3rd Quarter 2012
On September 13, 2012, the Federal Reserve announced a third round of quantitative easing (QE3) and extended the period for the low level of the Federal Funds Target Rate to at least mid-2015. These new measures are independent of the ongoing maturity extension program (“Operation Twist”). While Operation Twist is a balance sheet neutral program that matches the purchase of longer-term US Treasuries with the sales of shorter-term securities in an equal amount, QE3 will expand the Federal Reserve’s $2.8 trillion balance sheet. Under the new program, the Fed will purchase up to $40 billion a month of U.S. agency mortgage-backed securities (MBS). Unlike the two previous quantitative easing programs, however, neither a total amount nor a conclusion date for these purchases was specified.
Although the link between the mortgage-backed securities and labor markets has not been significant historically, the Fed has chosen to purchase these securities exclusively in its effort to boost the labor market. In our view, the amortizing nature of mortgage-backed securities is valuable to the Federal Reserve in managing and allocating its balance sheet. For instance, while US Treasuries are not being purchased under QE3, the future reinvestment of principal and interest payments could be diverted to Treasuries should the Fed elect to continue Operation Twist beyond 2012. Given our scenario analysis for the U.S. labor market, we anticipate the Fed’s balance sheet could continue to expand.
The Fund substantially outperformed its Barclays US Aggregate Bond Index benchmark during the quarter, aided by sector, quality, and yield-curve positioning. An overweight position in credit securities that outperformed duration matched Treasuries by a sizeable margin was a primary contributor, as was an underweight in Treasuries—the worst performing sector of the market. Moreover, much of the Fund’s Treasury exposure was in the form of TIPS (Treasury Inflation-Protected Securities), which benefitted from increasing inflation expectations from the Fed’s continued monetary easing. In addition, an overweight stake to lower-quality investment-grade securities boosted returns, especially within the credit arena, as BBB- and A-rated bonds significantly outperformed AA- and AAA-rated securities on a duration-adjusted basis.
The portfolio’s positioning on the yield curve also had a positive effect on relative returns. We employed a barbell structure emphasizing high-quality floating rate notes on the short end of the curve and lower-quality investment-grade securities on the long end. This worked out well as longer duration (a measure of interest-rate sensitivity) credit securities outperformed as spread curves flattened.
Against the backdrop of our expectations for monetary policy, we believe US Treasuries will overcome negative sentiment towards monetary policy and maintain their safe haven status. Although increased expectations for inflation steepened the yield curve during the third quarter in a flight-to-quality environment, we think the US Treasury curve may ultimately flatten. With the unemployment portion of the Fed’s dual mandate garnering the most attention, it is possible that the central bank will allow inflation to rise over the near term. Inflation has historically preceded declines in unemployment. Thus, we continue to view TIPS are an attractive asset class. Mortgage-backed securities may see further tightening given the lack of new production relative to demand from both investors and the Federal Reserve. The risk/return profile for these securities could become asymmetric, however, should the spread relative to Treasuries narrows to the point that investors are overexposed to increases in the rate of prepayments. Credit spreads tightened following the announcement of QE3, and we anticipate this trend will continue in the face of unprecedented liquidity.
Given these expectations, we continue to favor a barbell portfolio structure in order to capture the steepness of the US Treasury curve and will continue to utilize our relative value process to identify sector and security selection opportunities.
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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