Fixed Income Funds Commentary
How did the market’s fixed income sectors perform?
Second-quarter gross domestic product1 (GDP) grew at a 2.0% annual pace, and a similar number is forecast for the third quarter. The Federal Reserve Board (the Fed) cut interest rates twice during the quarter, bringing the federal funds target rate to a 1.75% - 2.00% range. The market is currently pricing in at least one more cut before year-end. Despite the Fed’s easing, the U.S. dollar remained strong during the quarter and likely contributed to the weakness in commodities. However, oil prices did spike briefly after the attack on a Saudi oil field. Wage growth continued to soften, although employment remained firm. These declining inflation inputs helped the 10-year break even inflation rate fall 28 basis points (0.28%) in the quarter to close to its lowest level since 2016.
Rate cuts, slow economic growth, and falling inflation made for a very friendly environment for the fixed income market, which continued its remarkable year in the third quarter. The Bloomberg Barclays U.S. Aggregate Bond Index1 was up 2.27% in the quarter, bringing its year-to-date return to 8.52%. The corporate bond sector was once again the biggest winner, with the corporate1 portion of the index up 3.05% for the quarter (gaining 13.20% for the year-to-date).
Treasuries also had a strong quarter as rates fell across the yield curve, particularly at the long end. The 2-year Treasury declined 13 basis points (0.13%), compared with a 34 basis point (0.34%) fall in the 10-year yield. The Treasury portion of the index rose 2.40%, with the 20-plus year subcomponent up 8.15% during the quarter. The commercial mortgage-backed securities1 (CMBS) portion of the index lagged the overall index, returning 1.89%. Agency MBS1 continued their underperformance as interest rate volatility remained high. The MBS portion of the index was up 1.37%. Lacking much duration or credit risk, the asset-backed securities (ABS) portion of the index was again the laggard, returning just 0.92%.
What were your primary investment strategies during the quarter?
We were modestly long duration versus our benchmark in the Limited Duration Fund, very short duration versus our benchmark in the Moderate Duration Fund, and modestly short duration versus our benchmark in the Bond Fund. We maintained the higher-quality bias versus the benchmark in all three funds as we continued to underweight Baa-rated securities.‡ We also remained underweighted in the corporate sector by a significant margin. Treasury yields fell substantially in the third quarter, so our shorter duration positions in the Bond and Moderate Duration Funds were headwinds, and the longer duration position in the Limited Duration Fund was a modest tailwind. The underweight to corporates, particularly Baa-rated, detracted significantly from performance in the third quarter as corporates continued their strength, again led by Baa-rated securities.‡
How did your strategies influence performance?
The Bond Fund underperformed the Bloomberg Barclays U.S. Aggregate Index by 17 basis points (0.17%) in the third quarter, Moderate Duration trailed the Bloomberg Barclays U.S. Intermediate Aggregate Index by 47 basis points (0.47%), and Limited Duration outperformed the ICE BofA Merrill Lynch 1-5 Year U.S. Corporate/ Government Index by 6 basis points (0.06%). The short duration position versus the benchmark was costly for the Moderate Duration Fund. The small short duration position versus its benchmark was a modest headwind for the Bond Fund, and the slight long duration position in the Limited Duration Fund helped marginally. The underweight to the corporate sector, particularly to Baa-rated securities, again detracted from the performance of all three funds in the third quarter.**
How do you expect to position your funds in the coming months?
Fixed income prices are at or near their highest levels in history. Because yields are the inverse of prices, the expected returns for fixed income are at or near their lowest levels in history. Given these valuations, it makes sense to exercise caution. The corporate bond market looks complacent, as it has thus far ignored what we believe to be a significant slowdown in economic growth expectations. The large underperformance of agency MBS so far this year, particularly relative to the returns in the corporate market, may provide a decent opportunity to move up in credit quality without giving up much yield. Outside of government-guaranteed bonds, we will continue to focus on securities that we believe can withstand significant slowdown scenarios.
Past performance does not guarantee future results. The performance data quoted represents past performance and current returns may be lower or higher. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. To obtain performance information current to the most recent month end, call 800-762-7085 or visit us at www.cavanalhillfunds.com.
Gross Domestic Product (GDP) measures the market value of the goods and services produced by labor and property within the respective country/economic region. Bloomberg Barclays U.S. Aggregate Bond Index measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgagebacked, agency, and non-agency securities. Bloomberg Barclays U.S. Intermediate Aggregate Bond Index represents securities in the intermediate maturity range from one year up to (but not including) 10 years. The securities in the index are SEC registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. ICE BofA Merrill Lynch 1-5 Year U.S. Corporate/Government Bond Index measures the performance of investment-grade government and corporate debt securities with maturities between one- and five-years. Bloomberg Barclays U.S. Corporate Investment-Grade Index covers all publicly issued U.S. corporate, non-corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements, to qualify, bonds must be SEC-registered. Bloomberg Barclays U.S. Mortgage-Backed Securities Index tracks agency mortgage backed pass-through securities, both fixed-rate and hybrid ARM, guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). These indexes are unmanaged and do not reflect the fees and expenses associated with a mutual fund. An investor cannot invest directly in an index.
An investor should consider a fund’s investment objectives, risk and charges and expenses carefully before investing or sending money. This and other important information about an investment company can be found in the fund’s prospectus. To obtain a Cavanal Hill Funds prospectus or summary prospectus, please call 800- 762-7085 or visit us at www.cavanalhillfunds.com. Please read it carefully before investing.
MUTUAL FUNDS AND OTHER INVESTMENTS: NOT FDIC INSURED • MAY LOSE VALUE • NO BANK GUARANTEE