Global bond markets generated positive returns in the third quarter. Escalating geopolitical tensions between the U.S. and North Korea and serial disappointments in inflation data helped to contain the increase in sovereign yields prompted by central bank policy normalization. Generally strong economic data, a rally in commodities prices, and continued demand for yield-producing assets supported credit markets and spreads tightened further. Most developed market currencies strengthened versus the U.S. dollar as political uncertainty and continued skepticism about the U.S. Federal Reserve’s (Fed) projected rate-hiking path weighed on the greenback.
Monetary policy continued along an incrementally more hawkish path during the period. The Fed announced it would begin tapering its asset purchases starting in October and continued to project another rate hike later this year. The European Central Bank (ECB) attempted to push back against its recent currency strength which has hampered its ability to achieve higher inflation. The ECB is expected to announce details of its own tapering intentions at its October meeting. Strong growth and inflation prompted the Bank of Canada to hike rates for the first time in seven years and hint that more rate hikes may be forthcoming. Meanwhile, the Bank of England signaled it is close to hiking rates to contain surging inflation despite uncertainty about the post-Brexit outlook.
U.S. GDP growth accelerated to 3.0% in the second quarter, buoyed by consumer spending and investment. However, core inflation failed to engage higher despite ongoing health in the labor market. Eurozone economic data showed continued improvement in domestic-oriented sectors, with strength in both business and consumer confidence. Japanese GDP expanded at a 4% annualized rate in the second quarter—the fastest pace in more than three years. China’s official Purchasing Managers’ Index (PMI) improved to its strongest level in more than five years, while property sales continued to drift lower. Despite continued labor-market strength and a rebound in commodities prices, inflation data across most developed market economics remained subdued.
The Fund’s Investor shares outperformed the Bloomberg Barclays U.S. Aggregate Bond Index for the third quarter, returning 0.90% vs. the benchmark’s 0.85% performance. The Fund’s exposure to agency mortgage-backed securities (MBS)—including pass-throughs and Fannie Mae (FNMA) Delegated Underwriting and Servicing (DUS) affordable housing bonds—and investment-grade credit represented the main contributors to outperformance, while its duration posture detracted from relative performance.
The Fund’s positioning within agency MBS had a favorable impact on performance during the quarter. It held an overweight to agency pass-throughs, given low interest-rate volatility and greater visibility on the Fed’s balance sheet intentions, and maintained an allocation to collateralized mortgage obligations (CMOs) and FNMA DUS bonds for their attractive income and convexity profiles. Mortgages benefitted from the extremely low level of volatility, which helped tighten spreads, and amid generally range-bound interest rates, which improved their carry. The sector’s strong performance was especially notable in light of the Fed’s September announcement that it will officially begin its balance-sheet normalization process in October.
Based on attractive valuations, the Fund also held an overweight to high-quality commercial mortgage-backed securities (CMBS), which was also additive to relative results. Most sectors of the market seemed to look past the negative retail headlines, implying that CMBS has already discounted a lot of the negative news in that space. Synthetic CMBX subordinate indices, on the other hand, came under pressure due to their exposure to lower quality shopping malls.
The submanager continued to favor high-yield credit and bank loans over investment-grade credit based on attractive valuations and low default expectations, and maintained an allocation to BB-rated high-yield issuances. Additionally, the Fund’s submanager used high-yield derivatives as a source of liquidity and to manage overall portfolio risk. The global high-yield sector generated strong gains, as generally strong economic data and a rally in commodities prices helped to offset escalating geopolitical tensions, and spreads tightened further. Bank loans also generated a positive total return, and given their floating-rate nature, they may benefit more than fixed-rate sectors from tighter U.S. monetary policy, as their coupons reset higher. High-yield and bank-loan positioning both contributed positively to the Fund’s relative returns, particularly in industrials.
Given the better opportunities in higher-yield sectors, the Fund maintained an overall underweight to investment-grade corporate bonds. Within the investment-grade sector, the Fund continued to favor taxable municipals. Generally solid corporate earnings and continued demand for yield-producing assets supported credit markets and spreads tightened further. Credit positioning was a positive contributor to relative results overall, as a negative impact from an underweight to industrials was more than offset by exposure to the banking subsector and the overweight to taxable municipals.
Within Government issues, the Fund remained positioned for rising inflation expectations, as the submanager continued to believe the market was underpricing inflation expectations. Inflation positioning was neutral for relative performance, as mixed inflation data and ongoing concerns about the domestic “reflation trade” were balanced by continued strong economic data and renewed optimism around prospects for tax reform, leading inflation-protected instruments to outperform duration-equivalent nominal Treasuries. The Fund held modest opportunistic interest-rate positions during the quarter, in both short- and long-term rates. Tactical duration positioning had a negative impact on relative performance, primarily from a tactical short position.
As is true of all Domini mutual funds, all securities held in the Bond Fund meet Domini’s social and environmental standards. Non-corporate fixed-income investments offer unique opportunities to support the creation public goods, help address economic disparities, and build a more sustainable and equitable society. Domini considers bonds that address affordable housing, economic development, public education, nonprofit healthcare, and climate change to be especially impactful. As of September 30, such securities represented 68% of the Fund’s total portfolio1, as shown in the table: