With the recent passing of the U.K.'s "Brexit" referendum to leave the European Union, markets and investors were reminded that seemingly unlikely events can, do, and certainly will continue to occur. In recent quarterly letters, we have written that investors should expect periods of higher volatility as the world adjusts to an increasingly uncertain future, something we view as likely to continue. Combine this uncertainty with high (and in some cases, record high) asset prices, proactive risk management is as important as ever. But before we continue to move toward our outlook and how we have positioned the Thornburg Strategic Income portfolio, specifically in anticipation of our outlook, let us first focus on a few key data points from the quarter ended June 30, 2016.
Across the quarter, investment-grade as well as high-yield corporate spreads tightened, with the Barclays Intermediate Government/Credit Bond Index universe OAS moving eight basis points tighter, and the Barclays U.S. Corporate High Yield Index OAS moving 59 basis points tighter. The S&P 500 Index ended the quarter up 2.46%, while the dollar index gained 1.65%. It wasn't, however, just risky assets that rallied. The 10-year U.S. Treasury bond marched lower in yield, starting the quarter at 1.77% and ending it at 1.47%, just 10 basis points shy of an all-time low. Combine the move lower in risk-free rates with the move tighter in spreads, and most fixed income universes sit at or near all-time lows in yield. Generally speaking, higher yields are viewed as compensation for potential risk and uncertainty. With indices today sitting near all-time lows in yield, this should signal that we live in a period of high certainty and known outcomes. As Brexit has proved, this is certainly not the case, and investors are faced with a nearly endless stream of unknown and potentially significant risk off scenarios. One thing we can state with certainty: there isn't a lot of room for error in investing with compensation for risk at extremely low levels.
Many Thornburg employees spent the evening and early morning hours post the U.K. referendum in the office assessing the outcome and seeking opportunity as markets adjusted to a period of renewed uncertainty. The period of volatility was intense, with the British pound sinking 12.5%, the S&P 500 Index off some 5.3%, and the Barclays U.S. Corporate High Yield Index closing down by 1.3%. Despite all of the negative return numbers for the two days following the vote, trading in fixed income land was relatively thin and within a few days many markets had rallied back to pre-Brexit levels. While the market has recovered from Brexit for now, investors continue to have many potential challenges to overcome. The continued devaluation of the Chinese renminbi, potential normalization of U.S. Federal Reserve monetary policy and rising U.S. short-term rates, an unknown U.S. election outcome, an Italian banking system facing crisis, elections in Germany and France are all risks the market faces within the coming year. We have already seen one member vote to exit the E.U., and populist agendas are gaining momentum in many other nations. The E.U. will soon likely impose fines on both Spain and Portugal for running excessive fiscal deficits, a move that is likely to further the call from populist political movements for an exit of their own. Given all of the challenges mentioned above, why are we today facing the lowest yields in the history of bond investing?
There are many potential reasons and no certain answers. To start, the U.S. 10-year Treasury, even at 1.38%, is attractive on a relative basis vs. equivalent tenure German bunds at negative 0.18%, Japanese government bonds at negative 0.28%, and the Swiss government bond at negative 0.69%. Additionally, the likely path of future rates is lower than it was just a few weeks ago, and thus an environment of lower rates does make some sense. Despite these and a few other reasons for such low yields, it feels that in many ways the market is simply complacent, willing to bet that rates will forever remain low and risk assets will be saved by infinite bailouts from the world's central banks. Thus far, the market has been right; however, at some point one has to question when enough is enough.
The investment philosophy of the Thornburg Strategic Income portfolio has and continues to be to provide a high level of current income and total return while managing our overall volatility experience in hopes of providing an optimal balance of risk and reward to our investors. As such, when the portfolios are well compensated to assume additional risk, we will selectively deploy cash in search of potential return. However, in recent periods when the opposite was true, Treasuries, spreads, and all in yields were low, we sought to move the portfolio higher in quality and hope for a better entry point into markets. Across the quarter we added a number of names and securities in which we feel the underlying cash flows are secure, and we also feel the portfolio is well positioned in times of uncertainty. This move, however, does come at the expense of lower current income and return potential, a tradeoff we are willing to make in today's environment of low yields and heightened uncertainty. As the market continues to evolve, we will search for good opportunities to invest and seek a higher return.
We continue to follow our central tenant of investing, seeking the best relative value in terms of risk and reward, and for now that continues to point to higher-quality instruments for the portfolio and a general posture of caution. We believe this portfolio is well suited to perform across many different outcomes. Given our ability to look up and down the capital structure and access unique stories globally, we feel that we are able to consistently add value, seek a higher total return relative to "core" fixed income strategies, and mute overall volatility relative to high yield and higher risk/return segments of the market. We want to remind all investors, this is NOT a core fixed income offering, and we expect it will have a higher correlation to risk-off assets in times of stress. However, for those investors willing to tolerate a higher level of volatility relative to "core" fixed income in search of higher potential return, we believe the Thornburg Strategic Income Fund continues to serve an important place in many portfolios.
Thank you for your continued trust and investing alongside us.
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