2nd Quarter 2017

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The first half of the second quarter was dominated by geopolitical tensions and political uncertainty, with a U.S. air strike in Syria, continued tensions with the volatile North Korean regime, and the looming French presidential election threatening global markets. Near the end of the quarter, however, geopolitical tensions had somewhat cooled. Emmanuel Macron secured the French presidency, and the bulk of the political drama was left residing in a deadlocked Washington, D.C.

Over the course of the quarter, expectations for an expanded growth rebound appeared to wane, and data releases ultimately began to fall short of forecasts. The battle of soft data vs. hard data remained an important market theme throughout the period. Sluggish economic growth was reported, coupled with improving employment. Additionally, inflation showed signs of subsiding. The market’s inflation expectations have been steadily declining since February, moving below 2.0% for most of the second quarter. While Federal Reserve (the Fed) Board Chair Janet Yellen expressed the belief that the recent pullback in inflation is likely to prove transitory, citing a drop in wireless phone billing, the market remained unconvinced.

The Fed again lifted its benchmark interest rate and announced a road map to begin shrinking its balance sheet. Despite increasing the Fed funds rate and striking a more hawkish tone, given its positive expectations for the economy, the benchmark yield curve flattened and markets became more accommodative. Even with the balance sheet discussion, the long end of the curve didn’t move as much as one might have expected. However, the longer end did indeed move in response to European Central Bank President Mario Draghi’s positive comments in late June regarding the eurozone economy. European bonds sold off, German bunds moved notably higher, and the U.S. 10-year Treasury yield went from 2.15% to 2.30%. For now, it would seem that international forces still hold significant sway over U.S. Treasuries.

The U.S. dollar weakened despite continued Fed rate increases. Perhaps market participants doubt the ultimate terminal rate as depicted in the Feds’ “dots” project. The weakness certainly reflects lower expectations from the fiscal side and continued uncertainty around the Trump administration plans for engaging with the world both in trade and other geopolitical matters. In addition, some economies, such as continental Europe, appear to be on the upswing. Other markets appear less troublesome from a political standpoint, take Mexico vs. U.S. as an example. Currently, the Mexican peso appears less risky than it had when the political rhetoric surrounding trade and the planned wall was at a fever pitch.

Except for a few brief moments of turbulence, markets remained largely complacent during the quarter. Volatility, as measured by the CBOE Volatility Index, also known as the VIX, continued its downward trend in the second quarter. In fact, near the beginning of June, the VIX touched its lowest level since 1993. This came despite West Texas Intermediate, the U.S. crude oil benchmark, ending the period down nearly 17% from the start of the year. Concerns of a supply glut continued to mount, buoyed by an increase in U.S. drilling rigs as well as rising production from nations, such as Libya, blunting the impact of production cuts among Organization of Petroleum Exporting Countries (OPEC). Exploration and production, oil services, and pipeline sectors reacted negatively but much less severely than in early 2016.

Many of the weakest firms in the energy sector have exited the business or restructured, and many others have termed out their debt, resulting in no immediate refinancing concerns. U.S. shale producers continue to grow production within some basins (the Permian, STACK), referencing a $30 or less breakeven, which has muted any sense of panic in the short-term. Meanwhile, OPEC doesn’t have as much market power as it used to enjoy. The organization’s influence as the world’s swing producer has diminished, but the fact that most countries seem to be cooperating and appear dedicated to maintaining supply discipline currently has offered the market a bit of comfort. Importantly, lower range-bound oil, as well as other commodity prices, appears to be having little or no effect on other sectors of the economy. We believe this to be further evidence of overall complacency in markets and take it as a sign to remain cautious.

Is a flattening yield curve, among the other issues mentioned above, an indication of a slowing economy and recession on the horizon? Certainly the bond market has started to doubt that the Trump administration will be able to implement any meaningful fiscal stimulus, and therefore, has started to price that out of the rate market.

At the same time, however, most risk markets, including U.S. stock and credit markets, continue to be strong. Why? Credit markets don’t require strong growth. Generally stable conditions are sufficient for decent performance. Meanwhile, low yields and muted volatility continue to entice investors to reach further out on the risk spectrum to achieve incremental return. However, the further investors are from their natural risk habitat, the worse a potential unwind may be. For now, generally stable U.S. economic conditions have caused investors to grind credit spreads ever lower. This phenomenon can be observed across the board in investment-grade corporate bonds, asset-backed securities (ABS), highyield bonds, and emerging market debt.

While corporate credit metrics overall appear to sit at very weak levels relative to recent history, the deterioration observed earlier in the year appears to have abated and even improved a bit during the quarter. With a little revenue growth, the majority of corporates (medium-to-larger corporations that use investment banks to issue bonds widely) were able to grow earnings before interest, taxes, depreciation and amortization (EBITDA) and cash flows in the quarter, improving metrics.

Still, there remain signs that suggest we are in the later stages of a global recovery; consumers remain highly indebted, with little to no deleveraging taking place other than through mortgage defaults. Credit card balances, student loan balances, and auto lending all remain at peak levels and delinquencies are beginning to rise in some of these sectors. Businesses across the world have leveraged themselves significantly, and while debt service coverage today looks good, it may adjust rapidly down if sales disappoint. Productivity remains low, which means that companies with large staffing needs face margins pressures. As profit margins contract, hope for a future capex expansion and further hiring may erode.

What this Means for the Portfolio

Our preference for increasing quality remains intact, as spread compression between ratings and riskier sectors continues. We also continue to prefer shorter duration bonds and do not currently view the compensation for duration, neither rate nor credit, as wholesale attractive at this point. We favor short-duration floating-rate notes, when spread (credit) compensation is reasonable. Lastly, while consumer performance deteriorated (i.e., higher delinquencies) on the margin, we still find value in many ABS structures. We continue to move up the quality spectrum amongst our holdings in the corporate sphere, and the portfolio has migrated further toward investment-grade issues as the cycle rolls on. Furthermore, we continue tilting toward less cyclical business models within both investment grade and high yield. In our opinion, business models can be more informative than credit ratings during times of stress.

Few storm clouds appear on the horizon currently. But low volatility in most asset classes has created an eerie silence, and since rates and spreads are low, we continue to trade off a bit of yield to prepare for any darker days. In keeping with the theme of defensive positioning, we ended the quarter with cash balances toward the higher end of their historical ranges, which we stand ready to deploy as opportunities present themselves.

Investors must remind themselves that financial market risks and other unforeseen developments can always present themselves. As active managers, we must balance both known risks, but also the unknown risks, investing only where we believe we are compensated for the risks that are always present. The robustness of our process, the structure of the team, and a keen eye towards the relative value of our various investments have led the portfolio to perform well over the long term. For example, according to Morningstar, the fund’s I shares rank in the top 18th percentile on a five-year basis when compared to the rest of the Multisector Bond category, based on total returns as of June 30, 2017, among 190 funds.

Thank you for investing alongside us in the 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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