Market Sector Update

• The third quarter was broadly risk-on as economic data and earnings surpassed expectations and the market closely evaluated trade policy. Initial jobless claims hit a 48-year low, consumers’ assessment of the labor market reached a 17-year high, U.S. factory activity hit a 14-year high, and equity markets posted strong returns. The risk-on environment resulted in Treasury yields moving higher with the 2-year yield climbing 29 basis points (bps) to 2.82% and the 10-year yield rising 20 bps to 3.06%. The Federal Reserve (Fed) raised the federal funds rate a 0.25-percentage to a range of 2.00-2.25%, and the market implied probability of another hike in December climbed from 43% to 69% during the quarter.
• The Fund’s benchmark returned 97 bps, but year-to-date remains negative. During the quarter, the spread of the index tightened from 123 bps to 106 bps and the spread component of returns was able to more to than offset the higher Treasury yields. For the year, spreads are still higher by 13 bps. The high yield market outperformed investment grade. In the quarter, the high yield index spread tightened 47 bps to 316 bps, which is 27 bps lower on the year.
• Corporate revenue and earnings growth remained strong – second quarter revenue and EBITDA growth was approximately 5% year-over-year, excluding the volatile commodities sector. Growth remains solid, but trails the rate of the previous two quarters. Caution is warranted as investment grade metrics such as gross leverage have not been improving despite the strong revenue and EBITDA trends.
• Issuance in the investment grade market was $277 billion in the quarter, roughly in line with the prior four-year average of $280 billion. Year-to-date issuance related to mergers and acquisitions (M&A) was $177 billion, which already exceeds the $143 billion total in 2017. Pending issuance for M&A is likely to drive total 2018 issuance for M&A to $230 billion, which would exceed the $221 billion issued in 2016, but well under the $275 billion in 2015. This type of funding is important to monitor as it often drives leverage trends higher.

Portfolio Strategy

• During the quarter the Fund reduced its duration. We ended the quarter slightly lower duration relative to the benchmark compared to being marginally above benchmark duration at the end of the second quarter.
• The Fund reduced its overall risk as evidenced by the spread of the Fund relative to the benchmark in the quarter. The Fund’s spread remains above the benchmark due to its exposure to the high yield market, which is not a material component of the benchmark.
• The Fund reduced exposure to more cyclical sectors such as the consumer cyclical and industrial sectors while increasing exposure in the consumer non-cyclical sector.

Outlook

• Going forward, we remain comfortable with our positioning to the investment grade and high yield asset classes as well as the portfolio’s overall duration, spread and sector exposure.
• While U.S. economic growth remains robust and continues to exceed expectations, the future contains potential headwinds to growth and consequently asset prices going forward. These risks include the pace of Fed rate hikes, political changes, tariff/trade concerns and volatility in several emerging market countries. While the risk of a recession in the near term appears remote, 2019 growth rates are likely to decelerate due to fading effects of the tax cut, the impact of tariffs on trade and slowing growth internationally.
• The Fed will likely hike rates again in December, which will not be a surprise to the market. However, we believe decelerating growth rates and the federal funds rate moving closer to neutral may result in the Fed pausing in 2019.
• The outlook for spreads is balanced – on the positive side, relative valuation as investment grade spreads have underperformed that of equities, high yield and other risk assets, while the negative is the lack of improvement in leverage trends. Given that balance, we remain focused on high-level risk factors (overall duration and spread relative to the index), as well as sector and individual security selection. We are enthusiastic about our ability to pick credits with compelling relative value as well as idiosyncratic catalysts which should contribute positively to returns going forward.

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, 2018, 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.

Rick Perry served as a portfolio manager on the Fund until April 12, 2018.

Risk factors: The value of the Fund's shares will change and you could lose money on your investment. Fixed income securities in which the Fund may invest are subject to credit risk, such that an issuer may not make payments when due or default or that the risk that an issuer could suffer adverse changes in its financial condition that could lower the credit quality of a security that could affect the Fund’s performance. A rise in interest rates may cause a decline in the value of the Fund’s securities, especially securities with longer maturities. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Investing in foreign securities involves a number of economic, financial, legal, and political considerations that are not associated with the U.S. markets and that could affect the Fund’s performance unfavorably, depending upon the prevailing conditions at any given time. Mortgage-backed and asset-backed securities in which the Fund may invest are subject to prepayment risk and extension risk. The Fund typically holds a limited number of fixed income securities (generally 30 to 50). As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s NAV than it would if the Fund invested in a larger number of securities. Fund performance is primarily dependent on the management company’s skill in evaluating and managing the Fund’s portfolio. There can be no guarantee that its decisions will produce the desired results. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.