Market Commentary as of 12/31/09
Update on the U.S. Economy
The U.S. economy is emerging from its deepest recession in seven decades, one exacerbated by an adverse feedback loop in which weakening economic and financial conditions became mutually reinforcing. Strengthening final demand as the housing market shows signs of stabilization, the labor market recovers, and consumers benefit from a rebound in equity markets, however, is supporting what a nascent recovery. Business spending should benefit from the need to replenish shrunken inventories as demand increases. Still, the recovery remains fragile and is dependent, in part, on accommodative government monetary and fiscal policy with the risk of a somewhat constrained growth outlook as support wanes and interest rates rise.
As massive government interventions and liquidity provisions expressly targeted for the credit markets took hold, Corporate bonds enjoyed their best year ever. Notably, the FDIC's Temporary Liquidity Guarantee Program (TLGP) enabled financial institutions to refinance debt in early 2009 at the same time that credit markets were effectively frozen. Meanwhile, the US Treasury's Supervisory Capital Assessment Program (the "stress test") reaffirmed the government's commitment to support critical financial institutions and enabled large banks to raise substantial private equity that in turn further strengthened capital. These financial market reform initiatives, including increasing capital requirements for financial institutions (with even higher standards for larger institutions), enhanced oversight of ratings agencies, hedge funds, securitization and derivatives markets, and new authority for the Federal Reserve to supervise non-banking institutions are expected to further benefit debtholders.
Corporate Bonds Lead the Way
For the quarter ending December 31, 2009, and the full year, the Fund outperformed its Barclays Capital Aggregate Bond Index benchmark thanks in large part to that rebound in Corporate bonds. Corporate bonds outperformed duration-adjusted Treasuries by nearly 20 percentage points during 2009. By way of background, the previous best year on record was 5.6 percentage points of outperformance. Long-maturity Corporates outperformed intermediates as spread curves flattened during the year. All credit sub-sectors realized exceptional returns with Utilities the standout—outperforming Industrials and Financials. Lower quality investment-grade bonds outperformed as well, with BBB-rated issues benefiting from the recovering economy and outperforming A, AA, and AAA bonds by huge margins.
Mortgage-backed securities posted their second best year on record in also outperforming duration matched Treasuries by a significant margin. In an effort to keep mortgage rates low, the Federal Reserve made a commitment to purchase $1.25 trillion in mortgage-backed securities by the end of the first quarter of 2010. By the end of 2009, the Fed had $910 billion in securities on its balance sheet. As a result, the option-adjusted spread (OAS) of the Barclays Capital U.S. Mortgage Index reached two basis points before widening out to 18 basis points, its tightest year-end level on record.
US Treasuries were the worst performing fixed income asset class in 2009, posting absolute losses in their worst year on record. This despite Federal Reserve purchases of $300 billion in securities as rising debt sales brought total public debt outstanding to $12.1 trillion at the end of 2009, an increase of 13.5%. In this environment, intermediate Treasuries outperformed long Treasuries as the yield curve reached its steepest level ever.
Outlook
While government initiatives have been successful in improving financial markets, challenges remain for 2010. Beyond the massive contingent liabilities borne by the financial system, the federal government likely faces still greater long-term costs associated with ever-growing entitlement programs, including pending health care reform. The many government initiatives also represent risks to the underlying long-term creditworthiness of the U.S. government. While the U.S. remains the global benchmark sovereign, the so-called "risk-free" rate could be questioned and any such challenges should lead to higher real interest rates. In this environment, we favor Treasury Inflation Protected Securities (TIPS) within a Treasury allocation to better insulate the portfolio from rising yields attributable to inflation.
Challenges facing the residential housing market have precipitated further actions on the part of the U.S. government. On December 24, the US Treasury extended its preferred stock purchase agreements with Fannie Mae and Freddie Mac for an additional three years and removed the $400 billion cap on its funding commitment level under conservatorship. The unconstrained level effectively ensures that the two government sponsored entities (GSEs) will both remain solvent during the next three years. The support is critical to both the residential housing market, as Fannie and Freddie underwrite nearly 90% of all new mortgages, and the fixed income market as the two lenders guarantee 40% of the Barclays Capital Aggregate Bond Index against credit losses.
Still, there remains no permanent resolution to the conservatorships of the GSEs. The lack of a permanent resolution for Fannie and Freddie highlights longer-term structural challenges for the credit markets and the broader economy. Valuations in mortgage-backed securities remain near the tightest levels on record and, in our view, do not fully compensate investors for potential prepayment risk or the uncertainties surrounding the housing markets. Instead, we believe valuations largely reflect a supply imbalance attributable to the $1.25 trillion purchase program undertaken by the Federal Reserve, with spreads likely widening as the purchase program nears its completion in March of 2010.
We believe Corporate bonds will continue to outperform as government programs supporting other sectors of fixed income wind down. Corporate bonds stand to benefit from strengthened balance sheets and the prospects for a sustainable economic recovery. Corporations have taken important steps toward improving their creditworthiness during the past year, including an emphasis on more permanent sources of funding, reduced leverage, and a strengthened capital base via equity issuance that have benefitted bondholders. Within Corporates, security selection will likely become an increasingly important source of value added as strengthened balance sheets may lead companies to more equity-friendly initiatives, particularly in a low interest-rate environment following a sharp narrowing in credit spreads.
Taplin, Canida & Habacht (TCH)
Miami, Florida
Note: Bond funds are subject to interest rate and credit risk similar to individual bonds. As interest rates rise or credit quality suffers, an investor is susceptible to loss of principal.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by PFPC Distributors, Inc.
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by PFPC Distributors, Inc.