As of 09-30-2017

Market Overview

Looking back at the third quarter in totality, not much changed from the end of the second quarter. For example, the yield on the 10-year U.S. Treasury bond began the quarter at 2.30% and ended the quarter at 2.33 %. However, over the course of the three-month period, there was a fair amount of volatility, with the aforementioned 10-year yield trading to a low of 2.03% at the beginning of September before reversing back up to 2.33% at month’s end. Three factors contributed to the volatility: continued improvement in the global economy, fiscal policy and geopolitical tensions.

Trends in the domestic economy have continue to improve at a moderate but arguably accelerated pace. The revised read on second quarter gross domestic product (GDP) growth was 3.3%, beating earlier expectations of 2.7%. Job growth also expanded, bringing the unemployment rate down to 4.4%. While the U.S. economy has been slowly trending higher over the past several years, the big change for 2017 is that every major economy globally is now expanding, which has not been the case for much of the post-2008 period. In particular, eurozone economic growth has surprised to the upside in 2017, along with continued growth in the Asian and Latin American economies. Yet despite the uptick in growth and full employment in the U.S., there still has not been a material increase in inflation.

This absence of inflation had led the market to assign low odds that the Federal Reserve (Fed) would hike the fed funds target rate again in 2017, until policymakers in September somewhat surprisingly forecast one more increase this year and three more in 2018. The fixed income and currency markets reacted by raising Treasury yields and reversing dollar weakness in the quarter’s final month. On the fiscal policy front, prospects for business tax reform continued to gain momentum, while ongoing regulatory changes signaled a friendlier business environment going forward. These factors continue to provide a supportive backdrop for credit and equity markets globally.

In the domestic high-yield market, the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Bond Index (BBC2%HYBI) returned 1.98% during the quarter, abetted by the low rate/low growth economy and very low corporate default levels. Tightening spreads further reflected rising economic optimism, with yields between the Credit Suisse High Yield Bond Index and comparable maturity Treasury securities narrowing from 428 to 402 basis points during the quarter.

Within the high-yield market, the strongest performing major industries relative to the BBC2%HYBI were oil field services, transportation services, independent energy, pharmaceuticals and metals. The worst performing major industries relative to the index were wireline telecommunications, health care, leisure, retail and consumer products. From a quality perspective, the credit sensitive CCC-rated sector led the way with a 2.50% total return. The higher quality BB-rated sector followed with a 2.01% total return, while the B-rated sector returned a respectable 1.75%.

Emerging markets (EM) also performed well during the third quarter, posting positive returns on stable oil, a still-robust Chin, and continued political improvement in Latin America sentiment. Furthermore, fears of an aggressive Nafta reformulation abated. Support for EM debt was bolstered as the U.S. dollar weakened against most currencies during much of the third quarter before its last rally.

For the quarter, the Bloomberg Barclay’s EM USD Aggregate Index returned 2.27%. The Latin American sector continued to outperform as it has much of the year, led by Brazil returning 5.15% and Argentina up 5.14%. Venezuela was a notable exception as bonds sold off on an increasing probability that the country ultimately defaults on its debt. Within the international sector, sub-investment-grade bonds returned 2.76 %, outperforming investment-grade bonds, which returned 1.93%.

In the U.S., investment-grade corporates performed very well, with the Bloomberg Barclays U.S. Corporate Investment Grade Index returning 1.35%. Within the sector, lower-rated BBB-rated bonds returned 1.63%, outperforming higher-rated A and AA bonds. From a sector standpoint, metals and mining, energy, and electric utilities outperformed. Consumer sectors including lodging, supermarkets and cable television underperformed. Financials continue to perform well, as higher interest rate are expected to help future earnings in this sector.

Mortgage-backed securities (MBS) had a total return of 0.96 % for the quarter, outperforming similar duration Treasury bonds.  Excess returns in the mortgage sector during the quarter were driven by limited supply and strong demand from Real Estate Investment Trusts (REITS) buyers.

Fund Performance

The fund’s institutional shares had a total return at net asset value of 1.50%, underperforming its blended benchmark (35% Bloomberg Barclays U.S. Mortgage-Backed Securities Index/40% Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index/25% Bloomberg Barclays Emerging Markets USD Aggregate Index) with a return of 1.70% during the quarter. The fund’s return significantly outperformed the Bloomberg Barclays Aggregate Bond Index, a commonly used barometer of performance for the broad high-quality bond market, which returned 0.85% during the quarter.

Performance data quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than what is stated. Other share classes may have experienced different returns than the share class presented. To view performance current to the most recent month-end and for after tax returns, click on the Performance tab.

Click the Performance tab for standard fund performance.

On a nominal basis, the fund’s performance was driven primarily by strong returns in all of its spread sectors. Relative to its benchmark, the fund’s largest benefit was derived from its sector overweights to domestic high-yield and investment-grade corporate bonds and underweight to mortgages. The fund’s exposure to the international sector was neutral during the quarter. Security selection within the investment-grade corporates was positive. Selection within high-yield and international allocations were in-line with their respective sectors. The fund’s net equity exposure performed in-line with the overall return of the fund. Finally, the fund’s exposure to the yield curve was slightly negative, as it was underweight intermediate-duration bonds, which outperformed the combination of longer and shorter duration bonds. The fund also benefited from market volatility by tactical intra-period adjustments to its duration.

Click on the Portfolio Characteristics tab for information on quality ratings and the fund’s top 10 holdings.

Fund Positioning

Relative to its benchmark, the fund continues to be overweight domestic high-yield (approximately 42%) and investment-grade corporate bonds (6.5% of the fund), and neutral in EM bonds (approximately 25% of the fund). The fund continues to underweight MBS (approximately 16% of the fund). Gross equity exposure in the fund is 4.2%, although the fund has purchased put contracts against the Russell 2000 index to hedge against adverse market events. The fund also is relatively neutral in its positioning along the yield curve with a slight underweight to intermediate maturities and slight overweight to a combination of shorter and longer-dated maturities.