Wasatch-1st Source Income Fund® (FMEQX)  Invest in this Fund 

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Q1 2018
Inflation Remained Lukewarm Despite a Surprising Jump in Wages
by Paul Gifford, CFA and Erik Clapsaddle, CFA, CFP

“Within the Fund, we continue to highlight the following: We don’t attempt to lower the Fund’s duration by investing in securities with shorter maturities; and we try to catch the upside to rising short-term rates by investing in floating-rate securities.”

Paul Gifford
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For the period ended March 31, 2018 the average annual total returns of the Wasatch-1st Source Income Fund for the one-, five- and ten-year periods were 1.09%, 1.00% and 2.30%, the returns for the Bloomberg Barclays US Intermediate Government/Credit Bond Index were 0.35%, 1.25%, and 2.92%.  Expense ratio: Gross 0.75% / Net 0.75%.

 

Data shows past performance, which is not indicative of future performance. Current performance may be lower or higher than the data quoted. To obtain the most recent month-end performance data available, please click on the “Performance” tab of the individual fund under the “Our Funds” section. The Advisor may absorb certain Fund expenses, without which total return would have been lower. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost.

Wasatch Funds will deduct a 2.00% redemption proceeds fee on Fund shares held 60 days or less. Performance data does not reflect the deduction of fees, including sales charges, or the taxes you would pay on fund distributions or the redemption of fund shares. Fees and taxes, if reflected, would reduce the performance quoted. Wasatch does not charge any sales fees. For more complete information including charges, risks and expenses, read the prospectus carefully.

Wasatch Funds are subject to risks, including loss of principal.

Overview

The views expressed in this commentary are those of 1st Source Corporation, the sub-advisor to the Fund, and may differ from the views of Wasatch Advisors.

The Wasatch-1st Source Income Fund declined -0.38% for the first quarter of 2018 and outperformed its benchmark, the Bloomberg Barclays US Intermediate Government/Credit Bond Index, which declined -0.98%. At the March meeting of the Federal Open Market Committee (FOMC), the first under new Federal Reserve (Fed) Chairman Jerome Powell, Fed officials increased the federal-funds target rate one-quarter of a percentage point to a range of 1.50% to 1.75%. During the first quarter, the Fed continued to reduce its balance sheet as scheduled by shedding securities it had acquired during and after the financial crisis. Short-term interest rates increased in the first quarter as the three-month London Interbank Offered Rate (LIBOR) rose to 2.31%, the highest rate since November 6, 2008.

Economic Activity

The U.S. economy continued to trudge along in a generally positive direction during the quarter. The labor market also improved with job gains averaging about 202,000 over the past three months. In February, the labor force participation rate increased to 63%—its highest reading since September 2017. The larger issue in the labor markets has become the number of job openings, a shortage of quality labor to some extent, as openings reached 6.1 million in February. This statistic remained at historically high levels and January’s result was the highest on record. The unemployment rate has remained steady at 4.1% for six consecutive months, while the underemployment rate, a much broader measure of employment in the U.S., rose to 8.2% for the first two months of the quarter from its bottom of 7.9% in October 2017 before falling slightly to 8% in March.

Inflation data generally has been benign and unsurprising to fixed-income investors over the past few years, until early February when average hourly earnings came in at 2.9% versus the forecasted 2.5%. This surprising increase moved Treasury yields higher and was certainly a catalyst for the stock market correction in early February. Beyond that one-time data release, inflation has remained lukewarm. The change in the core inflation rate that the Fed watches closely most recently read 1.6%, which is well below the 2% target inflation rate. Lately, Fed officials have said they are more open to giving inflation a little room to run up without abruptly changing monetary policy.

Interest Rates

Fed officials continued on their path of gradually tightening monetary policy by increasing the target range for the federal-funds rate one-quarter of a percentage point to 1.50% to 1.75% at the March meeting of the FOMC. This was the sixth interest rate increase since the Fed took the benchmark rate to 0% in December 2008. We expect Fed officials to fulfill their projections for 2018, which call for a total of three rate increases, unless there is a surprise surge in inflation.

The tougher challenge for the Fed in 2019 will be to continue increasing the target rate without causing longer-term bond yields to rise. As the Fed has increased the target rate, the gap between the yield on short-term rates and that of long-term rates has continued to narrow. The Fed cannot raise the target rate beyond the ceiling that longer-term bond yields creates. Bond prices move in the opposite direction of yields.

The value of traditional fixed-income investments declined as interest rates rose throughout the first three months of 2018. During the first quarter, short-term interest rates reached their highest level since the great recession of 2008. The three-month LIBOR, the interest rate some of the world’s leading banks charge each other for short-term loans, reached its highest level since November 2008. The three-month LIBOR increased from 0.85% at the start of the fourth quarter of 2016 to 2.31% on March 29, 2018.

Periods of rising interest rates have greater impact on the prices of fixed-income investments with longer maturities, such as the 30-year Treasury bond, than those of fixed-income securities with shorter maturities, such as the two-year Treasury note. To illustrate the effect of rising interest rates on fixed-income investments consider that the price of a 30-year Treasury bond purchased on the last business day of December 2017 declined approximately -4.9% over the first quarter as the yield on the 30-year bond increased from 2.74% to 2.98%. For comparison, the yield on a two-year Treasury note purchased on the same day increased from 1.89% to 2.26% at quarter-end, but the price of the two-year note only fell -0.21%.

