Quarterly Fund Commentary
WRA Government Securities Fund
June 30, 2016
Rick Perry, CFA
Market Sector Update
- The financial markets were taken by surprise with the United Kingdom’s (U.K) referendum to leave the European Union (EU), or “Brexit”. The Brexit surprise led to significant volatility the last week of the quarter in all global financial markets. In the U.S. fixed income market, Treasuries rallied significantly and credit spreads widened. The immediate reaction was considerable, but perhaps more significant was the uncertainty created for future events as the U.K. prepares for the process of leaving the EU.
- The U.S. Treasury yield curve shifted downward and flattened considerably during the quarter. Global fund flows were directed at U.S. Treasuries, and were magnified due to lower rates elsewhere in the developed world (Europe, Japan). The expectations of the Federal Reserve (Fed) raising short-term interest rates in the U.S. changed materially during the quarter, due to slowing economic growth as well as Brexit late in the quarter.
- The benchmark 10-year Treasury ended 2Q at 1.47% vs. 1.77% at the beginning of 1Q. The relationship between 2-year and 10-year ended 2Q at 89 basis points (bps) vs 105bps at the end of 1Q. A flattening yield curve has often been a good indicator of future slowing economic growth and/or future recession.
- The combination of negative interest rates in much of Europe and Japan, coupled with less than robust economic growth in the U.S., seems to indicate that Treasury rates may not be raised soon. The Fed also made it clear during 2Q that they would employ a measured pace for interest rate increases. Therefore, the Fund maintained its long duration position relative to the benchmark throughout the quarter. This positioning was beneficial to performance during the quarter, as rates declined across the yield curve.
- In addition, the Fund continued to position to benefit from further yield curve flattening. The yield curve did in fact continue to flatten during the quarter, which also benefited relative performance.
- Asset allocation was fairly constant throughout the quarter. There was a slight increase in the weight-to-Treasury allocation during the quarter. All of the securities in the Fund are AAA-rated. Relative to the benchmark, the biggest overweight asset class was collateralized mortgage obligations and biggest underweight was mortgage-backed securities.
- The Fed is expected to increase shortterm interest rates gradually in 2016, but all increases will be data dependent throughout the year. The Fed’s stance will most likely result in one or two rate hikes during the year. Should the Fed execute on their stated gradual pace for rate hikes, the yield curve is expected to continue to flatten throughout the year and not be particularly disruptive. However, a significant risk does exist that the Fed will act in a way inconsistent with market expectations, which would likely lead to market turbulence.
- Negative interest rates outside of the U.S. are having a profound impact on both the U.S. Treasury and credit markets. Investors across the globe are in a constant search for yield, which makes the U.S. look attractive vs most of the rest of the world. The positive fund flows into the U.S. in 2Q are expected to continue. Longer term, the divergent central bank policies by the Fed and most of the rest of the world is problematic.
- Making significant duration bets does not seem like an attractive risk-reward proposition in coming months. The Fund’s overall asset allocation is not expected to change significantly in the coming quarter unless credit quality metrics or Fed policies change materially in the nearterm.
The opinions expressed in this commentary are those of the Fund's managers and are current through June 30, 2015. The managers' views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.. Past performance is not a guarantee of future results.
Risk factors. As with any fund, the value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rate rise. These and other risks are more fully described in the Fund's prospectus.
Waddell & Reed Investments refers to the investment management services offered by Waddell & Reed Investment Management Company, the investment manager of the Waddell & Reed Advisors Funds, distributed by Waddell & Reed, Inc.