U.S. taxable investment-grade bonds posted a roughly break-even result in the first quarter, as measured by the Bloomberg U.S. Aggregate Bond Index. A positive start to the year was upended in March by a sudden rise in geopolitical risk, which pushed U.S. Treasury yields higher and bond prices lower.

As 2026 began, the U.S. bond market was coming off a strong 2025 in which the index rose 7.30%, its best annual result since 2020. That advance was aided by relatively stable inflation and a largely resilient U.S. economy, conditions that by the second half of the year prompted the U.S. Federal Reserve to resume the monetary-easing program it had paused in late 2024. The Fed cut its policy interest rate by a quarter percentage point (25 basis points) in September, October and December.

Following its December 2025 committee meeting, Fed officials signaled they might hold rates steady for a time. This shifted the market's expectation for additional rate cuts to later in 2026. In the absence of an immediate catalyst, U.S. Treasury yields were little changed in January, limiting price volatility. The Aggregate index advanced slightly for the month (+0.11%).

February brought a catalyst in the form of U.S. inflation and employment data. Headline inflation for January came in at 2.4%, the lowest reading since May 2025, while the jobs report showed solid January hiring. The annual benchmark revision to payroll data, however, adjusted total job gains for 2025 sharply down. Together, these reports were viewed as potentially accelerating the Fed's timetable for further rate reductions. At the same time, broad-market investors adopted a more defensive posture. These factors fueled a bond market rally in February, lifting the index by 1.64%. The market landscape changed abruptly at the end of February. In the late hours of February 28, the U.S. and Israel launched military operations against Iran. Tensions between the countries had been building in prior weeks but had not materially affected markets until then. The beginning of March saw a sharp rise in bond yields as expectations for Fed cuts shifted outward once again, and an increased risk premium was priced into the yield curve. Oil and energy prices surged, heightening investor concerns about a potential spike in inflation. The benchmark 10-year U.S. Treasury began the month at 3.97% and ended at 4.30%, after peaking at 4.44% on March 27. The index returned -1.76% for the month, reversing February's upturn.

Against a backdrop of rising yields, short-term debt issues with maturities of 1 to 3 years fared best in Q1, advancing 0.32%. Bonds with maturities of 3 to 5 years eked out a small gain (+0.04%), while all longer-term categories finished in modestly negative territory. Amid a cautious market backdrop, higher-quality bonds rated AAA and AA outperformed investment-grade debt rated A and BBB.

At the sector level, U.S. Treasurys (-0.04%) outpaced more credit-sensitive U.S. investment-grade corporate bonds (-0.54%).  Securitized sectors – including agency mortgage-backed securities (+0.40%), commercial mortgage-backed securities (+0.32%) and asset-backed securities (+0.31%) – outperformed, as investors viewed them as offering higher income and solid fundamentals.

Outside the Aggregate index, U.S. Treasury Inflation-Protected Securities gained 0.26%, per Bloomberg, while U.S. high-yield corporate bonds (-0.50%) and emerging-markets debt – both investment-grade (-1.32%) and high-yield (-1.40%) – lagged amid risk-off market sentiment. ■

Overall, we're beginning to see some pockets of opportunity, but credit spreads remain very tight. In light of the current risk backdrop – inclusive of geopolitical developments, Federal Reserve policy uncertainty, inflation, etc. – we think it's possible that spreads could widen, providing a window of opportunity for more attractive entry points for new investments. Whenever that occurs, we believe we're in a position to capitalize, given the fund's reserves of U.S. Treasurys and cash.

On the whole, demand for corporate bonds remains solid, in our view, fueled by yields that are higher now than they've been for some time. In light of intensified geopolitical uncertainty, along with concerns about rising inflation and declining employment, market participants have dialed back their expectations for Fed rate cuts this year. As of March 31, investors were forecasting one cut in 2026, down from two prior to the conflict in the Middle East. If the war in Iran drags on, keeping oil prices elevated, we expect further reductions in this forecast.

In terms of portfolio positioning, at quarter end the fund has substantial investments in Alphabet, Meta Platforms and Oracle, whereas before it had essentially no exposure to AI-related issuers. These companies have recently brought large new-issue deals to the market to fund digital infrastructure for AI expansion.

From a sector perspective, the fund's allocation to banks was roughly neutral with the benchmark at the end of Q1. Meanwhile, we continued to overweight insurers, real estate investment trusts and finance companies.

Given the challenge of finding compelling values in the current spread environment, we added industrial bonds that were trading toward the wider end of credit spreads. In this way, we tried to locate issuers offering some measure of relative value. Within industrials, we increased exposure to bonds in the technology and communications industries, and to a lesser extent in energy.

During the period, we adjusted the fund's allocations to Treasurys and cash, which we hold for liquidity and risk-management purposes. We lowered Treasurys from about 6% to roughly 3% and modestly increased cash from 0.5% to about 2%.

From a credit-rating perspective, we continue to emphasize issuers rated BBB, believing that there is opportunity for alpha potential over time resulting from improving credit quality. At the same time, we maintained a relatively consistent allocation to bonds rated A, in response to tight spreads and economic uncertainty.

With this positioning, we kept the fund's credit risk modestly greater than the benchmark, but, with spreads at a tight level, we did not extend it further. ■