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Executive Summary
Fixed income funds realized a return of positive 6.06% on average during the fourth quarter of 2023, marking a rebound from their third quarter loss (-1.70%). Fixed income funds have now reported four quarterly gains in the last five.
Tax-exempt bond funds (+6.79%) outperformed taxable bond funds (+5.81%) for the first time all year as they recorded their second largest quarterly return on record, trailing only Q3 2009 (+7.73%). Despite the nearly 100 basis point (bps) outperformance, taxable bond funds returned their highest quarterly return since Q2 2020.
On an annual basis, fixed income funds booked a 7.09% gain with both taxable fixed income funds (+7.59%) and tax-exempt fixed income funds (+5.67%) taking home their largest calendar year return since 2019. Last year taxable fixed income funds (-10.11%) and tax-exempt fixed income funds (-9.12%) suffered their lowest and second lowest annual returns of all time, respectively.
Market Commentary
Market census on future economic conditions over the past year shifted from a likely recession to higher interest rates for longer to what many are now forecasting as a soft landing in 2024. Since the beginning of 2022, Federal Reserve Chair Jerome Powell has been criticized for either doing too little, too much, moving too slowly, or overreacting. Right or wrong, the Fed’s rhetoric continues to be the focal point of all market participants. These turbulent times can be summarized by movement in the 10-year Treasury yield; in early 2022 the 10-year stood around 2.0% moving up to 3.9% by the end of the year, then peaking close to 5.0% in late October 2023, to where we stand now back at 3.9%. All in all, the Fed took its main policy rate range from 0.250.50% to 5.25-5.50% in just over a year.
Enter October 2023, the U.S. central bank decided to pause rates in September but Federal Open Market Committee (OTCPK:FOMC) meeting minutes showed conflicting opinions in regard to future return falls to positive 2.51%. policy actions. An excerpt from the meeting stated, “A majority of participants judged that one more increase in the target federal funds rate at a future meeting would likely be appropriate, while some judged it likely that no further increases would be warranted.” Another point from the minutes that was highly touted at the time was “policy should remain restrictive for some time until the Committee is confident that inflation is moving down sustainably toward its objective.” Roughly a week after the September minutes were released the 10-year Treasury yield hit its peak closing day value of 4.98%.
Taxable fixed income funds suffered a negative 0.79%, on average, in October while posting an outflow of $16.1 billion—most of which came from taxable mutual funds, taxable ETFs pulled in $11.4 billion during the month. Tax-exempt fixed income funds also struggled, realizing a negative 1.16% and seeing $8.3 billion in outflows. The only gains in fixed income during October, outside of money market funds, were short duration government and Treasury funds.
Minutes from the next FOMC meeting held October 31 to November 1 reiterated that the Committee will continue to rely on data presented and how that data may impact future economic LSEG Lipper risks. Powell went on to say, “The fact is, the Committee is not thinking about rate cuts right now at all.” The 10-year was hovering around 4.4% when minutes were released and in just over two weeks, closed below 4.0% for the first time since August. Rate stability brought solid performance for fixed income funds—both taxable fixed income (+3.17%) and tax-exempt (+5.31%) recorded monthly gains. Longer-duration corporate credit and municipal bond funds came in as the November winners. Taxable bond funds observed monthly inflows (+$19.1 billion), marking their largest in four months. Tax-exempt bond funds (-$1.0 billion) suffered their fourth straight monthly outflow.
At the end of November, $5.8 trillion sat in money market funds and investors still appeared uneasy. The Department of Labor’s Job Openings and Labor Turnover Survey (JOLTS Report), released in early December, showed that U.S. job openings fell to a more than two and half year low during October. However, it did not take long for the Bulls get off the sidelines as November datapoints continually hinted that the U.S. economy may be more resilient to higher rates than many anticipated. The Fed seemed to agree as it left rates unchanged during the December meeting.
While we may have ended 2023 on a high note, there is certainly a long way to go. The December Consumer Price Index (CPI) report is scheduled for January 11 with the Fed’s preferred gauge of inflation—the Personal Consumption Expenditures (PCE) index—being published on January 26. This would come a few days ahead of the next FOMC meeting, where it is now widely expected that the Committee will leave rates unchanged yet again. The only certainty as an investor over the past year has been that nothing is for certain. Geopolitical tensions remain high, we have an election on the horizon, U.S. debt has reached what one would think is a dangerous level, and all the while the Securities Exchange Commission (SEC) approved 11 spot bitcoin ETFs. So, like the Fed, we will remain data-dependent and look at what has actually happened over the past three months.
