1st Quarter 2017

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Markets across the globe continued to climb the proverbial wall of worry during the first quarter of 2017. The yield on the 10-year U.S. Treasury remained range-bound during the period, ultimately moving lower by 0.05%. Both investment-grade and high-yield corporate spreads tightened during the quarter, with the Bloomberg Barclays U.S. Corporate Investment Grade Index option adjusted spread (OAS) falling approximately 0.05% and the Bloomberg Barclays U.S. Corporate High-Yield Index OAS declining 0.26%.

Corporate investment-grade issuance set a record, yet, as evidenced by the declining spreads, the market remained strong despite increased supply. Both investment-grade and bank loan funds experienced significant inflows during the quarter, supporting the broader market. With respect to high yield, equity market hesitation during the first weeks of March proved a headwind leading to outflows, while gradually higher trending equity markets helped keep returns in solidly positive territory.

The market continues to appear yield hungry although skittish around rates, as the Federal Reserve (the Fed) made a widely anticipated hike to short-term rates in March. Fourth quarter 2016 company financial results appeared to satisfy market participants, and credit metrics deteriorated at a slower pace. These trends look like they will continue in the second quarter of 2017. While we believe fundamentals are still relatively attractive, we remain skeptical that current spreads adequately reflect weaker absolute credit metrics. Broadly speaking, investor complacency remains the status quo despite risks under the surface. The U.S. still faces very real debt challenges; student debt, auto debt, and commercial real estate come to mind when thinking about potential pockets of instability going forward.

Most investors will agree that quantitative easing (QE) from central banks around the world has been fantastic for both depressing risk-free yields and compressing risk-assets spreads. What then is the ultimate result of the inevitable unwinding? The truth of the matter is that no one out there truly knows, and while we believe it can be completed in an orderly fashion—that is to say we are unlikely to repeat taper tantrum—we ultimately sit at low overall yields, leading to lower expected returns on a go-forward basis. Said another way, if QE was a tailwind over the last few years, then negative QE should be a headwind going forward.

Recently, risk markets have benefited from what some call the "Trump trade," and although we viewed this optimism as largely due to hope, there were several underlying reasons to believe in. Sentiment and hard data had been strong to start the year; however, it appears to be weakening as of late. We've not seen any sizable pickup in realized economic activity, so either it may never actually be achieved, or we won't see much activity until there is positive and clear movement on the political front. It's too early, of course, to say that the market's hope in policy-driven growth was misplaced, but the political environment remains notoriously difficult to navigate as evidenced by the failed repeal of the Affordable Care Act. Next on the political agenda appears to be something that will matter to markets an order of magnitude more than health care—taxes. Our view is that some level of reform will ultimately be accomplished. However, it will be less than what market participants currently anticipate. Without health care reform, revenue neutral tax reform becomes significantly more tenuous. Add in further difficulties in implementing a generally negatively viewed Border Adjustment Tax and the image of everything being completed as expected becomes even murkier.

While this may not paint the rosiest of images for the investment environment we all currently face, that hasn't prevented us from continuing to deliver attractive results for our investors. Clients know well the deep level of research we conduct when analyzing individual credits. However, they may be less aware of how we also carefully consider the changing political/economic/social paradigms when we invest.

In deciding where to deploy client capital, we ultimately discern how likely something will happen, what will happen, over what time period, and what the market is currently pricing in. While we clearly follow day-to-day developments when positioning the portfolios to meet their goals over time, we step back and consider the longer term.

What this Means for the Portfolio

Throughout the quarter we expressed a defensive posture in multiple ways. Given our guiding philosophy of managing a diversified portfolio to be robust across many macro environments, we continued to build balanced risk exposures to avoid overdependence upon any singular outcome.

We remained cautious around interest rate risk and, as a result, the portfolio ended the quarter with an effective duration statistic towards the lower end of its historical range. During the quarter, we added floating rate bond exposure, as well as high-quality investment-grade exposure on the front end of the curve.

Additionally, within our high-yield holdings, we continued to upgrade quality and reduce potential volatility. All high-yield bonds are not created equal. Focusing on shorter maturities, less cyclical cash flows, and companies focused on the stronger segments of the economy will generally lower volatility at the portfolio level in times of stress. To this end, we have added interesting opportunities at the front end of the curve and focused on more defensive names over time, continuing this trend during the quarter. Furthermore, we continued to upgrade the overall quality of this portion of the portfolio by taking advantage of the narrowing spread differentials between the higher- and lower-quality ends of the high-yield spectrum, thus swapping into higher-rated issues where appropriate.

In our opinion, the concept of defensive positioning should be executed through more than one expression. While the fixed income world has primarily focused on defensive posturing with respect to interest-rate exposure, which in isolation we would largely agree with, it perhaps continues to underestimate the notion that economic softness may materialize. Or, even more so, it underestimates that rising interest rates themselves could ultimately cause that very economic malaise. In other words, if the Fed is forced to hike rates at a pace above current forecasts due to inflationary pressures, it could result in a cyclical headwind. In such a scenario, one could envision the need for at least some longer-term, high-quality, non-cyclical exposure to insulate the overall portfolio. Thus, in the spirit of balancing risks across the portfolio to provide a smooth ride through many economic realities, we were willing to add limited high-quality exposures beyond the front end of the curve.

In aggregate, we feel that continuing to focus on balancing risk exposures, high grading the portfolio, and remaining mindful of liquidity will serve our investors well, whatever the future may hold.

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

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