Active approach to navigating the credit market

Fixed income market overview

While the stage is set for stronger growth in Corporate America, the turn hasn’t happened yet. The U. S. Federal Reserve’s (Fed) series of interest rate cuts in 2019 was a reaction to slowing economic growth both in the U.S. and China, reduced business spending, plateauing corporate earnings growth and anticipation of instability driven by the trade war.

Manufacturing continues to struggle, with weakness in energy and trade putting a damper on investment. In addition, a historically low unemployment rate is making it challenging for many companies to add the workers they need to scale up production.

In our view, fixed income investors are more likely to detect recessions before other market followers. One warning sign fixed income investors saw in 2019 was a series of yield curve inversions, locking in lower yields on long-term Treasury notes while demanding higher yields from short-term Treasury bills. Historically, inverted yield curves have predated recessions.

The decade-long bull market could make a strong case for passive investing in equities. Now, this same sentiment may convince fixed income investors to do the same. However, we would argue equating passively managed equity investing with passive fixed income investing is like comparing apples to oranges.

The one-size-fits-all attraction of passive fixed income strategies can expose investors to greater risks than those associated with equity index funds.

The average option-adjusted spread (OAS) stands at approximately 75% of the 10-year average for Bloomberg Barclays U.S. Aggregate Corporate Index, the Fund’s benchmark, despite the fact that the credit quality of the index deteriorated dramatically over that time. The BBB-rated weight within the index has risen by nearly 15% over that time to over half of the investment grade universe.

The current credit cycle is much closer to its end than its beginning. Fortunately, credit markets are resilient, dynamic and often provide opportunity to investors who prefer to not run with the herd. The key to being prepared for the next slowdown is to rely on the fundamentals of credit investing, recognizing that credit rating or benchmark weight has limited correlation to actual risk in difficult markets.

The case for a more nimble approach

We believe there are fundamental flaws with major credit indices because the basic premise upon which these credit indices are constructed is inadequate. The concept that a higher debt load results in a larger index weighting is offensive to even the most novice credit investor. Unlike the major equity indices, which are largely a reflection of the market’s valuation of expected company earnings capacity, fixed income benchmarks reward aggregate debt. Given the massive increase in debt issuance over the past 10 years, this should be very concerning to credit market participants. In fact, the Bloomberg Barclays U.S. Aggregate Bond Index raised the minimum debt criteria in 2017 from $250 million to $300 million as increased incentive to profligate borrowing.

Chart Showing OPTION-ADJUSTED SPREAD (OAS) % OF 10-YEAR AVG AND BBB% OF IG CORPORATES
Chart Showing OPTION-ADJUSTED SPREAD (OAS) % OF 10-YEAR AVG AND BBB% OF IG CORPORATES

Source: Bloomberg Barclays, Securian Asset Management, Inc. Illustrates the degradation in credit quality despite tightening credit spreads, 2009-2019. Past performance is no guarantee of future results.

Furthermore, the idea that fixed income indices are “passive” is largely a fairytale. Certainly, the financial capacity of any company to service its nominal debt load must be considered in determining its credit worthiness. Rating agencies make active decisions that impact which issuers will be included within a particular index and which ones will be left out. The credit rating decision is very much arbitrary and very much active. For example, giving one company years to reduce debt after a large acquisition while penalizing another immediately. They may see one industry as more defensive than another or give credit to companies that have larger scale while penalizing those that are smaller. Given the performance of the rating agencies, particularly in times of turmoil, there should be little comfort in credit ratings.

The critical flaws of the benchmark framework have been exacerbated by increased dependence upon them since the last recession. Behemoth asset managers in fixed income markets have increased the risk to investors. Their sheer size, a limited market liquidity environment and the comparative ease of modeling larger benchmark securities has resulted in a crowding effect in large capital structures. The increased adoption of passive investment vehicles to gain quick exposure to fixed income markets has also increased the risk to investors.

This increasing credit risk reduces the overall credit quality of passive funds that track to the Bloomberg Barclays U.S. Aggregate Bond Index. Why? Because their mandates often restrict deviations from the index. This means they must take on the added debt of constituent companies, even if their underlying fundamentals are weakening.

Among active fixed income managers, smaller fixed income managers whose funds have a nimble level of assets relative to behemoth fund complexes can have certain advantages. They’re not pressured to hold hundreds or thousands of positions to keep the portfolio fully invested. Smaller fixed income managers are able to take advantage of offbenchmark credit opportunities by applying an active, fundamental approach to reviewing credit and not being tied to only holding securities that are held in the benchmark. Flexibility in portfolio construction allows for the ability to select bonds and structured securities that offer greater opportunities for yield and avoid companies that are potentially overly indebted.

Why this matters for long-term investors

It is easier for nimble fixed income managers to efficiently focus on the smaller end of the fixed income market for the potential of better risk-adjusted returns. Because they’re not bound by broad index constraints, the smaller managers can rely on their own proprietary research tools to manage credit risk and identify yield opportunities. They can identify yield premiums by using technical analysis to identify dislocation and mispricing opportunities within sectors or among individual securities. In addition, their mandates often allow them to take advantage of yield premiums offered by private placements and other alternative investments. And when recessions occur, their smaller portfolios often enable them to exit positions more efficiently and thoughtfully than larger firms that must quickly make hundreds of trading decisions to generate liquidity to accommodate outflows.

An example is in the structured market with Credit Risk Transfer (CRT) Bonds. CRTs were created in 2013 to transfer portions of risk from conventional residential mortgage loans backed by government-sponsored agencies, such as Fannie Mae and Federal Home Loan Mortgage Corporation (Freddie Mac), to private sector investors. These are unsecured general debt obligations, with principal and interest payments made on them monthly by the issuing government-sponsored agency. They have a floating rate of payment indexed to the 1-month LIBOR rate and a maturity of either 10 or 12.5 years.

