Considerable Stress on Financial Markets
In its most recent directive, the Federal Reserve Board noted that "financial markets remain under considerable stress." The recent widening of credit spreads and the difference between the three-month London Interbank Rate (LIBOR) and three-month Treasury Bills reflects both concerns about counterparty risk as well as a continuing flight-to-quality as further write-downs and additional efforts to raise capital appears likely for financial institutions.

Data from the first quarter of 2008 indicated that the U.S. economy expanded only 1.0% following a 0.6% rate of growth the prior quarter, which marked the weakest six-month economic expansion in five years. Continued weakness in residential spending was offset by the weak US dollar, which helped to buoy growth by reducing the negative trade balance to its lowest level in more than five years. An unintended consequence of the lower dollar, however, may have been sharply higher oil prices and a subsequent rise in import prices. All told, consumers now face tighter credit conditions, higher energy prices, greater expectations for inflation, a weakening labor market, and shrinking wealth resulting from declining equity valuations and the ongoing housing correction, resulting in the lowest consumer confidence level since 1992.

Corporate Bond Rebound
In a reverse from the previous quarter, US Treasury bonds delivered their largest quarterly loss in four years as inflation pressures mounted, and corporate bonds rallied. This despite ongoing weakness in the equity markets, concerns relating to asset valuations on company balance sheets, and a general economic slowdown in the US. To be sure, the trend began to reverse itself in June, though not enough to overcome the overall advantage that corporates enjoyed for most of the period.

On the back of that rebound in corporate bonds, the Fund posted positive returns in outperforming its Lehman Brothers Aggregate Bond Index benchmark. A tightening of credit spreads from record wide levels following a weak March quarter was the primary driver of performance. The Fund's barbell credit approach emphasizing BBB-rated corporates—the only credit subsector to post positive absolute returns for the quarter—on the long end of the yield curve and higher-rated floating rate notes on the short end of the curve paid off as well. Our commitment to floating rate notes added value to the portfolio as counterparty, liquidity and systemic risk concerns diminished somewhat. In addition, exposure to callable agency structures that outperformed in a rising interest rate environment aided returns.

An overweight stake in Industrials, the best performing subsector of the credit market, also provided a boost in terms of sector selection. Although Financials performed well overall, renewed concerns regarding write-downs and a need for further capital infusions adversely affected the sector again in June.

No Further Rate Changes Imminent
While the Fed has introduced unprecedented liquidity provisions to date, we believe further remedies to alleviate stresses in the financial marketplace are possible. To this end, the Fed may extend the period with which provisions are available and change key components of certain provisions that would allow for cash term financing of a wider range of collateral.  We believe the implicit and explicit support for financial institutions provided by the Federal Reserve bodes well for financial institutions and the broader credit market. On the heels of a reduction in its official economic growth projections, and in light of increasing pressures on consumer spending and the broader economy, however, we do not believe a near-term move to a tighter monetary policy is imminent.