2nd Quarter 2012 Commentary - ASTON/TCH Fixed Income Fund
2nd Quarter 2012
The Fund slightly underperformed its Barclays Capital Aggregate Bond Index benchmark during the second quarter. Favorable yield curve selection was offset somewhat by sector and quality exposures. The portfolio is structured in a barbell fashion, emphasizing lower-quality investment grade credit securities on the long end of the yield curve and high-quality floating rate notes and asset-backed securities on the front end.
Longer dated securities outperformed during the quarter as the yield curve shifted in a bull flattening fashion. Long-term US Treasuries outperformed intermediate Treasuries by a wide margin as investors sought the safety of US Government-backed securities following declining global economic fundamentals and continued concerns over the European sovereign debt crisis. In conjunction with the flight to quality, the portfolio’s overweight position in Corporate credit securities underperformed. Credit underperformed duration-matched Treasuries, while AAA-rated bonds outperformed lower-rated AA, A, and BBB securities detracted from relative returns as well.
Following the conclusion of its June meeting, the Federal Open Market Committee announced it will continue its maturity extension program, Operation Twist, through the end of the year. Under the program, the Fed will purchase Treasury securities with remaining maturities of six years to 30 years and sell or redeem an equal amount of Treasury securities with remaining maturities of approximately three years or less. Although this action will expand the program by $270 billion, by offsetting the purchases of longer Treasuries with sales of an equal amount in shorter term securities the size of the Fed’s balance sheet remains the same.
There are several implications for the extension of Operation Twist—most notably that exiting the program would have implied a more restrictive monetary policy in contrast with the Fed’s dovish tone. The Committee lowered its 2012 estimate for economic growth and expressed concerns about slowing employment growth. In addition, Chairman Bernanke noted that the extension of Operation Twist does not restrict the Central Bank from another round of quantitative easing.
The extension of Operation Twist also signals, in our view, that the Fed is targeting a flatter US Treasury yield curve. Although US Treasury rates remain near record lows, investors can take advantage of a historically steep yield curve and earn a substantial increase in both nominal and real yields by extending maturities. By reducing the yield advantage offered by longer maturity Treasuries, the central bank is increasing the likelihood that investors will accept more risk to earn additional return.
It is important to note that another round of quantitative easing would increase the size of the Fed’s balance sheet, and therefore would only occur if a period of negative growth appears likely. Given the weakness of recent data, the probability of such a program has increased, as fiscal policy alone (the vaunted “Fiscal Cliff”) threatens to remove between 3% and 5% from Gross Domestic Product (GDP). We think such a program would likely target mortgage-backed securities where option-adjusted spreads have widened. In addition, the amortization of mortgage-backed securities would allow the Fed to gradually reduce the size of its balance sheet by no longer reinvesting principal payments.
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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