In general, we use fundamental bottom-up research and seek to add value to the portfolio through security selection. We have been an investor in residential credit for many years. In selecting CRT bonds, we employ scenario analysis to stress the bonds under a range of economic environments by shifting several variables (i.e. prepayment speeds, defaults rates, and recoveries). In addition, these bonds provide the portfolio with consumer credit exposure, which is an important source of diversification away from corporate credit. We find the CRTs to be a fit within our portfolio because, on average, they tend to offer borrowers with excellent credit scores, geographically diverse home ownership locations and floating rate coupons, which benefit during periods of rising interest rates.

Summary

An uncertain fixed income market favors managers who can be nimble and selective and focus on finding yield premiums and higher credit quality outside the larger issuer universe. For example, right now, bonds from highly rated (A to A-) smaller issuers offer a yield premium ranging from 9 to 41 basis points higher than their larger counterparts. Some of this yield premium reflects the overall lack of market efficiency in the small end of the market. With mainstream investors favoring larger issuers, bonds from smaller companies are often undervalued, providing open-minded fixed income investors with opportunities to selectively exploit these opportunities.

When the economy is on a roll and markets are rising, investing in passive funds and active index-huggers may seem like the thing to do. However, when warning signs like weakening fundamentals and declining credit quality rear their ugly heads, prudent fixed income investors may be better off shifting some of their assets to smaller, more nimble fixed income asset managers who may be better prepared to weather the approaching storm.

Bloomberg Barclays
Index Credit Rating
# of Issuers
Option-Adjusted Spread (basis points)
   
All Issuers
Less than $5B
(Small Issuer)
$5 - $20B (Medium Issuer)
Greater than $20B (Large Issuer)
Small-Large Premium
A+ to A- 973 109 125 108 102 23
A+ 206 96 122 100 81 41
A 424 105 122 104 97 25
A- 343 122 129 119 120 9

Source: Bloomberg Barclays U.S. Aggregate Corporate Bond Index and Securian Asset Management, Inc.
Chart looks at the aggregate amount of debt outstanding by issuer and the OAS on each index-eligible issue. Past performance is no guarentee of future results.


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Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through February 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpyment of interest or principal than higher-rated bonds. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

The Bloomberg Barclays U.S. Aggregate Bond Index is market capitalization weighted index, representing most U.S. traded investment grade bonds. It is not possible to invest directly in an index.

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As the current market expansion continues to mature, the one size fits all attraction of some passively managed fixed income strategies could expose investors to a greater variety of risks than their equity counterparts. We believe in a more nimble approach.

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- The key to managing the next downturn is to rely on the fundamentals of credit investing.
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Ivy Securian Core Bond Fund

Market Sector Update

  • Markets went into full risk on mode in the fourth quarter. While strong returns early in the year were a make up for a dismal fourth quarter 2018, market action in the last quarter of 2019 was an unambiguous scramble for returns. The success of the Federal Reserve’s (Fed) mid-cycle adjustment convinced investors that they can have their cake and eat it too in the form of lower rates and strong stock returns. The fourth quarter marked a definite breakout as the S&P 500 Index gained over 9%, led by cyclical sectors like information technology and financials as investors shunned income producers like real estate and utilities. The S&P 500 index produced a total return of more than 31% for the year.
  • While the economy may have showed further slowing in the fourth quarter, market participants gained confidence that the worst may be over in the trade tensions between China and the U.S., as the two parties closed in on the first phase of a trade deal to finish the year. The consumer showed no real signs of impending weakness as the job market remained healthy with the unemployment rate at a 50-year low and average hourly earnings continuing to come in excess of 3%. Consumer confidence bounced back and the savings rate remained near a healthy 8% level. Also, we started to see signs that the worst may be over for growth in other developed economies around the world.
  • Much of the bullish tone can also be attributed to the Fed’s ability to convince the market that the central bank’s three “insurance cuts” in 2019 were effective and that no further action was necessary. More importantly, the Fed’s dovish commentary regarding its inflation target really got the markets excited. The Fed has acknowledged that it has had difficulty getting inflation to meet its 2% target, and Chairman Jerome Powell announced in November the central back was “strongly committed to symmetrically and sustainably achieving our 2% inflation objective…over time.” Other Fed officials have said that a period of time above 2% would be fine before any Fed hikes would be instituted. This is quite a turnaround from a little over a year ago, when Powell uttered his infamous “we’re on autopilot” comment in regards to further Fed hikes.
  • The Fed’s actions had the effect of tempering returns in the bond market in the fourth quarter as the U.S. treasury yield curve regained its normal positive slope as short rates followed the decline in the federal funds rate and longer rates rose during the quarter. Still, bonds delivered strong returns for the year as rates for long treasury securities fell by over 60 basis points (bps) during 2019. Treasuries produced returns close to 7% for the year.
  • GCredit spreads fell to near post-crisis lows during the quarter with the Bloomberg Barclays U.S. Aggregate Corporate Index, the Fund’s benchmark, average spread finishing tighter on the year. Investment-grade corporate- and high-yield bonds joined long treasuries in producing solid double digit returns for the year. Returns of investment grade corporates relative to Treasuries were up over 2% in the quarter, and up almost 7% for the year. Long corporates did exceptionally well, producing excess returns of almost 5% in the fourth quarter and close to 12% for the year. On the other hand, the securitized sector produced little in the way of excess returns for the quarter or for the full year, as the market was all about chasing lower quality spread and duration.

Portfolio Strategy

  • The Fund outperformed its benchmark for the quarter. The Fund experienced positive results from security selection, particularly from positions in the financials and utilities sectors, as well as agency Mortgage-Back Securities (MBS) and asset-backed securities (ABS) sectors. An overweight allocation to ABS negatively impacted the Fund, as well as an underweight allocation to agency MBS. The Fund’s interest rate exposure and yield curve positioning had a slightly positive impact on performance for the period.
  • In terms of duration contribution from corporate bonds, the portfolio remains most exposed to credits in the utilities, consumer non-cyclicals, energy, transportation and financials sectors relative to the index. The largest underweights from a market weight perspective in the corporate space are in industrials, including technology, capital goods, and consumer non-cyclicals, as well as real estate investment trusts in the financials space.
  • AStructured exposure fell as a percentage of the Fund’s net asset value during the period, primarily through monthly principal pay downs in ABS, as well as agency and non-agency MBS. Proceeds were reinvested primarily in Treasuries. The portfolio remains overweight ABS, CMBS and non-agency MBS, and underweight agency MBS.
  • The relative overall duration of the Fund fell slightly during the quarter.

