2nd Quarter 2014
The Fund outperformed its Barclays US Aggregate Bond Index benchmark during the quarter, driven again by an overweight position in Corporate bonds. Credit securities were the best performing fixed income sector on an absolute basis, gaining 2.71% during the period. Corporates outperformed duration-matched as yield spreads tightened. In conjunction with the shift in the yield curve, longer maturity credits outperformed intermediate credits on both an absolute and duration-adjusted basis. Utilities were the best performing credit subsector, benefitting from a longer duration (sensitivity to changes in interest rates) profile. Lower-quality investment-grade securities outperformed during the quarter as investors continue to seek additional yield within fixed income. BBB-rated securities outperformed A-, AA-, and AAA- rated bonds by 83, 93 and 114 basis points, respectively.
US Treasuries delivered only half the gain of Corporates overall as Treasury yields shifted in a bull flattening fashion during the quarter. In this environment, long-term Treasuries outperformed intermediate Treasuries. Despite the Federal Reserve tapering of its quantitative easing program, US Treasuries benefitted from slower than anticipated economic expansion, global geopolitical uncertainty, and a relative yield spread advantage to other developed nations. For example, the yield on 10-year US Treasuries now exceeds the 10-year German Bund yield by 129 basis points, the largest differential since May 1999.
Mortgage-backed securities (MBS) returned 2.41% during the quarter, outperforming duration matched Treasuries as the option adjusted spread (OAS) of the Barclays U.S. Mortgage Index tightened. Mortgages continued to benefit from the low volatility environment as well as supply and demand imbalances within the sector despite Federal Reserve tapering.
First quarter 2014 Gross Domestic Product (GDP) was revised downward to a -2.9% annual rate from a previously reported -1.0%, its worst reading since 2009. We continue to expect improving economic conditions during the second half of the year, however. A strengthening labor market, higher home values and stock prices, as well as contained inflation data are positive factors. The June gain of 288,000 in non-farm payrolls has pushed U.S. payrolls past their pre-recession high of 138.4 million (Jan. 2008) while the unemployment rate fell to 6.1%. On the other hand, in response to weakening economic conditions and concerns about deflation, the European Central Bank (ECB) eased monetary policy in June, becoming the first major central bank to move deposit rates to a negative rate.
In contrast, as expected, the Fed continued its tapering program, reducing its direct monthly purchases of assets from $45 billion to $35 billion. The reduction again was split between Treasuries and agency mortgages, reducing each by $5 billion per month to $20 billion and $15 billion respectively. The effects of tapering have been somewhat mitigated by the improving deficits in the U.S. Fiscal year to date through May, the U.S. government ran a $436.4 billion deficit, which is significantly improved over the $626.3 billion deficit over the same time frame last year. The deficit for the full fiscal year is expected to be the lowest in six years and nearly a third of the shortfall in the 2009 fiscal year. The improved figures derive from both increased revenue and decreased expenditures. In our opinion, signs of fiscal discipline have helped to contain potential increases in yields in the Treasury market. Combined with an accommodative Federal Reserve, favorable supply/demand dynamics within fixed income, weakening economies abroad, and geopolitical tensions rising, we see a low probability of a significant increase in yields heading into the second half of 2014.
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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