The third quarter of 2026 was defined by one central theme. Markets increasingly accepted that interest rates are likely to remain higher for longer. Earlier in the year, investors anticipated inflation would continue moderating and central banks would eventually begin easing policy. Instead, inflation proved more persistent than expected. Higher energy prices, resilient economic growth and continued consumer spending forced markets to reassess the outlook for both inflation and rates.
That shift became most apparent in September, when the US Federal Reserve raised its policy rate by 25 basis points to 4%. Bond markets reacted swiftly, with a ten year US Treasury yield moving above 5%, reaching levels we haven't seen in nearly two decades. Long term yields rose enough that the US Treasury increased purchases of longer dated bonds in an effort to contain upward pressure on borrowing costs.
While those actions provided some support, they did little to change the broader reality that investors are demanding higher yields to compensate for inflation risk and growing government debt burdens. Now, looking forward, we believe another
Federal Reserve rate increase remains more likely than a rate cut. However, we think an additional move before the US midterm elections is unlikely. Our expectation remains that the fed stays on hold through November before reassessing conditions later in the year.
Now the situation in Canada is somewhat different. The Bank of Canada maintained its policy rate at 2.25% throughout the quarter, while balancing above target inflation against increasingly fragile economic growth. Employment trends have weakened, consumer activity is slowing, and economic growth has become more uneven. While the Federal Reserve remains focused on controlling inflation, the Bank of Canada faces the additional challenge of a softer domestic economy.
Against this backdrop, fixed income markets experienced a difficult quarter. Rise in government bond yields created pressure across most traditional bond sectors, particularly longer duration securities. Credit markets, however, remained relatively stable, supported by healthy corporate balance sheets and continued economic resilience. Matco’s Diversified Income Fund returned -2.8% during the third quarter outperforming its benchmark by 0.2%. Year to date, the fund has returned negative 0.3%, outperforming the benchmark by 50 basis points and ranking in 15th percentile in its peer group. With absolute returns challenged by rising rates, we are encouraged the fund's relative performance during one of the most difficult environments for fixed income investors in recent years.
Now, from a portfolio management perspective. We continue to position the fund conservatively. Most notably, we further reduced exposure to the long end of the yield curve, where we believe investors are not being adequately compensated for both inflation and duration risk. Within the dividend equity sleeve, we exited our position in Telus prior to its quarterly earnings release and subsequent dividend reduction, we redeployed that capital into Canadian Utilities Fortis and Enbridge.
These businesses operate essential infrastructure assets, generate stable cash flows, and have long histories of paying and growing dividends.
As of September 30th, the fund's diversified sector exposure is: 25% in federal bonds, 25% in provincial bonds, 10% invested in a mortgage investment solution and 3% in dividend paying equities, and lastly, 1% in cash. The portfolio continues to generate a yield of approximately 4.4%, providing attractive income while maintaining a focus on capital preservation and diversification. Looking ahead, inflation remains the key variable for markets.
While it has declined significantly from its peak. Progress has slowed and central banks remain cautious. We do expect higher interest rate environment that investors experience through much of the previous decade. One of the more significant shifts occurring today is within fixed income itself. For years, investors operated under the acronym TINA, which used to stand for “There Is No Alternative”.
Interest rates were so low that meaningful returns often required taking on stock market risk. That environment is changing and in fact has changed. While we do not believe interest rates have fully peaked, TINA has left the building. High quality bonds, mortgages and corporate credit once again are providing attractive yields and offer investors a credible alternative to equities for generating returns.
We believe this is becoming one of the more compelling environments for income oriented investors in many years, as it becomes more attractive. We remain hyper vigilant and focused on generating reliable, income preserving capital while maintaining broad diversification across the segments of the income market. We believe the fund is well positioned to navigate this landscape, while continuing to deliver on its long term objectives.
