Fixed Income Funds Commentary
This commentary addresses the Cavanal Hill Bond Fund, Moderate Duration Fund (formerly named the Intermediate Bond Fund), and Limited Duration Fund (formerly named the Short-Term Income Fund):
How did the market’s fixed income sectors perform?
Third-quarter gross domestic product1 grew at a 2.1% annual pace, and a similar number is forecast for the fourth quarter. U.S. employment growth has remained resilient despite a historically low unemployment rate. The U.S. dollar weakened in the fourth quarter, wiping out most of its year-to-date gains. This weakness helped support commodity prices. Oil prices in particular were strong during the quarter and elevated tensions in the Middle East seem to have, at least temporarily, raised the floor for oil prices. The weaker dollar and higher commodity prices led to rising inflation expectations, as the 10-year Treasury inflation-protected securities breakeven inflation rate rose 27 basis points (0.27%) during the quarter. The year-over-year core Consumer Price Index1 rose 2.3% in December, remaining near the top end of its 10-year range.
The Federal Reserve Board (the Fed) monetary policy seemed to have had the largest influence over capital markets in the fourth quarter. The Fed cut the federal funds rate 25 basis points (0.25%) in October, bringing the target range to 1.50%–1.75%. More importantly, the central bank signaled its desire to remain on the sidelines absent a significant rise in inflation and has started to expand its balance sheet. This expansionary monetary policy was largely responsible for the sharp fourth-quarter rally in risk assets.
Opportunities in fixed income remain very limited. Treasury yields are still near their all-time lowest levels and credit spreads are close to their all-time tightest levels. This combination makes it challenging for fixed income investors to find risk-adjusted yield. However, callable agencies, taxable municipals, and the top tranches of some non-agency securitized products all offer attractive relative yields.
The corporate sector’s strong performance continued in the fourth quarter. Although the Bloomberg Barclays U.S. Aggregate Index1 returned only 0.18% in the fourth quarter, corporate1 bonds fared better, returning 1.18%, capping off an outstanding year up 14.54%. Bonds at the bottom end of the investment-grade spectrum were the biggest winners, as the Baa-rated portion1 of the index returned 1.69%, finishing the year up 16.46%.
The Treasury1 portion of the index lagged, returning -0.79%. On the long end of the curve, the Treasury 20+1 year portion of the index fell 4.24% in the quarter, though it still gained 15.11% for the year. However, after underperforming all year, the MBS1 portion of the index rallied in the final quarter, up 0.71%. High-yield corporates1 also had a strong quarter, with the Bloomberg Barclays U.S. Corporate High Yield Index1 up 2.61%, gaining 14.32% for the year.
What were your primary investment strategies during the quarter and how did they influence performance?
Our tactics didn’t change materially in the fourth quarter. In the Limited Duration Fund, we maintained a longer duration than the benchmark while we remained shorter than the benchmark in both the Bond Fund and Moderate Duration Fund.
Rates moved higher in the fourth quarter, but the moves were more pronounced on the long end of the curve. As a result, the duration positioning in both the Limited Duration and Moderate Duration were not very impactful. The Bond Fund’s shorter duration was a nice tailwind in the fourth quarter as long rates rose.**
We remained underweight the corporate sector across all three funds, and we were further underweight the Baa-rated portion of the corporate sector. This positioning fully explains the modest underperformance of all the funds in the fourth quarter. After posting very solid returns all year, the fixed income market paused in the final quarter, with the notable exception of corporate bonds, particularly Baa-rated corporate bonds. Despite higher Treasury rates, the Baa-rated portion of the Aggregate returned 1.69% in the fourth quarter. Moreover, because returns were difficult to generate during the quarter, missing out on any of the returns of Baa-rated bonds made outperformance difficult.**
We were overweight the securitized sector in all three funds, which was a tailwind as this sector reacted positively to the rise in Treasury rates and we played some catch up after underperforming all year. We also had sizable positions in taxable municipals in both the Moderate Duration and Bond Funds. We use these bonds as corporate substitutes and they performed well during the fourth quarter.
All three funds posted a small underperformance during the fourth quarter. The Limited Duration Fund underperformed by 14 basis points (0.14%), Moderate Duration trailed by 17 basis points (0.17%), and the Bond Fund lagged by 30 basis points (0.30%). This underperformance was almost solely caused by underweights to the Baa-rated portion of the corporate sector.**
How do you expect to position your funds in the coming months?
With expected returns in fixed income at or near their lowest levels in history, we believe it makes a lot of sense to maintain our conservative stance. Absent some significant spread widening, we will not get more aggressive in this market.
The flip side of very expensive risk assets is that the relative value of safe assets is currently elevated. We are able to find yields in taxable municipals that are as good as or better than the corporate market and the taxable munis typically carry higher credit ratings. Similarly, many callable agencies have yields that are competitive with the corporate market and have minimal credit risk. We also still like the top tranches on some products in the securitized sector. Because they have high levels of credit enhancement, we believe they should be able to withstand a negative economic outcome.**
With the Fed firmly on hold, interest rates at the short end of the curve are unlikely to move much higher, so we see little risk in holding our higher duration position in the Limited Duration Fund. Nevertheless if we do see higher levels of inflation, it is likely that yields at the longer end will rise, so we are likely to maintain our underweight to duration in both the Moderate and Bond Funds.**
Past performance is no guarantee of future results.
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, mortgage-backed, agency, and non-agency securities. Bloomberg Barclays U.S. Corporate Baa- and Ba-Rated Bond Indexes are sub-indexes of the broad corporate investment-grade bond index, broken down by credit rating. Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. 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. 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. Bloomberg Barclays U.S. Treasury 20+ Year Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with 20+ years to maturity. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. 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).Bloomberg Barclays U.S. Treasury Index measures the performance of the public obligations of the U.S. Treasury with a remaining maturity of one year or more are nonconvertible and are denominated in U.S. dollars. Securities must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody’s, S&P, and Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. Consumer Price Index is a measure that examines the weighted average of prices of a fixed basket of consumer goods and services (such as food, transportation, shelter, utilities, and medical care), and is widely used as a cost-of-living benchmark. Gross Domestic Product (GDP) measures the market value of the goods and services produced by labor and property within the respective country/economic region. ICE BofA Merrill Lynch 1-5 Year U.S. Corporate/Government Bond Index measures the performance of investmentgrade government and corporate debt securities with maturities between one- and five-years. 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.
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