not be as bad as recent market action might suggest.

That global growth has slowed and become less synchronized should not come as a surprise. The recent step-down in growth reflects individual economies across the globe moving toward more sustainable growth pathways. Weakening data are worth watching, but with actual growth near or above potential growth, we don’t believe we are headed toward a global recession in 2019. While 2019 global growth may not match 2018’s estimated 3.7%, it shouldn’t come in much below that pace either.

Rising market volatility in the fourth quarter suggests that investors fear a tilt away from global monetary policy accommodation. That implies less predictable, and potentially uneven, economic results are likely to follow across geographies. Despite investor anxiety, rising global frictions, and waning business confidence, central banks generally stayed on that course in the fourth quarter. The U.S. Federal Reserve has taken the lead on draining the punchbowl with a series of rate hikes and simultaneous balance sheet shrinkage. The Fed continues to grapple with current inflation that’s running close to its 2% target, while factoring in rising wages that could potentially fuel higher inflation down the road. Unemployment remains below 4% and wage growth has risen above 3%, creating a conundrum for policy makers. During the fourth quarter, the Fed battled signals from the financial markets as well as negative rhetoric from President Trump. The Fed ultimately stayed the course and hiked rates in December, but the median forecast for 2019 fell from three hikes to two in a dovish signal.

Still, the markets reacted negatively to Fed Chairman Jerome Powell’s mid- December statement that balance sheet reduction would remain on a pre-set course, after having priced in some probability of the Fed adjusting the pace of the run-off. The reality of both interest rate and balance sheet changes is that the Fed has been highly data dependent, and U.S. economic data has been quite strong. At times, the market has ignored this at its own peril. As stocks continued to fall toward year end, Powell eventually acquiesced and commented in early January that the balance sheet reduction remains isn’t on auto-pilot. The market took this as a dovish signal, with risk assets recovering to varying degrees.

Trade tensions between the U.S. and China continue, though Washington agreed to delay the start of additional tariffs and both nations plan to renew talks in 2019. While President Trump, among others, blames the Fed for recent U.S. stock market declines, there may also be some realization that a trade war between the world’s two-largest economies wouldn’t necessarily support equity prices. While we are still a long way from a workable trade agreement, risk markets have and will likely continue to respond well to no further escalation in trade-related tit-for-tat exchanges.

On the surface, U.S. tariffs on Chinese imports haven’t had significant, direct economic impact on China’s economy, but indirectly the impact on domestic sentiment in the Middle Kingdom appears heavy. Beijing’s deleveraging campaign in 2017 was likely a far greater factor in China’s slowing growth in 2018, though a slew of recent supply-side stimulus measures should kick in to support growth in 2019. We’re still awaiting further data on China’s growth dynamics, but one thing remains clear: China will continue to have major impact on global and emerging market growth expectations, along with global financial market performance.

In other international developments, the European Central Bank decided to hold rates steady in December and ended its asset purchase program as expected. However, ECB chief Mario Draghi offered dovish comments around the timing of the bank’s first rate hike, suggesting it could come around the end of 2019. Growth within the European Union is slowing, with little aid from the fiscal side coming. As such, the ECB reduced its growth forecast for 2019 and showed no signs of concern about inflation. But other concerns, such as Brexit, remain relevant for growth prospects and policy actions across Europe.

European governments appear to be playing hard ball, largely rejecting new negotiations, making a hard Brexit a larger risk for markets. That creates an additional challenge to regional economic growth as businesses and consumers await clarity before committing to significant expenditures. While both the U.K. and eurozone economies are still growing, the drag of uncertainty on economic performance is likely to linger. That said, the U.K. economy has been holding up remarkably well given the Brexit overhang.

Credit & Portfolio

After rallying slightly in the third quarter, investment-grade corporate spreads widened throughout the fourth quarter as the risk-off sentiment spread through markets. Option-adjusted spreads (OAS) increased from 106 to 153 basis points, representing a meaningful movement in what has been a steady market for some time. As risks increased earlier in the year, we’ve migrated the portfolio toward higher credit-quality issuers, and moved credit duration lower by shifting into more defensive industries. Our portfolio adjustments into more defensive sectors have ultimately helped mitigate the impact of spread widening for our portfolio during the quarter.

As for the high-yield market, the move wider in spreads and lower in price was more notable. High-yield yield to worst increased from 6.5% to 8% during the quarter, and option-adjusted spreads moved from 309 basis points to 526 basis points. Throughout 2018, Strategic Income has been quite conservative in positioning in terms of credit exposure relative to its mandate and opportunity set. As such, we took some advantage of the move wider and added a bit to our high-yield exposure, both in existing positions as well as a few select names we had originally passed on or had sold out of due to rich pricing. However, this is an example of how we seek to add some risk to the portfolio as compensation becomes more attractively priced; 526 basis points OAS at an 8% yield is attractive indeed, but not enough to drastically change portfolio composition, we remain opportunistic however.

One area of the market we continue to have discussions around is levered loans, which performed poorly in the fourth quarter. This may have awoken some market participants to potential liquidity issues as the cycle continues. We remain cautious on the space owing to weakened covenants, elevated leverage, and fundamental changes to the broader loan sector that are likely to negatively impact recoveries during the next downturn. We would not be surprised to see additional volatility within the space in the future, which is likely to present us with more future opportunities. As is true in many areas in life, patience is a virtue.

We continue to believe caution in the corporate sector, both within investment grade and high yield, is warranted, despite spreads that are wide to the average since 2010 as leverage and other credit metrics remain very weak relative to history. At this stage of the credit cycle, individual security selection across industries, credit quality, maturities, and region are likely to be key drivers of investors’ future results.

We favor investing in securities backed by the cash flows of the U.S. consumer, the engine of growth for the U.S. economy. Spreads in many of the asset-backed security sectors have moved wider in the fourth quarter and, after months of tightening, now offer some value. But we maintain our discipline around selectivity as it relates to credit risk—even in generally defensive sectors. Within mortgage-backed securities, we continue to anticipate a relatively benign prepayment environment, with limited prepayment activity as primary mortgage rates remain elevated relative to recent history.

Looking ahead, investors will most likely have to get used to increased volatility. But, with increased volatility comes increased opportunity to periodically deploy capital at more favorable prices. As we see more attractive buying opportunities arise, we’ll capitalize on them through our bottom-up, relative-value approach that we have found adds value for our clients.

Thank you for investing alongside us in Thornburg Strategic Income Fund.

Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The maximum sales charge for the Fund’s A shares is 4.50%.

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