Outlook

  • While the stage is set for stronger growth in corporate America, the turn hasn’t happened yet. Manufacturing continues to struggle, with weakness in energy and trade putting a damper on investment. The outlook looks brighter for 2020 as shocks from tariffs and a shakeout in energy recede. Earnings should improve on more stable global growth and easier comparisons. With unemployment at a nearly 50-year low, a recession next year seems unlikely.
  • A big question on investors’ minds is whether 2019’s extraordinary returns are justified or if we’ve simply pulled future returns forward. We previously acknowledged that if the Fed’s insurance cuts were effective, conditions could be good for risk assets. This scenario certainly was realized. Now, the market appears to be pricing in a return to a Goldilocks economy where both growth and inflation are measured. This could set the stage for continued demand for risk assets. The Fed is on hold, and the record expansion is set to extend through next year. Rhetoric around Brexit and trade has become more positive, calming markets in the near term. U.S. assets remain in demand in a low-growth, low-interest rate environment.
  • While we can identify much strength, these factors are tempered by real risks. A trade deal is good, but it’s unlikely to produce steadily expanding global flows. Labor markets are tight, corporate margins peaked in 2018, and corporate leverage is high. Nationalistic populism remains on the rise, and we believe that political risks will remain elevated. Late cycle growth of around 2% is good, but provides little room for error. The Fed’s three rate cuts in 2019 used dry powder, increasing concerns about how policy makers will counter the next downturn. With valuations stretched, we continue to think that bursts of volatility are likely in the coming year, placing a premium on risk management and investment discipline.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

All information is based on Class I shares.

The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-cap U.S. equity market. The index includes 500 of the top companies in leading industries of the U.S. economy. It is not possible to invest directly in an index.

The Bloomberg Barclays U.S. Aggregate Bond Index is market capitalization weighted index, representing most U.S. traded investment grade bonds. It is not possible to invest directly in an index.

Duration is a measure of a security's price sensitivity to changes in interest rates. A fund with a longer average duration generally can be expected to be more sensitive to interest rate changes than a fund with a shorter average duration.

Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. These and other risks are more fully described in the Fund's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.

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Ivy International Small Cap Fund

Market Sector Update

  • International small-cap equities delivered a strong positive return during the quarter. Equity market performance was driven by increasing optimism on U.S.-China trade, which culminated in an agreement on Phase 1 of the trade deal in late December. The U.K. election results were well received by the market, giving the ruling Conservative party a clear exit mandate and thereby removing some of the uncertainty tied to Brexit. However, negotiations on the future trading relationship with the European Union are likely to result in further volatility through 2020.
  • Christine Lagarde commenced her eight-year term as the president of the European Central Bank (ECB) during the quarter and has maintained the dovish rhetoric of her predecessor Mario Draghi. She has also been using her platform to push for a concerted fiscal stimulus in the euro area, which she believes would help speed up growth in the region. Achieving consensus on any such package is likely to be a challenging and lengthy process.
  • All sectors were positive for the quarter with the strongest performing sectors being information technology, consumer discretionary and industrials.

Portfolio Strategy

  • The Fund produced positive performance but underperformed its benchmark for the period. At the country level, stock selection in Australia, the U.K. and Ireland contributed to relative performance, while stock selection in Germany, Spain and France detracted from relative performance.
  • Top relative individual contributors to performance for the period included Games Workshop Group plc, a U.K.-based game and leisure products company; Kobe Bussan Co. Ltd., a Japan-based discount grocery store chain; and Future plc, a U.K.-based media company.
  • Top relative individual detractors to performance for the period included OSG Corp., a Japan-based machine-tool maker; SG Holdings Co. Ltd., a Japan-based delivery and logistics company; Sensyne Health plc, a U.K. health care company; and Almirall S.A., a Spanish-based health care company.
  • Portfolio changes within the Asia-Pacific region over the quarter included the addition of Japan karaoke equipment and venue operator Daiichikosho Co. Ltd. We like the company for its strong incumbent position in the karaoke industry with high barriers to entry. The company recently launched a new range of products which has been well received, and we believe the potential growth is not reflected in its valuation. In Hong Kong, HKBN Ltd., a provider of fixed broadband internet, was also added. We believe HKBN can continue to take market share from larger incumbents, particularly within the commercial market segment. We believe the stock provides a very attractive dividend and we look favorably on the incentives in place for management and employees to increase shareholder value. The Fund’s position in Taiyo Nippon Sanso Corp. was sold after a period of strong performance. We felt the company’s valuation left little room for outperformance.
  • Portfolio changes in Europe over the quarter included the initiation of a position in Breedon Group plc, the largest independent construction materials producer in the U.K. and Ireland. The company has displayed strong operational delivery over the last three years, despite a difficult market backdrop. With some of the uncertainty regarding Brexit removed, we believe corporations should be increasingly willing to increase capital investment, while the U.K. government’s commitment to substantially increase infrastructure spending may also be a tailwind for Breedon. In addition to organic progression, the group also has a robust balance sheet and a strong track record in mergers and acquisitions, leaving it well positioned to continue the consolidation of the U.K. aggregates market in our view.
  • We also added CD Projekt S.A., a video game developer and publisher, which we feel is well positioned to benefit from the continued secular growth of video gaming through strong franchises. Furthermore, we believe the market substantially underappreciates the potential unit sales of the upcoming release of CyberPunk 2077, and we also believe the market is conservative on the benefit from increased digital penetration.

Outlook

  • With the outcome of U.S.-China trade negotiations now largely known and discounted by markets, we look for macroeconomic data to improve as lower long-term interest rates and sentiment feed through to economic activity. However, given the strong performance of equity markets to this point, we see upside and downside risks over the near term as balanced.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.Past performance is not a guarantee of future results.

