Strategic Enhanced Yield Fund Commentary
How did the market’s fixed income sectors perform?
Second-quarter gross domestic product1 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 breakeven 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 MBS 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 securities1 (ABS) portion of the index was again the laggard, returning just 0.92%.
What were your primary investment strategies during the quarter?
The Fund began the quarter with a modestly long duration position versus the Bloomberg Barclays U.S. Aggregate Bond Index, but as rates fell precipitously during the quarter, we reduced some longer positions and ended the quarter with a small underweight to duration versus the index.**
The Fund continues to have a heavy weighting to nonagency mortgage-backed securities and asset-backed securities. Within the securitized sector, we continue to focus on very seasoned, pre-crisis securities, though we have added significant exposure to newer issues.**
We have a large underweight to the corporate sector, but the corporates we do own in the Fund are long duration, which helped offset some of the headwinds from our sector underweight as corporate bonds posted another strong quarter. However, overall, the underweight was a large headwind for the Fund.**
We also maintained a high-quality bias in the third quarter. We do own junk bonds, but within that category we stayed at the high end of the spectrum. U.S. high-yield bonds underperformed in the third quarter, so any allocation to that asset class was a marginal headwind.**
How did your strategies influence performance?
The Fund outperformed its index by 21 basis points (0.21%) in the third quarter. The outperformance was primarily driven by the longer-than-benchmark duration position through most of the quarter, and was helped out by large spread tightening in the few corporate positions in the Fund.**
How do you expect to position your Fund 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.**
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 covers the USD-denominated, investment-grade, fixed rate, taxable bond market of SEC-registered securities. 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. 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. 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. These indexes are unmanaged and does not reflect the fees and expenses associated with a mutual fund. An investor cannot invest directly in an index.
MUTUAL FUNDS AND OTHER INVESTMENTS: NOT FDIC INSURED • MAY LOSE VALUE • NO BANK GUARANTEE