Market Sector Update

• The third quarter saw a continuation of the risk-on environment from the second quarter, but experienced a moderate sell-off in risk assets in August as trade tensions resurfaced.
• Despite the risk-on environment, U.S. Treasuries continued to rally. This was due to the anticipation of the Federal Reserve (Fed) cutting its benchmark interest rate, as well as falling interest rates across the globe. At the end of the second quarter, the federal funds rate range was 2.25-2.50% with the market pricing in a greater than 50% chance of the rate ending the year at (or below) 1.50-1.75%. By the end of the third quarter, odds increased to more than 70% that the range would end the year below 1.50-1.75%.
• Macroeconomic data and expectations of easing by the Fed caused the 2-year U.S. Treasury yield to decline 13 basis points (bps) to 1.62% and the 10-year U.S. Treasury yield to decline 34 bps to 1.66%. The spread between the 10-year U.S. Treasury note and the 3-month U.S. Treasury bill remains inverted after turning negative for the first time since 2007. Historically, an inverted yield curve has implied a forthcoming recession, but the time lag can be significant. Another yield curve measure, the spread between the 10-year U.S. Treasury note and the 2-year U.S. Treasury note, flattened from 25 bps to 4 bps during the quarter. However, it did invert in August due to concerns that trade tensions would affect growth.
• After rising nearly 10% in the first half of the 2019, high yield rose 1.3% in the quarter mainly due to falling rates and coupon income. Spread tightening contributed slightly with the spread on the index falling from 377 bps to 373 bps. Similar to last quarter, higher quality segments of the high yield market outperformed with BB, B and CCC returning 2.03%, 1.65% and -1.76%, respectively. Leveraged loans returned 92 bps, continuing to trail high yield.
• Fundamentals for the investment grade universe continued to weaken, as revenue and earnings before interest, tax, depreciation and amortization (EBITDA) growth decelerated. In the second quarter, revenue and EBITDA (excluding commodity sectors) were up 2.4% and 1.3%, respectively. This was down from 3.2% and 2.6% in the first quarter of 2019. Sequentially, leverage for the investment grade universe was flat at 3.1-times, while the percentage of the universe greater than four-times leveraged was up 2% to 28%.
• Investment grade issuance was $385.5 billion in the quarter, up more than 40% year over year, with September being the third highest month of issuance on record. Issuance, net of maturities, was up nearly 28% year over year in the quarter and year-to-date net issuance is down less than 3%. BBB-rated issuance is 42% of year-to-date supply, down slightly from 43% of full-year supply in 2018. Overall maturity of issuance has increased this year with 59% of year-todate issuance longer than six-years-to-maturity versus 54% for calendar year 2018.

Portfolio Strategy

• The Fund had a positive return and was in line with its benchmark. The return was primarily driven by falling rates and coupon income, while the spread for the index was flat at 109 bps.
• The Fund slightly increased its duration relative to the benchmark, but remains modestly under benchmark duration which rose 0.3 year to 7.6 years at quarter end. Higher duration means higher price volatility for a given change in spreads.
• We increased the Fund’s BBB allocation and reduced AA and A rated exposure.
• The largest changes in sector positioning were increases in the consumer non-cyclical and industrial sectors and decreases in the financial and consumer cyclical sectors.

Outlook

• We believe the fourth quarter will likely be driven by the two principal concerns that have been the focus of investors this year – Fed policy and trade policy. During the quarter, U.S.-China trade tensions escalated with President Donald Trump announcing an additional 15% tariff starting on Sept. 1, as well as other tariffs targeted for October and December. Many believe a truce may develop in October with the remaining tariffs put on hold, but incremental damage to growth has already occurred and trade remains unpredictable.
• After easing by 25 bps twice in the quarter, we believe the Fed is likely to cut in October. We think macroeconomic data may continue to soften and likely fall short of expectations in the fourth quarter due to trade policy uncertainty, Brexit and geopolitical concerns.
• We believe credit spreads should widen in the fourth quarter due to a few factors. First, macroeconomic data points are likely to underwhelm relative to consensus. Second, fundamentals in investment grade credit remain stretched with corporate balance sheets at their most levered levels post-crisis. Lastly, duration in the investment grade marketplace continues to rise.
• Outside of investment grade, cracks are forming in certain areas of credit, most notably high yield and leveraged loans. CCC-rated debt has meaningfully lagged high yield returning 5.6% year to date versus 11.4% for the overall market. Additionally, the ratio of bonds trading below 70% of face value, a so-called distressed ratio, is at higher levels than during the fourth quarter of 2018 when risk assets sold off materially. We believe this portends an increase in the default rate. While this has generally not bled into the investment grade spread, it does speak to investor caution for risky assets.
• The technical backdrop for spreads remains relatively positive. We continue to expect net supply to be materially lower than last year due to smaller merger and acquisition volume and tax changes reducing the incentive to issue debt. However, we expect a higher amount of total fixed income issuance principally from U.S. deficit funding. On the demand side, we see trends modestly supportive of spreads. We believe robust mutual fund flow is likely to continue in the near future, but yield compression may reduce demand.
• Given our expectation for modest widening of spreads in 2019, we believe our conservative positioning relative to the benchmark is appropriate.

The opinions expressed are those of the Fund's managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Sept. 30, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The Bloomberg Barclays U.S. Credit Index measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related bond markets, including a non-corporate component of non- U.S. agencies, sovereigns, supranationals and local authorities. It is not possible to invest directly in an index.

Risk factors: 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 rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. These and other risks are more fully described in the Portfolio's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.