Fixed Income Fund Launches/Closures
FIGURE 1 – PROCEEDS AMOUNT + OVER SOLD ($BIL)
During Q4 2024 there were 45 total unique funds launched, marking the second straight month of increased launches—41 of the 45 were actively managed fixed income funds. There was a record-setting 39 fixed income ETFs launched during the quarter, nine of which fall under the Lipper Alternative Currency Strategies classification. Also during the last three months there were 32 unique fixed income fund closures, most since Q4 2021. Of the 32 liquidations, 21 were mutual funds spread across 16 different classifications.
Newly Issued Debt
The market saw an increase in proceeds amount for both high yield corporate debt and leverage loans over the prior three months. Total number of issues slightly decreased for high yield debt—falling from 66 to 60 quarter over quarter. Leverage loan total number of individual issues ticked up to 463 from 435.
Investment grade corporate debt saw a decrease in issuance amount for the third straight quarter. Both issuance amount and total number of new issues dropped to the lowest quarterly level since Q4 2022.
Active Vs. Passive Returns
FIGURE 2- ACTIVE VS. PASSIVE MANAGMENT: TRAILING ONE-YEAR AND Q4 RETURNS (%)
Passively managed fixed income funds outpaced their active counterparts during the fourth quarter of 2023—passive funds returned a positive 6.19% compared to active’s 6.05% gain. Passive funds in Q4 were led by Single State Municipal Debt funds (+8.19%) and General Municipal Debt funds (+7.85%). The top actively managed macro groups during the past quarter were General Municipal Debt funds (+7.78%) and World Taxable Fixed Income funds (+7.75%). The largest outperformance of passive over active during Q4 came in the General Domestic Taxable Fixed Income macro group where passive funds, on average, outperformed active funds by 98 bps.
Looking back at trailing one-year returns, active management took the lead—active fixed income funds (+7.12%) outperformed passive (+6.80%). The top active macro groups over 2023 were Alternative Bond funds (+11.07%) and General Domestic Taxable Fixed Income funds (+9.50). Passively managed macro groups to finish with the largest trailing one-year return were General Domestic Taxable Fixed Income funds (+9.33%) and World Taxable Fixed Income funds (+8.63%).
The largest macro group outperformance of active over passive funds in trailing one-year performance was National Municipal Debt funds. On average actively managed funds in this macro group realized 80 bps of outperformance over passive.
Lipper Classifications/Macro Groups
All 51 Lipper fixed income classifications ended the fourth quarter with gains—only 11 posted a plus-side return in Q3. All but two classifications outperformed quarter over quarter—Lipper Loan Participation funds and Specialty Fixed Income funds. These two classifications were the top performers last quarter.
The top-performing Lipper classifications throughout Q4 were Alternative Currency Strategies funds (+18.95%), Emerging Markets Hard Currency Debt Funds (+8.75%), New York Municipal Debt Funds (+8.56%), Corporate Debt Funds A-Rated (+8.31%), and General U.S. Treasury funds (+8.20%). The caveat for Alternative Currency Strategies funds is that if you remove the 21 funds with cryptocurrency derivative mandates, the remaining 90 funds in the classification report an average return of positive 2.51%—leaving it fourth from the bottom in Q4 return ranks.
Specialty Fixed Income funds (+1.36%), Ultra-Short Obligation funds (+1.78%), Short U.S. Treasury funds (+2.10%), Short Municipal Debt funds (+2.54%), and Short U.S. Government funds (+2.56%) closed the quarter as the worst-performing classifications. Specialty Fixed Income funds, Ultra-Short Obligation funds, and Short U.S. Treasury funds are three of eight classifications to realize five straight plus-side quarterly returns.
Lipper’s 51 fixed income classifications each fall under one of the eight fixed income macro-groups. All eight reported Q4 gains—General Municipal Debt Funds (+7.78%), World Taxable Fixed Income Funds (+7.75%), and Single State Municipal Debt Funds (+7.35%) were the top three.
