Quarterly Fund Commentary
Rick Perry, CFA
Market Sector Update
- The U.S. Treasury market was fairly volatile in the quarter, based on uncertainty about whether the U.S. Federal Reserve (Fed) would raise rates. The Fed did raise short-term rates in December. The yield curve shifted higher and flattened slightly during the quarter and the spread between the two-year and 10-year Treasuries tightened 19 basis points (bps). The 10-year Treasury ended the year yielding 2.27%, up 23 bps from the third quarter.
- Credit spreads also were volatile, led by extreme weakness in the commodity-based sectors. The high-yield credit market began having weakness in mid-third quarter, but rallied early in the fourth. However, the commodity-fueled weakness returned. Credit spreads ended the year at 155 bps, slightly tighter than the third quarter but wider than end-2014.
- The macro-economic backdrop remained generally supportive of corporate credit. Steady, slow economic growth is in many ways the sweet spot for the credit markets. However, financial market activities weren't supportive. New issuance of corporate debt was again heavy and 2015 marked the fourth consecutive year of record new issuance in corporate credit, as leverage on balance sheets continued to increase. The proceeds from the massive issuance often were used for shareholder-friendly activities, such as mergers and acquisitions, share buy backs and dividends.
- The Fund kept its slightly short duration posture relative to the benchmark throughout the quarter. The belief that interest rates would move marginally higher as the Fed rate hikes approached played out during the quarter. In addition, the Fund was positioned to benefit from a yield curve flattening. However, taking major positions based on duration and the shape of the yield curve didn’t seem prudent during the quarter. The overall duration of the Fund didn’t change significantly.
- Overall asset allocation did not change materially in the quarter. We did change allocation within Credit slightly, adding exposure to financials and reducing exposure to industrials. Financials, particularly the banking sector, have become more defensive because of regulations enacted after the 2008 financial crisis. The Fund did extend duration in a few selected names in order to increase portfolio yield and reduce exposure to rising short-term rates.
- Credit quality also did not materially change in the quarter. Exposure to short-duration Treasuries was slightly reduced and reinvested in securitized assets. Mortgage-backed securities (MBS) and commercial mortgagebacked securities (CMBS), which have minimal extension risk, were added during the quarter.
- The Fed is expected to increase shortterm rates gradually in 2016, likely in two to three rate hikes, depending on economic data. If the Fed executes on its stated gradual pace, we think the yield curve will continue to flatten throughout the year and not be particularly disruptive. However, there is a significant risk that the Fed will act in a way inconsistent with market expectations, which would likely lead to market turbulence.
- We believe the market is in the late innings of the credit cycle. As a result, we think conservative positioning within the credit market is prudent going forward. Commodity-based sectors and names are likely to remain under pressure in 2016. In addition, secondary market liquidity is expected to remain challenging in 2016. We think spread volatility and dispersion will be elevated, creating exaggerated market moves as well opportunities for excess returns.
- The timing of interest rate movements in the near term is expected to remain very difficult as the Fed unwinds its zero interest rate policy. Therefore, we do not think it prudent to take significant duration bets in early 2016. We believe the Fund’s expected asset allocation will selectively reduce credit exposure and increase exposure to securitized assets, specifically shorter duration MBS and CMBS.
The opinions expressed in this commentary are those of the portfolio manager and are current through Dec. 31, 2015. The manager's views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results.
Risk factors. As with any fund, the value of the Portfolio's shares will change, and you could lose money on your investment. An investment in the Portfolio 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 Portfolio may fall as interest rate rise. These and other risks are more fully described in the Portfolio's prospectus.
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