High-yield strategies were the top performers in fixed income in the first quarter of 2021, according to Morningstar Inc.'s separate account/collective investment trust database. Seven of the top 10 fixed-income strategies in the separate account universe were in Morningstar's high-yield bond category for the year ended March 31, an abrupt change from the 2020 calendar year, in which long-duration bonds dominated the one-year top 10 list each quarter.
"If Q1 2020 was a textbook credit-related shock, (the first quarter of 2021) was textbook interest-rate-related shock," said Gabriel Denis, an analyst for fixed-income strategies at Morningstar in Chicago.
Mr. Denis said concerns about inflation returned in the first quarter of 2021 as the Federal Reserve kept rates steady during the quarter ended March 31 and did not move towards a rate-hike cycle, following last August's policy change in which the Fed said it would target an average, over time, of 2% inflation.
Mr. Denis said the Fed signaled that they would have to see a sustained period of inflation before moving toward rate hikes. He also said the Fed announced the decision in the first quarter of 2021 to keep rates close to zero and said their current outlook is that any inflation will be transitory.
The first quarter also saw large government spending packages from the Biden administration, with the third stimulus bill passing at the beginning of March followed by the announcement of a large infrastructure bill at the end of the month. Mr. Denis said the combination of government spending, across the economy, and the lack of rate hikes contributed to the return of a risk-on sentiment in fixed-income markets.
"You see a lot of market participants start to fear this return of inflation, which we haven't seen for a very long time. In addition to that, there is this optimism around the fact that the vaccine rollout is proceeding, and we're starting to see more and more people return to 'normalcy' with work and with play, in terms of going out to restaurants, and all of that together leads to this big risk-on move," Mr. Denis said.
He said the long end of the Treasury curve "was the worst performing amongst the fixed-income assets that we track" during the first quarter of 2021 and that investment-grade corporate bonds and agency mortgages also experienced a performance drop during the quarter.
"We saw resilience among assets that have a little bit more credit risk involved," he said. High-yield corporate bonds, bank loans, and high-yield municipals performed well, Mr. Denis said.
"This was the textbook interest-rate shock, where investor anticipation of rising yields contributed to underperformance among the higher-quality and longer-duration fare. Both shorter-duration securities and those with higher yields, and thus more credit risk, tend to outperform in these environments," he said.
For the year ended March 31, the median one-year return for domestic high-yield strategies in Morningstar's universe was 21.98%, the median return for Morningstar's entire domestic fixed-income universe was 4.83% and the median return for long-duration domestic strategies in Morningstar's universe was 3.26%.
At the same time, the Bloomberg Barclays U.S. Corporate High-Yield index, returned 23.7% for the one-year period ended March 31; the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 7.1%; the Bloomberg Barclays U.S. Aggregate Bond index had a one-year return of 0.7%; and the Bloomberg Barclays U.S. Long Government/Credit index returned -2.1%.