Effective Feb. 21, 2019, Ivy IG International Small Cap Fund was renamed Ivy International Small Cap Fund. Additionally, the name of the sub-adviser changed from I.G. International Management Limited to Mackenzie Investments Europe Limited. Mackenzie Investments Europe Limited delegates to its subsidiary, Mackenzie Investments Asia Limited, for additional portfolio management responsibilities. References to Mackenzie Investments Europe Limited include both entities.

Top 10 equity holdings as a percent of net assets as of 12/31/2019: Rubis Group 2.4%, Logitech International S.A., Registered Shares 2.3%, Future plc 2.3%, Teleperformance SE 2.1%, ARTERIA Networks Corp. 2.0%, TechnoPro Holdings, Inc. 2.0%, SCSK Corp. 1.9%, Manulife U.S. REIT 1.9%, Sixt SE 1.9% and Games Workshop Group plc 1.8%.

All information is based on Class I shares.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in small-cap stocks may carry more risk than investing in stocks of larger more well-established companies. The value of a security believed by the Fund’s manager to be undervalued may never reach what the manager believes to be its full value, or such security’s value may decrease. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

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Ivy Global Equity Income Fund

Market Sector Update

  • The quarter saw a sharp increase in optimism on a trade resolution and signs of a bottoming of global purchasing managers (factory) indices, which had been signaling a possible recession.
  • The manufacturing part of the world’s economy has dramatically slowed but this has been more than offset by a solid services economy. Many segments within the industrial economies of the U.S. and Europe are now in a technical recession. The Fund’s benchmark index was up strongly during the quarter and U.S. equity markets hit all-time highs. Much of the market’s return this year has been via multiple expansion rather than faster earnings growth. There is a strong belief that global growth, which has recently slowed, has now bottomed.
  • The best performing sectors were health care, industrials, materials and information technology. In a reversal from the third quarter, utilities, consumer staples and communication services were the worst performing sectors during the quarter.

Portfolio Strategy

  • The Fund posted positive performance and performed in line with its benchmark this quarter. Stock selection benefitted relative performance, while sector and country allocation hurt relative performance during the period. Currency effects benefitted performance for the period.
  • From a sector allocation perspective, the Fund’s overweight position in consumer staples was a drag to relative performance, while the Fund’s overweight position in information technology helped performance.
  • Stock selection was most positive in information technology, financials and materials, while selection in health care, industrials and consumer staples were a drag on relative performance. Geographically, stock selection was positive in Asia-Pacific ex Japan and in the U.S., while negative in Europe.
  • We are currently overweight information technology, consumer staples, health care and energy, while underweight financials, consumer discretionary and communication services. During the quarter, we lowered our overweight in consumer staples as we believe valuations relative to fundamentals were no longer as favorable. We added to health care as we believe several stocks were mispriced/undervalued due to an overreaction of negative sentiment surrounding health care/drug price reform. While U.S drug pricing is facing downward pressure, reform will depend on the political outcome post the November Presidential election.
  • Our investment approach remains steadfastly focused on investing in what we believe are quality businesses with favorable near and intermediate fundamentals, generally rising dividends and attractive valuations. This approach is consistent across sectors and geographies. The core of our approach is based on stock selection as the key driver of portfolio inclusion and construction. As such, we do not significantly adjust portfolio positioning based on our shortterm economic outlook or other factors that could impact a company’s earnings outlook over the short run. However, a core part of our focus is on finding quality businesses that we believe are mispriced due to these shorter-term market dislocations or other factors that the market has underappreciated.

Outlook

  • Last quarter, our view was that global growth was clearly slowing due to the direct impact and broader uncertainty created by U.S.-China trade uncertainty. Our belief was the pressure this was creating would drive the U.S. and China to reach a phase one agreement, likely limited in scope that would lift market uncertainty, help drive market stabilization and potentially reaccelerate economic growth. It looks as though this will likely happen as a phase one trade deal is scheduled to be signed early in 2020. Accompany a trade deal with stimulus from governments and central banks, we believe the global economy should regain some confidence and gather strength.
  • We will continue to focus new Fund positions to those securities we believe are both attractively valued and have company specific drivers that allow them to perform well despite broader slow to moderate global growth environment.
  • Trade disputes with China will continue, and in our view, will result in more uncertainty for corporations impacted by global trade. This has the potential to further earnings volatility in impacted sectors. Global employment growth has slowed, but consumer spending dynamics have been resilient. We believe consumer balance sheets and savings levels currently offer a cushion to consumption and therefore to overall earnings and economic growth. Under this set of events, the overall market appears reasonably valued, though different industries and corporations have different implied fundamentals that may offer opportunities for those with free cash flow and solid dividends.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

All information is based on Class I shares.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Dividend-paying investments may not experience the same price appreciation as non-dividend paying instruments. Dividend-paying companies may choose to not pay a dividend or the dividend may be less than expected.These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

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Ivy Apollo Multi-Asset Income Fund