The three-bottom macro groups during the quarter were National Municipal Debt Funds (+4.62%), Short-Term/Intermediate Corporate Fixed Income Funds (+4.97%), and Government/Treasury Funds (+5.23%). All eight macro-groups outperformed their Q3 returns. The last time each macro-group realized positive returns was Q1 this year.
FIGURE 3 – TREASURY YIELD CURVE: MOVEMENT OVER THE PAST YEAR
Government/Treasury Funds Summary
Treasury yields sank drastically with the two- (-15.84%), three- (-16.81%), five- (-16.78%), 10- (-15.46%), and 30-year (-14.47%) yields all falling during the fourth quarter. Compared to where we were at the start of the year, the yield curve has seen slight steepening—two- (-3.47%), five- (-3.13%), 10- (+0.91%), and 30-year (+2.06%).
The Government/Treasury Funds macro-group posted a positive 5.23% return on average over the quarter, its largest quarterly return on record. Q4 also marks the first quarter in three reporting plus-side returns while also seeing gains in three of the last five quarters. Government/Treasury Funds reported a 4.09% annual return during 2023, its fourth calendar year gain over the last five years.
The best-performing classifications under this macro-group were General U.S. Treasury funds (+8.20%), General U.S. Government funds (+6.76%), and GNMA funds (+6.36%). General U.S. Treasury and General U.S. Government funds were the bottom two performing classifications during both Q2 and Q3 of this year. All three classifications ended a two-quarter stretch of negative returns. General U.S. Treasury funds logged their largest quarterly return since Q1 2020.
The three bottom Lipper classifications under Government/Treasury funds were Short U.S. Treasury funds (+2.10%), Short U.S. Government funds (+2.56%), and Inflation Protected Bond funds (+3.87%). The Short U.S. Treasury funds classification was the top performing during the second and third quarters of this year. Despite being at the bottom of the totem pole, this classification is the only classification under the Government/ Treasury Funds macro group to see five straight quarters of gains.
World Fixed Income Funds Summary
World Fixed Income Funds also realized a rebound in Q4 2023; their gain of 7.75% was the largest quarterly return since Q2 2009. All five of the Lipper classification in this macro-group came in with quarterly gains and outperformed the previous quarter’s returns.
Emerging Markets Hard Currency Debt funds (+8.75%), Emerging Markets Local Currency Debt funds (+8.17%), and International Income funds (+7.38%) finished at the top of this macro-group. Emerging Markets Hard Currency Debt funds have seen four positive quarters over the prior five.
Despite being at the bottom of this macro group during Q4, Global High Yield funds (+6.37%) realized its fifth straight quarterly gain giving them 11 over the past 15 in plus-side territory.
Short-Term Intermediate Corporate Bond Funds Summary
Short-Term Intermediate Corporate Bond Funds finished the fourth quarter with positive quarterly performance (+4.97%), their first gain in the last three quarters, yet third in the last five. This marks the largest quarterly return since Q2 2020. Over the trailing 12 months, the macro group witnessed a positive 6.00%, the highest annual return since 2019.
At the top of this macro-group during Q4 were Core Plus Bond funds (+6.87%), Core Bond funds (+6.74%), and Short High Yield funds (+4.35%). Core Plus and Core Bond funds were the lowest returning classifications during Q3 as they logged their first quarterly gain in three.
The bottom-performing Lipper classifications in this macro group were Ultra-Short Obligation funds (+1.78%), Short Investment Grade Debt funds (+3.00%), and Short-Intermediate Investment Grade Debt funds (+3.69%). Despite being the top performing last quarter and outperforming that level during Q4, Ultra-Short Obligation funds ended the quarter as the second lowest performing of all fixed income classifications.
Short High Yield and Ultra-Short Obligation funds are two of only three fixed income classifications to record six consecutive quarterly gains.
FIGURE 4 – Q4 2023 TAXABLE FIXED INCOME PERFORMANCE (%)
General Domestic Taxable Bond Funds Summary
As a macro-group, General Domestic Taxable Fixed Income Funds finished the quarter returning a positive 5.89%, their highest quarterly return since the second quarter of 2009. The macro group has realized four gains over the last five quarters while seeing a 6.14% improvement over Q3. Over the year, the macro group observed a 9.49% positive return, its largest annual gain since 2019.
