Most recently citing "modest further progress" toward its inflation objective, the Federal Reserve left the Fed Funds rate unchanged during the quarter . The Federal Reserve further explained that it is looking for "greater confidence that inflation is moving sustainably toward two percent" before reducing the Fed Funds rate . Treasury yields increased by 9-22 bps across the yield curve during the quarter while, generally, debt market spreads did not change meaningfully, notwithstanding changes in spreads in certain segments of the market. On an absolute basis, we continue to see an attractive opportunity to buy longer duration, High Quality bonds (rated single-A or higher), which we believe will enhance the Fund's long-term returns and the Fund's short-term upside-versus-downside return profile. We do not generally view Credit (investments rated BBB or lower) as attractively priced, but we continue to search and will seek to opportunistically invest in Credit when we believe that prices adequately compensate for the risk of permanent impairment of capital and near-term mark-to-market risk. The Fund's Credit exposure decreased to 9.0% on June 30, 2024 versus 10.0% on March 31, 2024. Cash and equivalents represented 4.8% of the portfolio on June 30, 2024 versus 4.6% on March 31, 2024.
Asset-backed securities ('ABS') backed by equipment were the largest contributor to performance because of coupon payments that were partially offset by lower prices as a result of an increase in risk-free rates.
Agency mortgage pools were the second-largest contributor to performance owing to coupon payments and principal amortization applied to the pools' discount dollar price, partially offset by lower prices caused by an increase in risk-free rates.
The third-largest contributors to performance were our corporate holdings, comprised primarily of corporate loans and bonds that benefited from coupon payments and price appreciation because of an overall decrease in spreads for these investments. Our common stock holdings also contributed to returns as a result of price appreciation. Common stocks represented 1.6% of the portfolio, on average, during the quarter.
Although certain individual bonds detracted from performance during the quarter, there were no detractors at the sector level.
The table below shows the portfolio's sector-level exposures at June 30, 2024 compared to March 31, 2023:
We have been taking of advantage higher yields to buy longer-duration bonds, because we believe these bonds not only offer an attractive absolute long-term return but also improve the short-term return profile of the portfolio. The duration of these investments is guided by our duration test, which seeks to identify the longest-duration bonds that we expect will produce at least a breakeven return over a 12-month period, assuming a bond's yield will increase by 100 bps during that period. Consistent with this test, during the first quarter, we bought fixed-rate, High Quality bonds including agency-guaranteed residential mortgage pools, non-agency residential mortgage-backed securities ('RMBS'), agency-guaranteed commercial mortgage-backed securities ('CMBS'), ABS backed by equipment, ABS backed by prime quality auto loans, ABS backed by credit card receivables, and non-agency CMBS backed by single-family rental properties. On average, these investments had a weighted average life of 6.4 years and a weighted average duration of 5.3 years. We also extended the duration of the Fund's Treasury holdings.
To fund investments, we used a combination of proceeds from maturing investments and sales of High Quality bonds with a weighted average life and duration of 1.9 years and 1.7 years, respectively. We also sold a BBB-rated corporate bond and unrated bonds backed by non-performing single-family mortgages.
As shown in the following chart and as noted by the Federal Reserve, there has been "modest further progress" in reducing inflation toward the Federal Reserve's 2% target.
CPI Urban Consumers less Food and Energy Year/Year Change
Noting the need for more data to instill "greater confidence that inflation is moving sustainably toward two percent," the Federal Reserve opted to leave the Fed Funds rate unchanged at both its May and June meetings.
Despite lower inflation and growing confidence that the Federal Reserve is nearer to cutting rates, uncertainty as to the exact timing of such easing led to an increase in Treasury yields, as shown below.
Perhaps contributing to higher risk-free rates is uncertainty created by the federal elections in November and the impact they could have on the direction of the federal government, fiscal policy, trade policy, economic growth, inflation, monetary policy, etc.
We won't try to predict the macroeconomy, politics, elections, or other macro factors because we do not believe that can be done with any level of conviction. Betting on a specific event and tying prospective returns to that outcome would be speculative and create a less certain path to attractive long-term returns. All we can do is consider possible outcomes and weigh them against market prices. We seek investments at prices that we believe compensate for the possibility of negative outcomes. That said, because overall market prices have not changed materially in our view over the past few months, the implementation of our investment process has also not changed meaningfully during that period.
The following two charts show that Treasury yields and yields on High Quality bonds are still among the highest in over 15 years.
