2nd Quarter 2013 Commentary - ASTON/TCH Fixed Income Fund
2nd Quarter Commentary
Volatility increased significantly throughout financial markets during the last six weeks of the second quarter as investors sought to adjust to the timing, scope, and scale of a potential change in the Federal Reserve’s purchases of US Treasury bonds and agency mortgage-backed securities. Although the debate over the efficacy of such policies will undoubtedly continue, there is no question that valuations for most asset classes have benefited greatly from the liquidity provided by the Fed.
Worst Quarter in 9 Years
The Fund’s Barclays Capital U.S. Aggregate Bond Index benchmark declined 2.32% during the second quarter, its worst performance in nine years. Negative returns across all fixed-income sectors were driven by concerns that the Fed would begin pulling back or “tapering” its bond purchases this year. June was by far the worst month of the quarter in driving much of negative performance. U.S. Treasury bonds dropped nearly 2% for the quarter and more than 1% for the month of June, with long-term Treasuries (-5.58% for the quarter, -3.17% for the month) dramatically underperforming intermediate-term Treasuries (-1.42% quarter, -0.82% month) as the yield curve steepened. The yield of the 10-year Treasury bond ended the quarter having spiked more than 90 basis points above its May 1 low. Mortgage-backed securities (MBS) underperformed duration-matched Treasuries amid concerns over rising rates and potentially slowing Fed purchases.
The Fund underperformed the benchmark as an overweight stake in Corporate bonds fared even worse than Treasuries. Credit securities dropped 3.44% in aggregate during the quarter, and 2.85% for the month of June. Long-term credit underperformed intermediate credit on a duration-adjusted basis. AAA-rated investment grade securities were the best performing group from a quality perspective, followed by A-rated bonds. Both AA-rated and BBB-rated bonds lagged by sharper margins. On a sector level, Industrials were the best performing credit subsector on a duration-adjusted basis, outperforming Financials and Utilities.
Outlook & Positioning
Whereas the Fed may see diminishing returns on furthering their purchases under quantitative easing, there remains sufficient slack in the U.S. economy to warrant an exceptionally low Fed Funds target rate. According to a statement released by the Federal Reserve on June 19, 2013, it sees the downside risks to its economic outlook as having diminished but noted that fiscal policy is restraining economic growth and inflation will run at or below its long run average of 2%. Consistent with their message that overall economic activity must demonstrate significant and sustainable improvement, the Fed elected to continue purchasing $85 billion a month of U.S. Treasuries and agency mortgage-backed securities.
Given our view that the Federal Funds rate and short-term Treasury rates will remain low for an extended period, the increase in volatility and interest rates present an opportunity to add duration (a measure of interest-rate sensitivity) at higher yields. The cost of financing a 30-year home has increased nearly 50% from an all-time low, which may indicate prepayment rates have peaked. Given this re-pricing, certain areas within U.S. agency MBS have become relatively attractive. Following the underperformance of U.S. investment grade Corporate bonds relative to Treasuries, credit yields have increased to levels not seen in several years and appear attractively valued across much of the term structure.
Although valuations in high-yield, global credit, and Emerging Markets have corrected, they remain stretched in our view. After adjusting for the differences in liquidity and volatility, U.S. investment grade valuations appear more compelling to us.
Taplin, Canida & Habacht (TCH)
Note: Bond funds are subject to interest rate and credit risk similar to individual bonds. As interest rates rise or credit quality suffers, an investor is susceptible to loss of principal.
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