Intermediate- and long-term U.S. Treasuries rallied in the second quarter, driving their yields lower and confounding market expectations for higher rates. The Treasury yield curve flattened as shorter-term rates held relatively steady or ticked upward slightly. The yield on the benchmark 10-year Treasury note fell nearly 0.20% over the quarter to finish at 2.53%. U.S. economic data over the quarter were decidedly mixed. Some signs of inflation began to appear, which alleviated deflation worries, and the unemployment rate declined. However, first-quarter gross domestic product (GDP) shrank at a 2.9% annualized rate, the weakest quarterly GDP reading in five years, which was attributed to severe winter weather. The Federal Reserve continued to wind down its monthly asset purchase program.
The U.S. Treasury Intermediate Fund returned 1.61% in the quarter compared with 1.75% for the Barclays U.S. 4−10 Year Treasury Bond Index and 2.59% for the Lipper General U.S. Treasury Funds Average. For the 12 months ended June 30, 2014, the fund returned 1.88% versus 2.37% for the Barclays U.S. 4−10 Year Treasury Bond Index and 3.36% for the Lipper General U.S. Treasury Funds Average. The fund's average annual total returns were 1.88%, 3.97%, and 4.64% for the 1-, 5-, and 10-year periods, respectively, as of June 30, 2014. The fund's expense ratio was 0.49% as of its fiscal year ended May 31, 2013.
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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.
The fund invests at least 80% of its assets in Treasuries but maintains small positions in securities backed by the U.S. government, including Treasury inflation protected securities (TIPS) and Ginnie Mae mortgage-backed securities (MBS). TIPS provide some inflation protection, while our MBS holdings provide added yield over Treasuries, decent liquidity, and diversification for the fund. The fund's duration, which measures its sensitivity to changes in interest rates, was shorter relative to the benchmark, as we stayed on the defensive against the risk of rising rates given the improving U.S. economy and a less accommodative Fed.
We expect that the economy will rebound from its first-quarter slowdown and rates will trend higher. With labor market slack diminishing and wage inflation starting to increase, it is possible that the Fed may raise short-term interest rates earlier than expected. The Fed's own forecasts suggest that short-term interest rates will move higher in mid-2015. Two- and five-year Treasury yields might experience the largest increases as the first rate hike approaches and the market gauges the pace of subsequent Fed rate changes. While we have some flexibility to manage interest rate risk by keeping the fund's average duration shorter than that of its benchmark, rising rates generally result in price declines for bonds. Our mandate of investing in intermediate-term securities puts the fund at risk of generating negative total returns should interest rates markedly rise.