Market Sector Update

  • Financial markets reacted positively during the quarter as political conflicts, trade uncertainty and global economic growth concerns waned late in the year. Global equity markets delivered strong returns for the quarter. The macro environment stabilized with indicators of growth in both China and Europe improving, although slowly. The U.S. and China announced Phase 1 of a trade deal, the U.S. House of Representatives approved the U.S.-Mexico-Canada Agreement (USMCA) and passed it to the Senate for approval, U.K. Prime Minister Boris Johnson’s party won an election that kept him in power and reduced uncertainty about the planned Brexit, and the U.S. Federal Reserve (Fed) made it clear that it is unlikely to increase interest rates in 2020.
  • The normalization of the Fed’s balance sheet ended in the third quarter as it stated it would reinvest maturing U.S. Treasuries and mortgage-backed securities. The Fed also announced it would start expanding its balance sheet to better align it with the size of nominal gross domestic product (GDP). It cut the fed funds rate 25 basis points (bp) in October to 1.50%. In addition, the Fed injected cash into the system to calm year-end funding pressures because of stress during the quarter in the short-term funding, or “repo,” market.
  • During the previous quarter, the European Central Bank (ECB) and Bank of China started loosening monetary conditions by cutting deposit rates, strengthening forward guidance, relaunching asset purchase programs and reducing reserve requirements for the banking industries. This quarter, there was a change in leadership at the ECB with Christine Lagarde taking over as president. She has hinted at more of a fiscal response to the lack of growth in the region with a continuation of the easy monetary policies.
  • The U.S. Treasuries yield curve steepened 30 bp with renewed growth prospects as 2-year Treasuries remained range bound and 10-year Treasuries declined approximately 25 bp. Credit spreads narrowed in the high grade, high yield and emerging markets over the course of the quarter.
  • Global real estate securities outperformed global bond indices, but trailed the broader equity market for the period. They produced solid absolute returns in the quarter as risk assets benefitted from receding trade and political tensions, accommodative monetary policy and stabilizing leading economic indicators.
  • By switching their focus from tight labor markets and accelerating wage growth to slowing economies and softening inflation expectations, policymakers in our view are trying to create a backdrop for lower volatility.

Portfolio Strategy

  • The Fund had a positive return for the quarter but trailed the returns of its blended benchmark and Morningstar category.
  • About 48% of the portfolio was allocated to equity at the end of the quarter. The Fund’s equity holdings were the largest contributors to performance in the quarter, led by allocations to the financials, information technology, energy, real estate and materials sectors.
  • The allocation to high yield corporate fixed income securities also was a key contributor to performance, as spreads in this sector tightened relative to other higher quality credits. The Fund’s shorter relative duration also helped its performance because the yield curve steepened during the quarter.
  • With renewed global growth prospects, the U.S. dollar weakened during the quarter against other developed market currencies, with the U.K. pound and the euro gaining 8% and 2.8%, respectively. The Fund’s U.S. dollar exposure of about 70% was a detractor from its relative performance.
  • We continue to seek opportunities to reduce volatility in the Fund. We also have continued a low-duration strategy, as we feel it allows us a higher degree of certainty about those companies in which we can invest.
  • The Fund also continued to hold a higher level of liquidity in the quarter. We will be opportunistic in allocating that capital as we find dislocations in the market.

Outlook

  • The Fed’s interest rate cuts in 2019 paid out with strong support in the interest-sensitive segments of household activity. The benefit of lower rates continues to support the U.S. economy and counteract the loss of the “tailwind” supplied by tax cuts implemented in late 2017. We think exports and business investment will stabilize and rise from very low levels on the likely implementation of USMCA and phase one of a trade deal with China. We think the Fed will remain on hold throughout the first half of 2020 and watch to see if inflationary pressures build from an ever-tightening labor market. The U.S. budget deficit has touched $1.0 trillion and we expect deficit spending to continue.
  • Fundamentals in the credit markets remain stretched, with balance sheets still leveraged and debt levels at historic levels. Technical factors in credit are supported by international investors searching for yield, domestic demand for income and “reverse Yankee” issuance to tender for U.S. issues. A “reverse Yankee” refers to a company issuing debt in Europe at extremely low rates, taking the proceeds in euros, changing them into U.S. dollars and then tendering for the higher yielding dollar securities. It means fewer issues to buy for U.S. investors and the resulting supply/demand issue tends to compress spreads – which is considered a positive technical factor.
  • Given the current levels of credit spreads and our expectation for modest widening of these spreads during 2020, we believe our conservative positioning relative to the benchmark is appropriate. We will be opportunistic about our credit selection and overall positioning in order to seek to take advantage of perceived opportunities and dislocations as they present themselves.
  • Real estate operating fundamentals remain solid across much of the globe as most companies remain well positioned with high-quality asset portfolios, flexible financial positions and attractive access to capital. We believe low interest rates, steady economic growth and easier financial conditions could continue to support a stable operating environment for real estate securities and values.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

All information is based on Class I shares.

The Fund is managed by Ivy Investment Management Company. The total return strategy is sub-advised by Apollo Credit Management, LLC and the global real estate strategy is sub-advised by LaSalle Investment Management Securities, LLC.

Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. Although asset allocation among different sleeves and asset categories generally tends to limit risk and exposure to any one sleeve, the risk remains that the allocation of assets may skew toward a sleeve that performs poorly relative to the Fund's other sleeves, or to the market as a whole, which would result in the Fund performing poorly. While Ivy Investment Management Company (IICO) monitors the investments of Apollo Credit Management (Apollo) in addition to the overall management of the Fund, including rebalancing the Fund's target allocations, IICO and Apollo make investment decisions for their investment sleeves independently from one another. It is possible that the investment styles used by IICO or Apollo will not always complement each other, which could adversely affect the performance of the Fund. As a result, the Fund's aggregate exposure to a particular industry or group of industries, or to a single issuer, could unintentionally be larger or smaller than intended. Investment risks associated with investing in real estate securities, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes and differences in real estate market values. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed-income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Loans (including loan assignments, loan participations and other loan instruments) carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loans may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

