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The fourth quarter was a very difficult one for the closed-end fund (CEF) marketplace. The average CEF was lower by 8.74% for the three-month period ended on 12/31/18. The sell-off during the fourth quarter helped contribute to what turned out to be an overall negative one for the average CEF in 2018. The average CEF was lower by 10.73% for the year. It was a broad sell-off as, on average, both equity and fixed-income CEFs were lower for the year. Equity CEFs were down 17.94%. Taxable fixed-income funds were weaker by 6.76%, while Municipal CEFs were lower by 5.95% for the year. (Source: Morningstar. All data is share price total return.) 

As is often the case, there were many varying factors which impacted the performance of equity and fixedincome CEFs, but clearly the negative performance for most U.S. and international equity indices hurt equity CEFs. Indeed, the MSCI All-Country World Ex US Index was down 16.42% for the year while the S&P 500 Index was lower by 4.39% during 2018. Rising short- and long-term interest rates hurt municipal CEFs, while many credit-sensitive taxable fixed-income CEFs were negatively impacted by investor fears that the global economy was slowing down. The BofAML Global Corporate Index was weaker by 3.46% for the year. (Source: Bloomberg)

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When equity markets have sold off over the past decade, many have been quick to point at exchange-traded funds (ETFs) as the possible culprit (remember the "flash crash"!?).  Plenty of active mutual fund managers have ample incentives to characterize ETFs as problematic, especially while facing consistent outflows, as ETFs continue to gobble up market share.  Thus, it's not uncommon for investment advisors to encounter clients that have had seeds of doubt planted about whether or not ETFs really are to blame when volatility picks up, or equities sell off.

Among such investors, these concerns may have been further stoked by an unexpected spike in volatility and equity market sell-off in Q418.  Surely, ETFs were to blame as nervous investors exacerbated the downturn by selling their ETFs into a declining market, right!? Nope.  If anything, the data points in the opposite direction. In Q4, US equity and sector ETFs had over $31 billion of net inflows. Even in December, as the S&P 500 Index had its steepest decline, US equity and sector ETFs had over $13 billion of net inflows. Meanwhile, traditional US equity and sector mutual funds had nearly $38 billion of net outflows in Q4.  If anyone was selling into a falling market, it was mutual fund investors!  However, before anyone starts blaming the Q4 market decline on traditional mutual funds, keep in mind that this is nothing new.  In fact, traditional equity mutual funds had net outflows for 8 of the prior 9 months in 2018, averaging over$11 billion per month.

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Mounting fears regarding the pace of interest rate hikes by the Federal Reserve, increased tensions between the U.S. and China over trade, and concerns over slowing global growth led to volatile conditions in both equity and fixed income markets during the final quarter of 2018. These fears led equities to fall 13.52% in the quarter, as measured by the S&P 500. The decline in equities during the quarter induced selling across a wide spectrum of asset classes, including high-yield bonds, which fell 4.64% and senior loans which were down 3.42%. The risk-off sentiment led to a flight to quality, notably into U.S. Treasury Bonds. As Treasury's increased in value, interest rates declined. The yield on the 10 Year U.S. Treasury Bond had its first quarterly decline since the second quarter of 2017 as the yield moved from 3.06% at the end of the third quarter to 2.68% at the end of the fourth quarter. Despite the volatility in the fourth quarter, senior loans outperformed most fixed income asset classes in 2018. Loans finished the year marginally positive at 0.47% (Exhibit 1) while high-yield bonds were down 2.25% (Exhibit 2), investment grade corporate bonds were down 2.24% and the Bloomberg Barclays Aggregate Index, a good proxy for the overall bond market, finished the year up one basis point.

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The weakness continued in emerging markets for the third quarter as the JP Morgan GBI-EM Global Diversified Index (the "Index") fell -1.83%. The yield on the Index rose 3 basis points (bps) over the quarter to 6.62% while similar duration 5-yr maturity US Treasury bond yields rose 22 basis points to 2.95%.

Although yields rose modestly for the emerging market (EM) asset class, the return from local currency bonds was positive over the quarter at 0.24% due to the high carry earned on the index. Weaker emerging market currencies versus the US dollar drove the volatility over the period. Emerging market currencies contributed -2.06% to the Index return over the period.

The continued rise in US Treasury yields is a concern for fixed income investors especially when comparing US domestic fixed income to global fixed income opportunities. With rising US Treasury yields the spread between international bond yields and US domestic yields compress. The less attractive pick-up in yield on the face of it shows that foreign bonds are now more expensive or less of a value proposition, however, that may overlook some of the benefits of diversifying globally when it comes to fixed income.

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¹ Source: Morningstar, as of 9/30/18. Includes all US-listed exchange-traded funds, exchange-traded notes and other exchange-traded products. All net inflow and outflow numbers are estimates based on information provided by Morningstar.

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Given the magnitude of credit spread widening during the 2nd quarter, it should not be too surprising that the investment grade credit market recovered during 3Q 2018. However, given ongoing concerns about rising interest rates, trade tensions, Italian sovereign risk, and the growth of the BBB-rated segment -- the magnitude of the recovery was somewhat unexpected. The option-adjusted spread on the Bloomberg Barclays US Corporate Index tightened 17 basis points (bps) to 106 over the three month period ending September 30, 2018. This compares to 93 bps at the beginning of the year, and 101 bps at the end of 3Q 2017. In the U.S. Treasury market, the benchmark 10-year yield increased from 2.85% on June 30, 2018 to 3.057% on September 30, 2018– after having traded as high as 3.101% and as low as 2.82% during the quarter.

Most of the spread retracement occurred during July, as strong earnings combined with solid economic data to foster a "risk on" tone. Interest rates moved higher, leading to increased demand as all-in-yields (UST rate plus credit spread) become more compelling. This positive technical was helped by a muted new issue calendar. Not surprisingly, given the rally, the best performing sectors tended to be those with higher spread beta and lower credit ratings. The July snap back was the strongest monthly excess return performance for the Bloomberg Barclays U.S. Corporate Index since April 2016, though total returns were hurt by the selloff in Treasuries.

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