Corporate Debt A-Rated funds (+8.31%), Corporate Debt BBB-Rated funds (+8.09%), and General Bond funds (+7.05%) were the highest performing classifications of the macro-group. These three classifications all have average effective durations of more than 6.5, with Corporate Debt A-Rated funds holding the third highest of all fixed income (8.74). These top performers were the laggards of the macro group last quarter and observed their first positive return in three quarters.
Specialty Fixed Income funds (+1.36%), Lipper Loan Participation funds (+2.80%), and Flexible Income funds (+5.91%) were the leading classifications under General Domestic Taxable Bond Funds. Despite the relative low performance to the rest of the classifications, Loan Participation funds continued their hot streak with the sixth straight quarter of positive returns—one of three fixed income classifications to reach that feat. Most funds under the Loan Participation classification are primarily made up of bank loans and floating rate loans, so although they reported the lowest average duration (0.42), their floating rate nature has made them both a steady top performer and attractor of new capital— seeing the fifth largest quarterly inflow under all fixed income classifications (+$2.2 billion).
Municipal Debt Funds Summary
FIGURE 5 – Q4 2023 TAX-EXEMPT FIXED INCOME PERFORMANCE (%)
Municipal Debt Funds recorded an average gain of 6.79% in the fourth quarter of 2023—marking their fourth positive return in five quarters. All 20 municipal classifications realized plus-side returns during the quarter—the first time since Q1 2023.
The macro groups under Municipal Debt Funds all had positive quarterly returns— General Municipal Debt funds (+7.78%), Single State Municipal Debt funds (+7.35%), and National Municipal Debt funds (4.62%) were in the black. For National and Single State Municipal Debt funds, this was the first gain in three quarters. General Municipal Debt funds logged its fourth positive quarterly return in five.
The two top-performing non-single state tax-exempt Lipper classifications were High Yield Municipal Debt funds (+7.88%) and General & Insured Municipal Debt funds (+7.72%)—both classifications have realized four plus-side quarters over the previous five.
The three bottom-performing classifications under Single State Municipal Debt funds were California Short-Intermediate Municipal Debt funds (+3.77%), Other States Short Intermediate Muni Debt funds (+4.06%), and California Intermediate Municipal Debt funds (+5.51%). All three of these classifications were among the top three single state performing classifications last quarter despite all seeing negative Q3 returns.
Alternative Bond Funds Summary
The Alternative Bond Funds macro group ended the quarter returning a positive 7.03%, their highest quarterly return since the second quarter of 2009. The macro group has realized four gains over the last five quarters while seeing a 7.80% quarter-over-quarter gain. Over the year, the macro group observed a 10.91% positive return, its largest annual gain since 2008.
There are only three fixed income classifications under this macro group—Alternative Currency Strategies funds (+18.95%), Alternative Credit Focus funds (+5.19%), and Absolute Return Bond funds (+4.63) all recovered from Q3 losses. Although Alternative Currency Strategies funds dominated Q4 performance relative to other classifications, the large gains were nearly all attributed to cryptocurrency futures funds. If we were to remove the 21 Bitcoin (BTC) and Ethereum (ETH) derivative funds the classification average return over Q4 falls to positive 2.51%. The Alternative Currency Strategies classification has realized three plus-side returns in the last four quarters, with two of those being double-digit gains.
FIGURE 6 – FTSE 1- YEAR TREASURY & US BROAD IG BOND INDEX PERFORMANCE (%)
FIGURE 7 – FIXED INCOME INDEX RISK RETURN PROFILE: TRAILING ONE-YEAR
Final Thoughts
During the first nine months of 2023 it paid to be in short-duration funds with high yields and government back debt providing safe returns. The fourth quarter, however, flipped everything on its head as the market started betting that we have seen the last of Fed tightening while pricing in interest rate cuts starting in early to mid-2024. If you sat in short duration, you missed out on strong Q4 gains. But who’s to say market dynamics won’t change again? I’m willing to bet most hard landings over the course of our history started off as projected soft landings. As always, it’s wise to balance the risk/return profile of your fixed income portfolio.
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