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Ivy Crossover Credit Fund

Market Sector Update

  • The fourth quarter saw strong returns across risk asset classes as trade tensions eased significantly between the U.S. and China, Brexit appeared headed toward a benign outcome and macro data strengthened. The equity market had an impressive high-single-digit return in the quarter.
  • Given the reduction in macro and geopolitical risks, U.S. Treasuries sold off during the quarter with the yield on the 10-year U.S. Treasury climbing 26 basis points (bps) from 1.66% to 1.92%. The yield on the 2-year U.S. Treasury fell 5 bps from 1.62% to 1.57% as the Federal Reserve (Fed) cut rates by 25 bps in the quarter to a target range of 1.50-1.75%. The market have priced in more than 60% odds of one additional rate cut in 2020. The yield curve steepened in the quarter with the difference between the 10-year U.S. Treasury note and the 2-year U.S. Treasury note rising 30 bps to 34 bps.
  • The spread of the funds benchmark, the Bloomberg Barclays U.S. Corporate Bond Index, tightened from 115bps to 93bps in the quarter, marking the tightest level for the index since early 2018. High yield continued to deliver solid gains in the quarter returning 2.62% with the spread on the high yield index tightening from 373 bps to 336 bps. The full-year return for the asset class was 14.32%.
  • After CCC-rated credits lagged returns of BB and B in previous quarters, they outperformed in the fourth quarter returning 3.73% versus 2.45% and 2.61% for BB and B, respectively. We believe this is a sign of a more broad-based risk-on environment compared to the prior three quarters. Leveraged loans underperformed high yield as they have done all year with the index returning 1.68%, with a full-year return of 8.17%.
  • Debt growth in the investment grade universe, excluding the volatile commodity sectors, slowed to 4.3% in the third quarter of 2019 compared to last year, its slowest pace since 2011. The same universe saw a slowdown in EBITDA growth to 2%, resulting in leverage of 3.1-times, flat sequentially, and up 0.1-time year over year. Despite concerns over the BBB space recently, BBB leverage has declined 0.1-time year over year to 3.6-times, while A-rated company leverage increased 0.3-time year over year to 2.5-times. This is consistent with the trend in the earnings payout ratio (the proportion of EBITDA used for dividends and share repurchases) where BBB-rated issuers payout ratio declined 4% year over year to 30%, while the payout ratio for A-rated issuers rose 3% to approximately 55%.
  • In high yield, median net leverage was up 0.1-time to 4-times in the third quarter of 2019. Leverage increased 0.2- time to 7.8-times for the highest leveraged quartile of high yield. Downgrades exceeded upgrades with the upgradeto- downgrade ratio of 0.55-times and 0.29-times for Moody’s and Standard & Poor’s, respectively.
  • Investment-grade issuance was $231.6 billion in the quarter, up 14% year over year. This is an underwhelming increase given the low issuance in fourth quarter 2018 as the market sold off during that period. Issuance, net of maturities, was up 50% year over year but remained small at $22 billion in the fourth quarter, typically a light period for net issuance. For the year, gross issuance was nearly $1.3 trillion, an increase of 7% year over year, while net issuance was $356 billion up 5% year over year. BBB-rated issuance was 43% of gross issuance in 2019, in line with 2018 levels. Longduration issuance increased during the year with 58% of issuance longer than 6 years, compared to 54% in 2018, as low rates encourage longer duration issuance.
  • High-yield issuance was $68 billion in the quarter, up dramatically from the $18 billion in fourth quarter 2018 when the market had a substantial sell off. Net of maturities, issuance was $16 billion, up from -$25 billion in fourth quarter 2018.

Portfolio Strategy

  • The Fund had a positive return and outperformed the benchmark. The return was primarily driven by the benchmark spread tightening 22 bps and coupon income, which was partially offset by rising interest rates.
  • The Fund’s duration rose slightly and remains modestly under benchmark’s duration of 7.9 years.
  • The Fund increased its allocation to A-rated credits, at the expense of the Fund’s exposure to BBB and BB rated credits. The largest changes in sector positioning were increases in the consumer non-cyclical and technology sectors and decreases in the financial and industrial sectors.

Outlook

  • The principal risk of 2019 was trade policy, and given the likelihood of a trade deal in January 2020, this risk has abated. Replacing this risk is the 2020 U.S. presidential election, as the two political parties have starkly different candidates and policies that could dramatically impact risk assets. Also, we expect the Fed to remain “on hold” for 2020, rate cuts are possible if the macro picture worsens.
  • The quarter saw a notable change in high yield as CCC credits began to outperform higher rated high yield in December. While this bodes well for staving off a larger uptick in the default rate, we believe some of these companies and capital structures are broken and will need restructuring. We think an increase in the default rate is likely in 2020, although we don’t expect recession-level defaults.
  • The technical backdrop for spreads remains very positive. We expect net supply of investment-grade issuance in 2020 to be materially lower than 2019 due to smaller merger and acquisition volume, lessening leveraging trends and higher maturities in 2020. However, we expect a higher amount of total fixed income issuance principally from U.S. deficit funding. On the demand side, trends are modestly supportive of spreads. Mutual fund flows remain robust and foreign demand may remain strong given the yield gap between U.S. investment grade yields and those found in foreign countries.
  • We believe spreads will widen in 2020 as valuations are near historically tight levels. One potential catalyst would be if rating agency action turns more negative. The agencies have been lenient with companies pushing the envelope on leverage or failing to hit deleveraging targets. This leniency is appearing in financial media and the political realm, which may catalyze rating action. As it stands, 2019 saw deterioration in the upgrade-to-downgrade ratio in investment grade, which was 1.46 in 2018 for Moody’s, dropping to 1.25 for 2019, and 1.07 in fourth quarter 2019.
  • In high yield, BB outperformance may be much harder to achieve. The vast majority of the BB index is trading-to-call meaning further price appreciation is limited by the call option of the securities. Duration on BB credits has fallen to 3.5 years, below the historical average of 4.7 years. This makes further appreciation harder to achieve. The 20-year average BB spread is 372 bps and the BB index ended the year at 182bps, a near 20-year low. Consequently, we believe the majority of high-yield returns need to come from B and CCC rated credit which may be difficult.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market and includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. It is not possible to invest directly in an index.

All information is based on Class I shares.

