Waddell & Reed Government Securities Fund

09.30.17

Market Sector Update

  • The third quarter of 2017 produced yet another solid quarterly performance for virtually all U.S. fixed income sectors. According to Bloomberg Barclay’s Indices, all major sectors posted positive returns, including U.S. corporates, U.S. high yield, Treasuries, and securitized assets. Investor sentiment for risk assets continued to be bolstered by expectations that the Trump Administration would be successful at reducing taxes and regulations on Corporate America, despite very limited results thus far. Global demand for yield remained in place throughout 2017, just as has been the case for the past several quarters. The strong global demand for U.S. fixed income is a result the yield advantage U.S. fixed income provides over both Europe and Asia.
  • The Federal Reserve Board (Fed) didn’t raise short-term rates in the third quarter, after raising rates by 25 basis points in both the first and second quarters. The lack of Fed action in the third quarter and continued extremely low rates outside of the U.S. led to little movement in the Treasury market during the quarter. Market expectations going forward are for the Fed to raise rates by 25 basis points in the fourth quarter and to potentially raise rates several times in 2018. The Treasury curve continued its flattening trend during the third quarter, however. The often cited 2-year to 10-year Treasury spread relationship flattened from 91basis points to 85 basis points during the quarter. On the long end of the curve, the 30-year Treasury ended the quarter just 2 basis points higher than at the end of the second quarter. The probability of significantly higher interest rates in 2018 seems to be somewhat unlikely given the low (or negative) interest rate environment outside of the U.S. Central Bank policies around the globe are not currently aligned, which could introduce risk and/or volatility into the financial markets in later 2017 and 2018.

Portfolio Strategy

  • The Fund’s asset allocation changed considerably during the third quarter. The Fund increased exposure to Treasuries from 42% to 53%. The increase to Treasuries was funded by sales of securitized assets and cash. Agencies held constant throughout the quarter, at 8%. The securitized assets were reduced from 41% to 35% and cash held constant at 4% during the quarter. The Fund’s effective duration remained the same at the beginning and end of the quarter, at 5.3 years, which is duration neutral versus the Fund’s benchmark. Roughly 92% of the Fund’s assets have an effective duration of less than 10 years at quarter end. The Fund was also positioned to benefit from a flattening trend of the yield curve. Overall, the Fund out-performed its benchmark by 25 basis points during the first nine months of 2017.

Outlook

  • As has been the case for several quarters, Central Bank policies inside and outside of the U.S. continue to have a profound impact on the U.S. fixed-income market, both in Treasuries and credit. The demand for positive yield from foreign investors is providing an opportunity for U.S. companies to borrow (issue bonds) at very attractive rates. Although the foreign demand provides a short-term boost to the credit market, it is uncertain how stable this demand will prove to be over the longer-term. Credit metrics for U.S. companies, such as leverage and interest coverage, have been eroding for several quarters as more corporate bonds are issued to meet demand. Should foreign investors reduce their appetite for U.S. credit, the credit market could experience some weakness. However, in the near-term,as long as yield differentials between the U.S. and the rest of the world remain at elevated levels, U.S. rates are not expected to go materially higher. Longer-term it seems likely that the yield differential will get smaller as Central Bank policies converge over time.
  • The Fed has repeatedly stated its desire to raise the Fed funds rate at a measured pace. Should the Fed execute on its stated goal of a gradual pace for short-term interest rate hikes, the yield curve is expected to continue to flatten throughout the coming months. However, if the Fed acts inconsistently with market expectations, the financial markets could experience some volatility in 2018. As long as interest rates outside of the U.S. remain materially lower than U.S. rates, it seems unlikely that Treasury yields will materially increase in the near term. Current expectations are the Fed will raise the Fed funds rate by 25 basis points late in calendar year 2017, with perhaps another increase in the first half of 2018, depending on domestic economic data and interest rates outside of the U.S. The shape of the yield curve going forward will largely be determined by the market’s expectations of Fed short-term interest rate moves, inflation and longer term economic growth expectations.

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, 2017, 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.

Diversification and asset allocation are investment strategies that attempt to manage risk within your portfolio but do not guarantee profits or protect against loss in declining markets.

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.