Investment Environment
In the fourth quarter of 2009 the economy continued to show modest signs of improvement building upon the momentum established in the third quarter. Inflation remained contained, short-term rates were low, and risk assets such as stocks, corporate bonds, and high yield performed well.
On the economic front, industrial production and capacity utilization continued to improve, leading economic indicators returned to pre-recession levels, the ISM manufacturing index remained above 50, retail sale improved and jobless claims were lower. The housing market was mixed and headwinds were still present as consumer confidence remained low and unemployment high at 10%.
The Federal Reserve held rates at historic lows and reiterated that rates would stay low for an extended period while inflation risks were not in the forefront of Federal Open Market Committee (FOMC) member’s minds. Most importantly, the FOMC indicated plans to curtail and/or unwind some of the alphabet soup of liquidity programs initiated in 2008 and 2009 in support the financial markets.
We believe the market’s focus should now shift to Fed actions designed to remove excess liquidity from the system and reduce the Treasury’s ballooning $1 trillion plus balance sheet. These actions are expected to include the use of reverse repurchase agreements, raising the rate of interest paid on reserves and outright sales of securities. Lastly, we think the Fed will then move to increase the Federal Funds rate. This evolution from an easy monetary policy to a tighter policy by the Fed should be gradual and transparent.
U.S. Treasury yields ended the quarter higher following a better than expected November employment report (released on December 4th) and immense supply from the U.S. Treasury as market demand waned heading into the holidays. The two-year U.S. Treasury note ended the quarter 19bp higher at 1.14%. The yield curve was steeper as the ten-year U.S. Treasury note jumped 53bp to 3.84%. The difference between short-term and long-term rates ended the quarter at historic wide levels.
The top performing sectors during the quarter were corporate bonds and CMBS. U.S. Agency adjustable rate mortgages (ARMs) performed better than fixed rate U.S. Agency mortgage backed securities as rates rose late in the quarter.
Factors Affecting Performance
The return of the RidgeWorth U.S. Government Securities Ultra-Short Bond Fund I Shares was 0.58% in the fourth quarter and 5.39% for all of 2009. The Fund outperformed its benchmark, the Citigroup 6-month U.S. Treasury Bill index which returned 0.06% and 0.47% over the same time periods.
The Fund continued its heavy emphasis on U.S. Agency mortgage backed securities during the quarter. This sector allocation was the primary driver of outperformance during the fourth quarter and for all of 2009. Additionally, due to fund flows and potential uncertainty regarding prepayment trends of ARMs, we reduced our relative exposure to U.S. Agency ARMs, and added U.S. Agency CMO floating rate securities and U.S. Agency callable bonds. While this strategy reduced the yield of the Fund, we expect this strategy to provide added stability, especially if short-term rates rise or prepayments jump.
Strategy & Outlook
Although the economy has shown definite signs of improvement, the healing from the past two years most likely has a long way to go. Economic activity is far from pre-recession levels, unemployment is high, and there remains significant slack in resource utilization. Consumers are in the midst of deleveraging and boosting savings. The U.S. economy could see a near-term jump in GDP growth due to fiscal stimulus, inventory rebuilding, and a very low starting point. However, over the longer-term, we continue to expect a tepid recovery that will most likely be underwhelming. We have previously written that sustained, above trend, growth would be accompanied by (i) renewed confidence in the financial markets, (ii) expansion of credit, and (iii) improvement in employment. Financial markets seem to be back on solid ground, but consumer lending and employment have not yet shown the strength needed to put the U.S. economy on solid ground.
We expect to maintain a conservative duration posture between 0.5 and 1.0 years due to low short-term rates. The steep yield curve provides an opportunity to add yield with a slight emphasis on longer maturities when warranted. Our focus on U.S. Government Agency adjustable rate securities (ARMs) will be on those securities that should generally prepay slower, specifically by limiting exposure to ARMs subject to significant loan modifications and bankruptcies. We also favor the additional yield on U.S .Government Agency MBS backed by non-residential properties. Lastly, we have added U.S. Agency CMO floating rate securities due to their monthly reset and relative price stability.
Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher-quality bonds generally offer less risk than longer-term bonds and a lower rate of return. Mutual fund investing involves risk, including the possible loss of principal.
Mortgage-backed investments involve risk of loss due to prepayments and, like any bond, due to default. Because of the sensitivity of mortgage-related securities to changes in interest rates, the Fund’s performance may be more volatile than if it did not hold these securities.
Credit rating is a measure of the quality and safety of a bond, based on the issuer’s financial condition. More specifically, an evaluation from a rating service indicating the likelihood that a debt issuer will be able to meet scheduled interest and principal repayments. Typically, AAA is highest (best), and D is lowest (worst).
A basis point is equal to 0.01%.
The Barclays Intermediate Govt./Credit Index is an unmanaged index composed of all bonds that are investment grade rated Baa or higher by Moody’s or BBB or higher by S&P. An investor cannot invest directly in an index.
The views expressed by the Fund's managers are as of the quarter-end specified. This information is subject to change without notice as market conditions change, and is not intended to predict the performance of any individual security, market sector, or RidgeWorth Fund.
Past performance does not guarantee future results.