Risk factors: The value of the Fund's shares will change and you could lose money on your investment. Fixed income securities in which the Fund may invest are subject to credit risk, such that an issuer may not make payments when due or default or that the risk that an issuer could suffer adverse changes in its financial condition that could lower the credit quality of a security that could affect the Fund’s performance. A rise in interest rates may cause a decline in the value of the Fund’s securities, especially securities with longer maturities. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Investing in foreign securities involves a number of economic, financial, legal, and political considerations that are not associated with the U.S. markets and that could affect the Fund’s performance unfavorably, depending upon the prevailing conditions at any given time. Mortgage-backed and asset-backed securities in which the Fund may invest are subject to prepayment risk and extension risk. The Fund typically holds a limited number of fixed income securities (generally 40 to 70). As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s NAV than it would if the Fund invested in a larger number of securities. Fund performance is primarily dependent on the management company’s skill in evaluating and managing the Fund’s portfolio. There can be no guarantee that its decisions will produce the desired results. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

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Ivy Apollo Strategic Income Fund

Market Sector Update

  • Financial markets reacted positively during the quarter as political conflicts, trade uncertainty and global economic growth concerns waned late in the year. The macro environment stabilized with indicators of growth in both China and Europe improving, although slowly. The U.S. and China announced phase one of a trade deal, the U.S. House of Representatives approved the U.S.-Mexico-Canada Agreement (USMCA) and passed it to the Senate for approval, U.K. Prime Minister Boris Johnson’s party won an election that kept him in power and reduced uncertainty about the planned Brexit, and the U.S. Federal Reserve (Fed) made it clear that it is unlikely to increase interest rates in 2020.
  • The normalization of the Fed’s balance sheet ended in the third quarter as it stated it would reinvest maturing U.S. Treasuries and mortgage-backed securities. The Fed also announced it would start expanding its balance sheet to better align it with the size of nominal gross domestic product (GDP). It cut the fed funds rate 25 basis points (bp) in October to 1.50%. In addition, the Fed injected cash into the system to calm year-end funding pressures because of stress during the quarter in the short-term funding, or “repo,” market.
  • During the previous quarter, the European Central Bank (ECB) and Bank of China started loosening monetary conditions by cutting deposit rates, strengthening forward guidance, relaunching asset purchase programs and reducing reserve requirements for the banking industries. This quarter, there was a change in leadership at the ECB with Christine Lagarde taking over as president. She has hinted at more of a fiscal response to the lack of growth in the region with a continuation of the easy monetary policies.
  • The U.S. Treasuries yield curve steepened 30 bp with renewed growth prospects as 2-year Treasuries remained range bound and 10-year Treasuries declined approximately 25 bp. Credit spreads narrowed in the high grade, high yield and emerging markets over the course of the quarter.
  • By switching their focus from tight labor markets and accelerating wage growth to slowing economies and softening inflation expectations, we continue to believe policymakers are trying to create a backdrop for lower volatility.

Portfolio Strategy

  • The Fund had a positive return for the quarter and outperformed its benchmark and Morningstar peer group. Most of the outperformance was attributable to the Fund’s exposure to credit. The Fund’s large exposure to CCC-rated credits helped its performance, as this sector’s credit spreads tightened relative to other higher quality credits. There also was a rebound in prices related to Argentina because investor expectations improved about potential recovery rates. The Fund’s shorter relative duration also helped its performance because the yield curve steepened during the quarter.
  • With renewed global growth prospects, the U.S. dollar weakened during the quarter against other developed market currencies, with the U.K. pound and the euro gaining 8% and 2.8%, respectively. The Fund’s 98.8% U.S. dollar exposure detracted from its relative performance versus its benchmark and category peers.
  • We continue to seek opportunities to reduce volatility in the Fund. We also have continued a low-duration strategy, as we feel it allows us a higher degree of certainty about those companies in which we can invest.
  • The Fund also continued to hold a higher level of liquidity in the quarter. We will be opportunistic in allocating that capital as we find dislocations in the market.

Outlook

  • The Fed’s interest rate cuts in 2019 paid out with strong support in the interest-sensitive segments of household activity. The benefit of lower rates continues to support the U.S. economy and counteract the loss of the “tailwind” supplied by tax cuts implemented in late 2017. We think exports and business investment will stabilize and rise from very low levels on the likely implementation of USMCA and phase one of a trade deal with China. We think the Fed will remain on hold throughout the first half of 2020 and watch to see if inflationary pressures build from an ever-tightening labor market.
  • We still expect the U.S. budget deficit to rise to $1.0 trillion (4.7% of GDP) in 2019 from structural forces that have deteriorated by a much greater amount than the offsetting cyclical improvement.
  • Fundamentals in the credit markets remain stretched, with balance sheets still leveraged and debt levels at historic levels. Technical factors in credit are supported by international investors searching for yield, domestic demand for income and “reverse Yankee” issuance to tender for U.S. issues. A “reverse Yankee” refers to a company issuing debt in Europe at extremely low rates, taking the proceeds in euros, changing them into U.S. dollars and then tendering for the higher yielding dollar securities. It means fewer issues to buy for U.S. investors and the resulting supply/demand issue tends to compress spreads – which is considered a positive technical factor.
  • Given the current levels of credit spreads and our expectation for modest widening of these spreads during 2020, we believe our conservative positioning relative to the benchmark is appropriate. We will be opportunistic about our credit selection and overall positioning in order to seek to take advantage of perceived opportunities and dislocations as they present themselves.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

All information is based on Class I shares.

The Fund is managed by Ivy Investment Management Company. The total return strategy is sub-advised by Apollo Credit Management, LLC.

Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. Although asset allocation among different sleeves and asset categories generally tends to limit risk and exposure to any one sleeve, the risk remains that the allocation of assets may skew toward a sleeve that performs poorly relative to the Fund's other sleeves, or to the market as a whole, which would result in the Fund performing poorly. While Ivy Investment Management Company (IICO) monitors the investments of Apollo Credit Management (Apollo) in addition to the overall management of the Fund, including rebalancing the Fund's target allocations, IICO and Apollo make investment decisions for their investment sleeves independently from one another. It is possible that the investment styles used by IICO or Apollo will not always complement each other, which could adversely affect the performance of the Fund. As a result, the Fund's aggregate exposure to a particular industry or group of industries, or to a single issuer, could unintentionally be larger or smaller than intended. Investment risks associated with investing in real estate securities, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes and differences in real estate market values. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed-income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Loans (including loan assignments, loan participations and other loan instruments) carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loans may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

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Ivy VIP Securian Real Estate Securities