As we have described in past commentaries, higher yields over the past couple of years have created what we believe is an attractive opportunity to buy longer-duration, High Quality bonds. We believe our investors will be better off in the long term earning today's yields for multiple years. Therefore, we want to lock in today's yields for as long as possible. However, because the future is uncertain, we also want to be thoughtful about limiting the short-term mark-to-market risk associated with increases in interest rates.
To help strike a balance between locking in yields for as long as possible and providing some short-term price-related downside protection, we select the duration of our investments using our 100 bps duration test described above. The chart below illustrates this test.
The dark blue bars above show Treasury yields of various maturities at June 30, 2024. The green bars show the results of our 100 bps duration test and represent the short-term downside return potential for these bonds. For example, the 5-year Treasury (US5Y) purchased at a 4.38% yield would be expected to return 0.82% over twelve months if its yield increased by 100 bps from 4.38% to 5.38% during that time. A similar analysis applied to the 7-year Treasury (US7Y) would result in a total return loss of -0.70%. With a better-than- breakeven return, the 5-year Treasury would be a candidate for our portfolio but the 7-year Treasury would not because it produces an expected loss over twelve months.
Shorter-maturity bonds would also pass our duration test in today's market and would be expected to produce positive short-term returns if yields increase by 100 bps, but longer-maturity bonds add more short- term upside potential to the portfolio. The light blue bars on the chart above show the short-term upside return potential, namely the potential total return over twelve months if rates decrease by 100 bps. The 5- year Treasury offers a potential upside return of 8.1%. Although the 7-year Treasury offers a higher potential total return in the upside scenario, that upside should be balanced with the prospect of losing money in the short-term. The 5-year Treasury captures over 80% of the short-term upside return of the 7-year Treasury but with less short-term downside risk. Likewise, our investments in longer-duration bonds create the potential for the portfolio to capture a meaningful portion of the upside offered by longer-duration bonds like those represented in the Bloomberg Aggregate Bond Index but with better short-term downside protection against an increase in interest rates. If interest rates increase going forward (within reason), we believe we can preserve capital in the short-term - which will leave us well-positioned to take advantage of the cheaper investment opportunities that appear.
To that end, we have spent the past two-and-a-half years increasing the Fund's duration. Whereas the average fund in the Morningstar U.S. Short Term bond category had a 2.75-year duration at the end of 2021 - before rates began to increase - and maintained a similar duration of 2.86 years through June 2024, the Fund's duration increased from 1.39 years at December 31, 2021 to 3.21 years at June 30, 2024, a 1.82 years increase. When rates were very low in 2021, the Fund had a far-below-average duration because we believed investors should take less risk when the market is expensive (i.e., when rates are low). Now that the market is cheaper (i.e., rates are higher), we believe investors should be willing to take on more duration risk because they are now being compensated for that risk through higher yields.
Although we see an attractive opportunity to buy longer-duration High Quality bonds, we do not generally see attractive investment opportunities in lower-rated debt. In the high yield market, yields also remain near 15-year highs, but spreads have retreated to the sixth percentile, as measured by the BB component of the Bloomberg U.S. Corporate High Yield index excluding Energy, an index we believe provides the most consistent view of high yield market prices over time with fewer distortions caused by changes in the composition of the overall high yield index.
Bloomberg U.S. Corporate High Yield BB excl. Energy
Further, the extra spread offered by high yield bonds in comparison to investment grade bonds has also compressed. For example, the spread on the aforementioned BB-rated high yield index, excluding energy, less the spread on investment grade corporate bonds, has decreased to the fourth percentile.
Bloomberg U.S. Corporate High Yield BB excl. Energy Spread less Bloomberg U.S. Investment Grade Corporate Spread
Importantly, measures of the high yield market such as yield and spread do not account for the underlying quality of bonds in the market at any given point in time. It is our opinion that, on a comparable ratings basis, there has been a degradation in the quality of high yield bonds over the past few years (most notably because of weaker structural protections for bondholders) which, all things being equal, makes high yield debt more expensive than the charts above would suggest. Given current prices in the high yield market, we generally find that, compared to investment grade bonds, the low spreads in the high yield market do not offer enough incremental compensation for the extra credit risk involved in high yield debt. We continue to research the high yield market for investment opportunities, but these days we typically find High Quality bonds more appealing.
As always, we invest with a flexible, opportunistic, patient, and long-term -oriented investment approach that seeks attractive short- and long-term risk-adjusted returns. As described in the attached letter celebrating the Fund's 40th anniversary under FPA's management, this is an approach we've been employing for 40 years, delivering competitive total returns and attractive risk-adjusted returns in the process. We are proud of what we have been able to accomplish over 40 years, but our focus remains on the present and the investment opportunities ahead.
Thank you for your confidence and continued support.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.