Market Sector Update

• Market volatility continued in the second quarter as U.S. Treasury yields continued their climb higher, and returns on spread products widened. The 2-year note rose 26 basis points in the quarter to 2.53% and the 10-year note rose 12 basis points to 2.86%.
• The yield on the 10-year note reached a seven-year high of 3.13% in mid-May, following a hawkish speech by John Williams, who has since moved from the position as President of the San Francisco Federal Reserve (Fed) to his current role as the President of the New York Fed. He is now a more significant player on the monetary policy stage, because the New York Fed President is a permanent voting member of the Federal Open Market Committee. That yield above 3% proved fleeting, as just days later the U.S. Treasury market enjoyed a huge flight-to-quality rally centered on worries about Italy, dropping the 10-year yield to 2.78%. While the trend has certainly been for yields to rise, they have been doing so in a roller coaster fashion.
• Spread products in general have underperformed U.S. Treasuries thus far in 2018, but the mortgage sector has had better relative performance than the credit sector. The Bloomberg Barclays U.S. Mortgage Backed Securities Index (a subset of the fund’s benchmark, the Bloomberg Barclays U.S. Government/Mortgage Index) delivered an excess return of -24 basis points in the first half of the year, while the Bloomberg Barclays U.S. Credit Index posted excess returns of -154 basis points in that same time. While there are duration differences in the two indexes, there is no denying the better performance of the mortgage sector so far this year.

Portfolio Strategy

• We kept duration at about 95% of that of the benchmark during the quarter. We added mortgages during the quarter, primarily in the form of agency collateralized mortgage obligations, and now have our allocation to securitized products close to even with the benchmark. We anticipate keeping duration short of the benchmark while we anticipate more hikes from the Fed.

Outlook

• The Fed hiked rates for the seventh time in this cycle in June. It came as no surprise. Most believe there will be at least one more hike and probably two hikes before year-end. The big unknown right now is trade and how the tariffs and tweets and rhetoric between the U.S. and our trading partners will play out. Whether or not growth is impeded both domestically and globally may determine whether the Fed may need to slow down their expected pace of rate hikes.
• The yield curve, the difference between the yield on the 10-year note and the 2-year note has been flattening for some time and finished the quarter at 33 basis points. This has also been causing some concern. Continued rate hikes should cause continued flattening of the curve. An inverted yield curve (where two-year yields are higher than 10-year yields) generally precedes a recession by anywhere from six to 24 months. Right now, however, things look good. Company profits are doing well. The labor market is strong. Unemployment is low. Inflation is not an issue. We will keep monitoring the data for changes, but recession appears to be beyond the horizon.

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 June 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.

Effective duration is a calculation used to approximate the actual, modified duration of a callable bond. Effective duration is calculated using the long position holdings of the portfolio.

The Barclays U.S. Government/Mortgage-Backed Securities Index measures the performance of U.S. government bonds and mortgage-related securities. The Bloomberg Barclays U.S. Credit Index measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government related bond markets. The Bloomberg Barclays US Mortgage Backed Securities (MBS) Index tracks agency mortgage backed pass-through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). 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 Fund's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.