Long-duration bonds continued to dominate the list of top-performing fixed-income strategies in the last quarter of 2020, once again claiming nine of the top 10 spots, according to Morningstar Inc.'s separate account/collective investment trust database, but the return of a risk-on sentiment in the fourth quarter led to strong returns among high-yield municipal and corporate bonds.
"The fourth quarter was the culmination of a lot of the optimism that was starting to bubble through in the third quarter. Really, the two biggest pieces of optimism for a lot of investors at that point kind of came true," said Gabriel Denis, an analyst for fixed-income strategies at Morningstar in Chicago.
Mr. Denis said election results signaled the direction of U.S. policy regarding taxes and regulation, relieving some political uncertainty, and the anticipated COVID-19 vaccines became ready for distribution toward the end of the fourth quarter.
"As conditions changed and a risk-on sentiment returned, high-yield municipal and corporate bonds rallied in the fourth quarter," Mr. Denis said. "Among the biggest winners of the quarter were emerging market sovereign bonds issued in local currencies."
The J.P. Morgan Government Bond Index-Emerging Markets Global Diversified benchmark, which tracks a broad basket of these bonds, posted a 9.6% return for the quarter ended Dec. 31, he said.
Despite losing some ground in the fourth quarter, U.S. Treasuries performed well year over year and posted a positive return for 2020 largely due to the strength of the first quarter's risk-off rally that benefited long-duration bonds, Mr. Denis said.
Long-duration U.S. government bond strategies continued to dominate Morningstar's list but dropped to five of the 10 best performers at the end of 2020, down from seven out of 10 for the year ended Sept. 30.
"One of the things that people had been watching throughout this quarter was the U.S. dollar, which had been so strong when everyone was running to the safety of U.S. Treasuries and the safety of the U.S. dollar. We saw a lot of global currency post big losses against the dollar earlier in the year. The inverse happened (in the fourth quarter) so the dollar depreciated in value and there was a lot more optimism around the potential for global growth to outstrip U.S. growth," Mr. Denis said.
The Bloomberg Barclays U.S. Long-Government Bond index returned 17.55% for the year ended Dec. 31; the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 10.11% for the year; and the Bloomberg Barclays U.S. Aggregate Bond index had a one-year return of 7.51%.
"In fact, almost every single fixed-income asset that we monitor in these broad benchmarks did post a positive return. There were few 'losers,' but some returned less because they had so much catch-up to play after their poor returns over the year," he said.
Generally speaking, he said, the final quarter of 2020 saw the completion of a "V-shaped recovery" for the markets. "So, despite those huge losses in the beginning of the year, a lot of people ended up in the green at the end of the year." Investment-grade and high-yield bond spreads resembled an "inverse V" in 2020, he said, rising from low levels at the end of 2019 to some of the highest levels bond markets have experienced in some time, driven by the onset of the pandemic in March, before returning to their previously low levels in the fourth quarter.
"While they haven't quite reached their 2019 low, a lot of those areas have reached close to that low. So it's almost as if the crisis that we saw back in March has faded into recent memory, with a lot of corporate assets posting some of the lowest yields they've ever posted," he said.
For the year ended Dec. 31, the median one-year return for long-duration domestic strategies in Morningstar's universe was 16.83%, the median return for domestic high-yield strategies was 6.85% and the median return for Morningstar's entire domestic fixed-income universe was 6.44%.