4th Quarter 2013
On December 18, 2013, the Federal Reserve announced that beginning in January it would reduce the pace of quantitative easing (QE) asset purchases by $10 billion, to $75 billion per month. The reduction will be evenly split between both US Treasuries and agency mortgage-backed securities. Offsetting this announcement, was a lowering in its forward guidance for the Fed funds rates to a median expectation of 0.75% through the end of 2015, compared to the previous forecast of 1.0%. In addition, the Fed clarified earlier guidance that a 6.5% unemployment rate may trigger a change in monetary policy as a “soft” threshold. The Fed expects a target range for Fed funds below 0.25% would be, “… appropriate well past the time that the unemployment rate falls below 6.5% should inflation expectations remain below 2.5%.” In our view, the Fed’s decision to taper its purchases does not equate to a change in monetary policy.
Indeed, by extending and lowering its forward guidance the Fed is changing its mix of tools, but maintaining its highly accommodative stance toward monetary policy. With expectations through later 2015 for the funds rate being lower, it will be interesting to see if the Fed also lowers its stance on what constitutes a normal (or “longer run”) expectation for a “neutral” Fed funds. We do not anticipate large changes in economic output from this change, nor do we foresee a significant adverse reaction from financial markets. Compared to the broad re-pricing that occurred during the second and third quarters of 2013, the change in interest rates following the announcement was modest, with the U.S. yield curve flattening and credit spreads narrowing. As a whole, we believe this reaction suggests the market anticipated the Fed’s decision to taper, and eventually exit, its asset purchase positively.
The Fund outperformed its Barclays U.S. Aggregate Bond Index benchmark during the quarter and the full year. This was only the third year since 1976 in which the Barclays Aggregate recorded a negative annual total return (1994 and 1999, being the others). US Treasuries declined during the year as the yield on the 10-year US Treasury ended 2013 at 3.03%, up from only 1.76% at the beginning of the year. In this environment, intermediate-term Treasuries benefited from a shorter duration (a measure of sensitivity to moves in interest rates) profile and significantly outperformed long-term Treasuries. Indeed, long-term Treasuries lost more than 12% overall. The US Treasury yield curve, as measured by the difference between the two- and 30-year maturities, increased during the year, ending at its steepest year-end level since 2010.
The Fund benefitted from sizeable stakes in mortgage-backed securities (MBS) and Corporate bonds, both of which outperformed duration-matched Treasuries. MBS did well as mortgage originations (supply) did not keep pace with the level of purchases made by both investors and the Fed (demand). Intermediate-term Corporates outperformed long-term credits on an absolute basis, but the decline in long spreads exceeded that of intermediate spreads, giving long credits an edge in terms of excess return. Financials were the best performing credit subsector during 2013, on both an absolute and duration-adjusted basis. BBB-rated securities were the best performing quality bucket, outperforming AAA-, AA-, and A-rated securities as investors continued to add to lower-quality spread sectors, which have historically outperformed in a rising interest rate environment.
Given the reemphasis on the Fed’s most traditional policy tool—the Fed funds rate—we anticipate the front-end through the “belly” of the U.S. yield curve will remain steep over the intermediate timeframe. Comparing the flattening yield curve observed after the Fed’s announcement to the shape of the yield curve indicated by the futures market, however, the potential for further flattening of the longer-dated portion of the yield curve is possible, particularly if the Fed’s exit strategy gains credibility.
In this environment, we continue to view the best opportunities as those which are positioned in areas of the yield curve that appear too steep or are being valued too cheaply given our expectations for a modest reaction to tapering. Given the compression in yield spreads through the riskier corridors of fixed income, however, we continue to view investment grade securities as more reasonably valued, and moreover, valued with a better risk/return tradeoff should our expectations change. As we enter 2014, we continue to structure the portfolio along the lines of yield curve expectations and scenarios, rather than targeting specific levels of interest rates. While it may be difficult to foresee a broad decline in interest rates as the Fed changes the recipe, we do not foresee a marked increase across the yield curve.
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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