4th Quarter 2018

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During the fourth quarter of 2018, Thornburg Limited Term Income Strategy returned 1.14% (net of fees), underperforming the benchmark Bloomberg Barclays Intermediate U.S. Government/ Credit Bond Index, which returned 1.65%. For the full calendar year, the strategy returned 1.38%, also outpacing the benchmark return of 0.88%.

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 Fed, 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 to investors. In fact, the recent step-down in growth could be viewed as a normal process as individual economies across the globe move 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.

Rising market volatility in the fourth quarter suggests that investors fear a tilt away from global monetary policy accommodation and the less predictable, and potentially uneven, economic results that are likely to follow. 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 at or close to its 2% target, while factoring in the specter of rising wages potentially fueling 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 the Fed has been highly data dependent. The market has ignored this at times to 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 data dependent as well. The market took this as a dovish signal, with risk assets recovering to varying degrees.

Overseas, the European Central Bank decided to hold rates steady in December and ended its purchase program as expected. However, Draghi offered dovish comments around the timing of the ECB’s first rate hike, suggesting it could come around the end of 2019. Growth within the European Union is slowing, with little aid coming from the fiscal side. As such, the central bank reduced its growth forecast for 2019 and showed no signs of concern as it relates to inflation.

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 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 slightly reduced our exposure to corporates in the Limited Term Income Strategy, moved credit duration lower, and shifted into more defensive industries. Shifting into more defensive sectors ultimately helped mitigate the impact of spread widening for our portfolio, though it didn’t eliminate the negative impact. Investment-grade floating-rate corporates also sold off notably in early December and then again in late December and into the New Year as market participants decided the Fed would no longer hike rates in early 2019. Fortunately, we had earlier reduced the exposure to floating-rate notes from approximately 20% to 13% as the relative value of such investments had decreased.

With wider spreads and the market perhaps offsides relative to rate expectations, we are currently looking to add back a bit of corporate exposure to portfolios. In general, though, given our already significant position in corporates, we are not looking to materially increase exposure but are certainly seeing some attractive opportunities to add on the margin and swap out less attractive positions. We continue to believe caution in the corporate sector 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 is likely to be a key driver for investor results going forward.

We continued to increase duration in our core portfolios at the start of the quarter as U.S. Treasury rates continued to rise. In Limited Term Income, we moved from 2.94 years at the beginning of the quarter to approximately 3.2 years in mid-November as the U.S. 10-year went from 3.06% to 3.25%. As Treasury rates then fell to 2.69%, we reduced duration from 3.25 to 2.95 at year end in what was a quicker rate turnaround than expected. Our U.S. Government Strategy followed the same path. As mentioned above, we believe the market may have rallied a bit too far, so we’ve moved duration toward the lower end of our range rather than in the middle as it had been in recent quarters.

We continue to favor investing in securities backed by the cash flows of the U.S. consumer, still the engine of growth for the U.S. economy. Spreads in many of the asset-backed security sectors, then moved wider in the fourth quarter after months of tightening, but not enough to make wholesale purchases attractive. Given our questions around the likely path of growth going forward, we maintained our discipline around selectivity as it relates to credit risk—even in generally defensive sectors.

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. Patience is a virtue, and we see more attractive buying opportunities down the road. 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 with us in Thornburg Limited Term Income, Limited Term U.S. Government, and Low Duration Income Strategies.


Important Information

Performance data for the Limited Term Income Strategy is from the Limited Term Income Composite, inception date of February 1, 1993. The Limited Term Income Composite includes all non-wrap discretionary accounts invested in the Limited Term Income Strategy. Returns are calculated using a time-weighted and asset-weighted calculation. Returns reflect the reinvestment of income and capital gains. Periods less than one year are not annualized. Individual account performance will vary. The performance data quoted represents past performance; it does not guarantee future results. Gross of fee returns are net of transaction costs. Net of fee returns are net of transaction costs and investment advisory fees. For periods prior to 2011, net returns for some accounts in the composite also reflect the deduction of administrative expenses. Thornburg Investment Management Inc.’s fee schedule is detailed in Part 2A of its ADV brochure. Performance results of the firm's clients will be reduced by the firm's management fees. For example, an account with a compounded annual total return of 10% would have increased by 159% over ten years. Assuming an annual management fee of .75%, this increase would be 142%.

Unless otherwise noted, the source of all data, charts, tables and graphs is Thornburg Investment Management, Inc., as of 12/31/18.

The views expressed are subject to change and do not necessarily reflect the views of Thornburg Investment Management, Inc. This information should not be relied upon as a recommendation or investment advice and is not intended to predict the performance of any investment or market.

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