Western Asset Core Bond outperformed the Barclays Aggregate Index during the quarter, helped by high quality credit and an overweight to non-agency MBS. The team recently added to its agency MBS exposure to take advantage of improved valuations.
Market Overview:
– U.S. Treasury yield curve flattened during third quarter
– U.S. bond markets posted positive returns as spread sectors outperformed Treasuries
– Commerce Department reported that second quarter 2017 GDP was 3.1%
o Strongest GDP growth reading in two years
o Increase of growth reflected upturn in private investment, acceleration in personal consumption, deceleration in imports and increase in federal spending
– Labor market was generally solid during the quarter
o Unemployment rate fell to 4.2% by September, representing lowest level since 2001
– Manufacturing sector continued to expand and pace of accelerated as quarter progressed
o 11th month of consecutive expansion
– Fed kept rates on hold in range of 1.0-1.25% during the quarter
o Left open the possibility of another hike in December
o Committee will initiate balance sheet normalization in October
Performance Overview:
– During the quarter, the fund outperformed the Agg
– An overweight to investment grade corporate bonds was positive as spreads narrowed
o Strong performers included Wells Fargo, Bank of America, and Citigroup
– An overweight to non-agency MBS contributed to performance amid solid demand
– CMBS and ABS were modestly beneficial during the period
– Finally, duration positioning contributed to performance
– Underweight to agency MBS was a relative detractor
o Negative results from United Technologies and Anglo American Capital
– Team added to its agency MBS exposure, moving from an underweight to overweight
o Change made to take advantage of improved valuations
o We are more comfortable with this sector as the Fed’s balance sheet reduction
Market Outlook:
– U.S. economic recovery continues as unemployment is back to pre-crisis levels at 4.2%
– However, core inflation continues to remain stagnant
o Janet Yellen has declared much of the decline to be transitory due to one off factors such as wireless pricing
– The Fed’s models predict inflation based on core PCE
o This suggests the Fed needs to continue gradually increasing rates to more normal levels
– Fed admits that the shortfall of inflation is surprising given that there are not similar headwinds to previous years
o If 2% inflation is a target and not a ceiling, then perhaps the notion of raising rates needs to be questioned
– With global growth picking up EM and European countries, there should be few headwinds from abroad to impede U.S. growth
o The team believes spread products should continue to outperform government bonds
– Returns in high quality fixed income products should be expected to be modest
– Demand for income and yield provides the possibility of spreads tightening further
– The global economy is healing against a muted inflation backdrop that is unlikely to change soon
o Central Bank policy should remain benign
Performance Review:
