Market Sector Update

• The U.S. government securities market produced a negative total return for the quarter, as interest rates moved higher during the first three months of 2018. The Bloomberg Barclays U.S. Government/Mortgage TR Index, the benchmark for the Fund, produced a quarterly total return of -1.17% for the first quarter. According to Bloomberg Barclay’s fixed income indices, several other fixed income sectors also posted negative total returns during the first quarter, including U.S. Aggregates, U.S. Corporates, U.S. High Yield, U.S. Treasuries, U.S. Securitized, and Emerging Markets. Investor sentiment for risk assets was volatile starting at the beginning of February and continuing for the remainder of the quarter. Global demand for yield did remain firmly in place, however, just as in 2016 and 2017. The strong global demand for U.S. fixed income products is largely the result of the yield advantage these products provide over comparable assets in both Europe and Asia.
• As was expected by the market, the Federal Reserve Board (Fed) raised short-term rates 25 basis points in March, after doing the same three times in 2017 (first, second, and fourth quarters). The move by the Fed contributed to the flattening of the yield curve in the latter part of the quarter. The common measure of the shape of the yield curve, the yield difference between the 10-year and 2-year Treasuries, declined to 47 basis points at quarter-end. This relationship at the beginning of the year was 52 basis points, but had steepened considerably earlier in the first quarter. Market expectations going forward are for the Fed to raise short-term rates two to three more additional times in 2018. On the long end of the curve, the 30-year Treasury ended the quarter at 2.97%, which was 23 basis points higher than at the beginning of the year. Finally, the Fed got a new Chairman during the first quarter, Jerome Powell. Although Chairman Powell is not expected to act significantly different than his predecessor, a new Chairman does introduce a bit of uncertainty and potential volatility into the financial markets generally.

Portfolio Strategy

• The Fund’s asset allocation didn’t change materially during the first quarter of 2018. The Fund decreased exposure to Treasuries from 56% to 53% at quarter-end, which is similar to the benchmark weighting. U.S. government agencies held a consistent amount throughout the quarter at 8%, which is an overweight. The securitized assets (mortgagebacked securities, collateralized mortgage obligations, commercial mortgage-backed securities) increased from 33% to 38%. The Fund continued to be underweight mortgage-backed securities pass-throughs and overweight both collateralized mortgage obligations and commercial mortgage-backed securities. Cash was less than 1% at quarterend, at the lower end of the desired range of 1-5%. The Fund’s effective duration was reduced to 5.1 years in anticipation of higher interest rates. The Fund was slightly underweight its duration benchmark throughout the quarter. Roughly 92% of the Fund’s assets had an effective duration of less than 10 years at quarter-end. The Fund continued to be positioned to benefit from a flattening trend of the yield curve between the 2-year and 10-year. Overall, the Fund outperformed its benchmark during the first quarter of 2018.

Outlook

• The financial market reaction to higher short-term interest rates continues to be one of the biggest risks to market stability in 2018. Thus far, there has been a significant amount of market volatility caused at least in part by the front end of the yield curve shifting higher. In addition to higher rates in the U.S., the yield differentials between the U.S. and rest of the world remains important. Interest rates outside of the U.S. may limit the magnitude of rates moving higher in the U.S., particularly at the long end of the yield curve. As has been the case for the past several quarters, global Central Bank policies are not in synch and will likely continue to have a profound impact on the U.S. fixed-income market. The demand for positive yield from foreign investors continues to provide some support to the U.S. market. Although the foreign demand has provided a sustained boost to the U.S. fixed income market, it is uncertain how stable this demand will prove to be over the longer-term. Should foreign investors reduce their appetite for U.S. fixed income, the market could experience some weakness. Longer-term, it seems likely that the yield differential will get smaller as Central Bank policies converge in coming quarters and years.
• The Fed has repeatedly stated its desire to raise the fed funds rate at a measured pace. Current expectations are the Fed will raise the fed funds rate two to three more times in the remainder of 2018. Should the Fed execute on its stated goal of a gradual pace for short-term interest rate hikes and inflation expectations remain in check, the yield curve should remain fairly flat in the coming months. However, if the Fed acts inconsistently with market expectations, the financial markets could experience more volatility in 2018. The new leadership at the Fed may increase the probability of continued volatility. How effective the Fed is at navigating the transition to a more “normalized” interest rate policy is crucial to how the financial markets will behave in 2018.

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 Mar. 31, 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.

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.