Strategy

The Fund maintains an effective duration that is much shorter than its benchmark. The Fund ended the first quarter with an effective duration of 2.52 years compared to the benchmark’s duration of 3.97 years, a slight decrease from 3.99 years in the fourth quarter of 2017. We reduced the Fund’s duration during the quarter by raising our allocation to floating-rate debt. Within the Fund, we continue to highlight the following: We don’t attempt to lower the Fund’s duration by investing in securities with shorter maturities; and we try to catch the upside to rising short-term rates by investing in floating-rate securities. These are primarily securities with approximate durations of 0.05 to 0.25, fixed-to-floating rate securities that are currently floating or are within three-years of floating, and government agency mortgage-backed securities with adjustable-rate mortgages.

The Fund’s overall allocation to securitized investments remained stable in the first quarter, but we reduced the Fund’s holdings of fixed-rate mortgage-backed securities and increased the Fund’s allocation to asset-backed securities and mortgage-backed securities with adjustable-rate mortgages. Asset-backed securities continue to be a more integral part of the Fund because we believe this is where we can find value and more yield for the Fund while still maintaining or improving credit quality and owning securitized cash flows.

The core of the Fund is currently invested in securities with effective durations of less than five years. For the Fund overall, 99.2% of its holdings have effective durations of less than six years. To offset the interest rate risk of bonds with longer maturities, the Fund is overweight relative to its benchmark in bonds with durations of less than three years. Our efforts have been directed toward maintaining the Fund in a favorable position based on our expectation that the Fed will continue to gradually raise the target rate to slightly below 3% by the end of 2019.

Thank you for the opportunity to manage a portion of your assets.

Sincerely,

Paul Gifford and Erik Clapsaddle

 

 

**Bloomberg Barclays US Intermediate Government/Credit Index is a broad-based flagship benchmark that measures the non-securitized component of the US Aggregate Index. It includes investment grade, U.S. dollar-denominated, fixed-rate Treasuries, government-related and corporate securities. You cannot invest directly in this or any index.

CFA® is a trademark owned by CFA Institute.

The investment objective of the Wasatch-1st Source Income Fund is to seek current income consistent with the preservation of capital.

Asset-backed securities are securities backed by loans, leases or receivables against assets other than real estate and mortgage-backed securities.

Effective duration is a measure of the responsiveness of a bond’s price to market interest rate changes. For example, if the interest rate increased 1%, a bond with an effective duration of five years would experience a decline in price of 5%.

The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.

The federal-funds target rate (also known as the fed-funds target rate) is set by a committee within the Federal Reserve System called The Federal Open Market Committee (FOMC). The FOMC usually meets every six weeks, and it is at these meetings that the FOMC votes on whether to make changes to the federal funds target rate.

The Federal Open Market Committee (FOMC), a component of the Federal Reserve System, is charged under United States law with overseeing the nation’s open market operations. Open market operations are the means of implementing monetary policy by which a central bank controls the short term interest rate and the supply of base money in an economy, and thus indirectly the total money supply.

The global financial crisis, also known as the financial crisis of 2007-09 and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

Fixed-to-floating preferred shares and bonds offer a steady yield for several years, then switch to a floating rate that keeps pace with market interest rates.

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or the federal-funds rate, plus a quoted spread (also known as a quoted margin). The spread is a rate that remains constant.

Government agency bonds are debt securities issued by a U.S. government-sponsored agency.

The great recession was an economic downturn experienced by the United States beginning in December 2007. The downturn is not described as a depression since the severity did not encompass the levels of the Great Depression of the 1930s.

LIBOR or ICE LIBOR stands for IntercontinentalExchange London Interbank Offered Rate. It is a benchmark interest rate that some of the world’s leading banks charge each other for short-term loans. LIBOR serves as the first step to calculating interest rates on various loans throughout the world.

Mortgage-backed securities are debt issues backed by a pool of mortgages. Investors receive payments from the interest and principal payments made on the underlying mortgages.

Investing in bonds, you are subject, but not limited to, the same interest rate, inflation and credit risk associated with the underlying bonds owned by the Fund. Return of principal is not guaranteed. Interest rate risk is the risk that a debt security’s value will decline due to changes in market interest rates. The interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Even though some interest-bearing securities offer a stable stream of income,their prices will fluctuate with changes in interest rates. Inflation risk is the possibility that inflation will reduce the purchasing power of a currency, and subsequently reduce the value of a security or asset, and may result in rising interest rates. Inflation is the overall upward price movement of goods and services in an economy that causes the value of a dollar to decline. Credit risk is the risk that the issuer of a debt security will fail to repay principal and interest on the security when due. Credit risk is affected by the issuer’s credit status, and is generally higher for non-investment grade securities.

  The Bloomberg Barclays US Intermediate Government/Credit Bond Index is an unmanaged index considered representative of the performance of government and corporate bonds with maturities of less than 10 years. 

You cannot invest directly in indexes.

View the Income Fund’s most current Top 10 Holdings

Portfolio holdings are subject to change at any time. References to specific securities should not be construed as recommendations by the Funds or their Advisor.

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CFA® is a trademark owned by CFA Institute.