Market Sector Update

  • The fourth quarter of 2019 marked a definite breakout for most equities. Unfortunately, investors shunned income producers like real estate and utilities. However, real estate investment trusts (REITs) delivered solid returns for the year ended Dec. 31, 2019, advancing 26%, as measured by the FTSE NAREIT Equity REITs Index, the Portfolio’s benchmark.
  • We believe the economy is poised to do modestly better in 2020. The consumer continues to drive growth with low unemployment and higher wages supporting spending. Although the stage is set for stronger growth in corporate America, the turn has not fully materialized due to weakness in the manufacturing and energy sectors.
  • Still, the outlook appears brighter for 2020 as the shock from recent tariffs recedes. Corporate earnings should improve amid more stable global growth and easier year-over-year comparisons. In addition, a recession next year seems unlikely given economic fundamentals like unemployment at a nearly 50-year low.
  • With macro-economic and interest rate conditions remaining favorable for real estate, the prospect of improved corporate earnings and continued consumer strength is likely to support a healthy backdrop for operators. We believe 2020 earnings growth for REITs will approach 5% as landlords enjoy the benefit of contractual lease obligations from their tenants and today’s ultra-low interest rate environment is providing a refinancing boost to the expense structure. This expected earnings growth should set the stage for another solid year of dividend increases across the sector.

Portfolio Strategy

  • The Portfolio delivered a positive return for the quarter, but underperformed its benchmark.
  • The Portfolio’s overall performance for the period is attributed to favorable stock selection and sector allocation across many of the property types. Most notably, stock selection among owners of net lease, data centers, and health care facilities contributed the lion’s share of the Portfolio’s performance.
  • An overweighting to owners of cell towers and single-family residential (SFR) also contributed favorably. As the clouds overhanging economic growth began to lift, we shifted to a less defensive position with certain portfolio holdings by increasing our weighting to hotel owners and decreasing exposure to certain net lease REITs. We also modestly reduced exposure to the health care, which badly lagged the benchmark as “risk on” sentiment overtook the market.
  • Net lease REITs delivered positive performance for the quarter, despite the “risk-on” environment and interest rate headwinds. Driving the segment’s performance were two gaming REITs, which own, but do not operate casinos. We have increased our exposure to these companies as they offer very attractive valuations relative to other net lease REITs, yet are expected to deliver significantly higher earnings growth than those REITs.
  • Datacenter REITs slightly trailed the broader index for the quarter. The Portfolio’s overweight position to the group hindered performance, but favorable stock selection meant the group was still supportive of relative performance. Demand for space remains strong, with the continued enterprise migration, edge and cloud computing, and artificial intelligence all expected to provide tailwinds to the group for the foreseeable future. We continue to see the space as attractively valued when considering its growth prospects, and the Portfolio remains overweight to this sector.
  • Health care REITs fell for the quarter, as interest rates walked back from their mid-2020 low and the “risk-on” environment took hold. The Portfolio’s underweight allocation to the sector and stock selection aided the Portfolio’s performance for the period. Occupancy continues to suffer for senior housing due to new supply, and labor cost pressures persist. Skilled nursing also suffers from a labor cost perspective, but a more constructive regulatory approach may provide some relief. REIT tenants in both segments continue to encounter rent coverage deterioration, some requiring lease restructure. Medical office buildings continue to deliver slow, steady organic growth and appear to be back in favor with investors.
  • SFR REITs outperformed the benchmark for the quarter. We were overweight to the segment, which contributed to the Portfolio’s performance. We increased our SFR position during the period on the belief there is a long runway for growth.
  • Hotel REITs and operators benefitted from a broad risk-on shift for the market. While the portfolio’s underweight position to the space detracted from relative performance, good stock selection led to the sector being a net positive contributor. We continue to expect that new supply and higher labor costs will limit earnings power for the next several quarters and we continue to remain underweight this group.

Outlook

  • Macroeconomic conditions remain favorable for real estate operators. Occupancies across most every property segment remain at historically high levels, and speculative construction continues to be held in check with few exceptions. We believe 2020 earnings growth for REITs will be positive as landlords enjoy the benefit of contractual lease obligations from their tenants and the current ultra-low interest rate environment is providing a refinancing boost to the expense structure.
  • The big question investors have is whether this year’s returns are justified or if we have simply pulled future returns forward. We previously acknowledged that if the Fed’s insurance cuts were effective, conditions would be good for risk assets. This scenario certainly was realized, and the market is pricing in a return to a Goldilocks economy where both growth and inflation are measured. This sets the stage for continued demand for risk assets.
  • Within the commercial real estate space, we broadly expect stable operating trends to continue across the sector with the recognition that today’s occupancy levels and tempered rental rate increases will result in modest earnings growth. We remain optimistic as we see few material concerns emerging, as in previous cycles. Bank lending, commercial construction, equity allocations, and overall pricing metrics remain much healthier than was often the case in previous cycle peaks. Ultra-low interest rates, continued favorable operating conditions, and dependable cash flows have emboldened investors to see real estate as a relative “safe haven” in today’s low-growth, low-rate environment.

The opinions expressed are those of the Portfolio's managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The FTSE NAREIT Equity REITs Index is designed to present investors with a comprehensive family of REIT performance indexes that spans the commercial real estate space across the U.S. economy. The FTSE NAREIT Equity REITs index contains all Equity REITs not designated as Timber REITs or Infrastructure REITs. The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. It is not possible to invest directly in an index.

Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Investment risks associated with investing in real estate securities, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes and differences in real estate market values. Because the Fund invests more than 25% of its total assets in the real estate industry, the Fund may be more susceptible to a single economic, regulatory, or technical occurrence than a fund that does not concentrate its investments in this industry. These and other risks are more fully described in the fund's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.

Annuities are long-term financial products designed for retirement purposes. Annuity and life insurance guarantees are based on the financial strength and claims-paying ability of the issuing insurance company. The guarantees have no bearing on the performance of a variable investment option. Variable investment options are subject to market risk, including loss of principal. There are charges and expenses associated with annuities and variable life insurance products, including mortality and expense risk charges, management fees, administrative fees, expenses for optional riders and deferred sales charges for early withdrawals. Withdrawals before age 59 1/2 may be subject to a 10% IRS tax penalty and surrender charges may apply.

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