Mortgage-backed securities (MBS) posted solid returns in the fourth quarter despite the Federal Reserve ending its purchases of MBS in October. The asset class benefited from a lack of direct exposure to commodities and energy as plunging oil prices dragged down returns in several other fixed income segments. Shorter-term U.S. Treasury yields rose in anticipation of the start of the Fed's policy tightening, which we believe is likely later this year. The yield on the 10-year Treasury note declined significantly amid strong demand for relatively high-yielding U.S. government debt, contributing to a flattening in the overall Treasury yield curve. The MBS yield curve also flattened.
The GNMA Fund returned 1.16% in the quarter compared with 1.60% for the Barclays U.S. GNMA Index and 1.13% for the Lipper GNMA Funds Average. For the 12 months ended December 31, 2014, the fund returned 5.42% versus 5.97% for the Barclays U.S. GNMA Index and 5.04% for the Lipper GNMA Funds Average. The fund's average annual total returns were 5.42%, 3.70%, and 4.35% for the 1-, 5-, and 10-year periods, respectively, as of December 31, 2014. The fund's expense ratio was 0.61% as of its fiscal year ended May 31, 2014.
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Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results.
Share price, principal value, and return will vary and you may have a gain or loss when you sell your shares.
We build the overall portfolio with the goal of providing shareholders with the most attractive risk- appropriate opportunities in the market, focusing on segments of the MBS market that offer compelling relative value. We reduced our underweight to intermediate-term MBS as rates in that segment became more attractive relative to short- and long-term MBS. The portfolio holds some out-of-benchmark allocations, such as Fannie Mae MBS that made a positive contribution to performance. However, we eliminated a small position in Treasury inflation-protected securities as inflation indicators softened. Although we reduced the portfolio's interest rate sensitivity in October when Treasury yields declined sharply, we later increased it to be approximately neutral relative to the benchmark.
The Fed is likely on track to raise rates in mid-2015 despite the drop in energy prices putting downward pressure on inflation. Even with the Fed poised to raise rates, we expect the pace of monetary tightening to be moderate. However, the Fed's responses to changing economic data could trigger elevated interest rate volatility. We think that the larger risks to the GNMA market include changes in how the Fed communicates its strategy for its large holdings of MBS and the timing of when the central bank will eventually stop reinvesting the proceeds from its portfolio back into the market.