Ivy Advantus Bond Fund

Ivy Advantus Bond Fund
12.31.17

Market Sector Update

  • Washington and Wall Street focused on tax reform for much of the fourth quarter. By repeatedly reaching new alltime highs, the markets celebrated the December passage of the most significant tax changes in 30 years. Under the new tax regime, some sectors of the economy will fare better than others.
  • Some companies have publically indicated they expect to deploy the forecasted increase in earnings by raising employee pay, providing bonuses, and investing in technology and infrastructure. The question is whether these actions will be broad or sustainable enough to drive up inflation. We believe the effects will include continued growth with moderate pressure toward higher inflation. Retail, industrial and financial corporations will benefit from the corporate tax rate dropping from 35 percent to 21 percent. Financials will also benefit from regulatory relief, which should increase profitability. Retail companies will get a lift from continued economic growth. These sectors could step in as market leaders in 2018.
  • Technology, which led equity market gains in 2017, may not get as much help from the new law. The effective tax rate for most technology companies is already well below the statutory rates due to the nature of the business. The bill’s repatriation provisions give U.S. companies incentives to bring money kept overseas back into the country. While technology companies may not have a strong enough incentive to participate, other companies may return money now kept overseas, a potential economic stimulus.
  • Housing, which drives a large part of the economy, may feel some negative effects from new limits on mortgage interest and property tax deductibility, along with the increase in the standard deduction. We foresee a real trade-off between owning and renting, especially for younger millennials. On the plus side, the economy is already approaching full employment, and additional economic growth could help push up average hourly wages. That in turn could help workers afford more expensive homes and apartments, giving real estate a boost. Commercial real estate may see some of the biggest benefits go to real estate developers and operators, thanks to accelerated depreciation. Tax reform is expected to lead to higher corporate earnings and increased hiring, which could increase demand for commercial real estate. The tax law’s limits on deducting interest expenses will help investment-grade corporate bonds and may hurt lower quality (high yield) issues. Companies will need to rely less on debt, which should help strengthen balance sheets.
  • Spreads relative to Treasuries on investment grade and high yield corporates, mortgage-backed, asset-backed and commercial mortgage-backed securities narrowed again in the quarter. Spreads on investment-grade corporate bonds are now at the tightest levels in 10 years.

Portfolio Strategy

  • During the quarter we further reduced the Fund’s corporate bond exposure, primarily in the industrial sector. The Fund remains overweight the corporate bond sector relative to its benchmark, but with spreads at post-crisis tightness, it has become more difficult to find attractive relative value. We sold positions in capital goods, communications and pipeline companies. The Fund remains overweight pipelines. We continue to like the stable cash flow profile of the business, but we sold several positions that reached their valuation targets. We added to the Fund’s positions in the utility sector, which remains the Fund’s largest overweight sector relative to its benchmark, the Bloomberg Barclays U.S. Aggregate Bond TR USD Index. We were quiet in the financial sector, but we believe the banking sector remains attractive overall.
  • We continue to like the securitized sector and the Fund remains overweight asset-backed securities, commercial mortgage-backed securities (CMBS) and non-Agency MBS. We added to the Fund’s positions in non-Agency MBS during the quarter. The underwriting in this sector has remained disciplined since the housing crisis and we feel the U.S. housing cycle has longer to run relative to the corporate credit cycle. We also added to the Fund’s positions in CMBS, as new AAA-rated tranches were issued during the quarter that represented attractive value to us. We kept the duration of the Fund slightly short of its benchmark.

Outlook

  • We expect slow and steady growth, low inflation and a lack of market volatility. Tax reform should keep the expansion going, but it could also increase inflation and spur accelerated economic growth, which could prompt the Federal Reserve (Fed) to respond. Treasury markets already appear to reflect potential inflation risk, as well as prospects for greater growth, following the passage of the tax bill.
  • Central Bank policies here and in Europe have the potential to upset the apple cart. Janet Yellen wraps up her term as Fed chair, with Jerome Powell ready to take over in February. We believe Powell will likely to follow a path similar to Yellen’s, although he may be slightly more aggressive about raising interest rates. Four vacancies on the Fed’s board of governors await filling. The new occupants could affect future Fed policy as much as the change at the top. The December Fed meeting minutes projected three rate raises in 2018. For now, interest rate futures pricing indicates the market expects the Federal Reserve to raise rates only twice in 2018. If the Fed begins to quickly raise rates it could put a dent in the markets. The European Central Bank (ECB) is also tilting more hawkish. It announced a slowdown in monthly bond purchases in October, and rising inflation and increased growth forecasts make it unlikely that ECB will continue its quantitative easing program past its currently planned end in September 2018. Rates could finally start to rise in Europe and could start to drive up rates here.
  • It’s worth noting that there appears to be an unusual disconnect between the stock and bond market outlooks. Stock markets see lower corporate tax rates and economic growth justifying current equity prices. Projected earnings for the Standard & Poor’s 500 are very strong. The equity markets clearly anticipate another year of market gains.
  • The bond market’s outlook, as reflected in the yields of two- and 10-year Treasuries, is more pessimistic. The difference in yields between the two- and 10-year Treasury has narrowed to just over 50 basis points, down from its traditional 100-point spread. With spreads at or near post-crisis tightness levels, investors appear to be comfortable buying corporate bonds and other forms of spread product. We believe Treasury yields haven’t increased due to concerns about low economic growth, low volatility and lack of inflation. We expect the yield curve will continue to flatten unless the economy grows more than anticipated.
  • Meanwhile, investors continue to search for yield. Low interest rates abroad are drawing foreign investors into the bond market. Foreign buyers are seeking income opportunities in U.S. corporate bonds as well as U.S. equities. The U.S. corporate bond market is three times the size of Europe’s. Foreign buyers, who had focused on Treasuries, may be seeking to invest in utility company stocks – attracted by their potential stability.
  • Geopolitical issues could shake things up in 2018 – the North Korea situation, rivalry between Saudi Arabia and Iran, political landscape in Japan, and Russia investigation here in the United States. All have the potential to upset the economic apple cart. Market volatility has been low for some time. We can’t dismiss that an unforeseen “black swan” event could bring volatility back, but our forecast indicates good things for the economy and markets in 2018.

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, 2017, 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 Ivy Bond Fund was renamed Ivy Advantus Bond Fund on April 3, 2017.

The Bloomberg Barclays U.S. Aggregate Bond TR USD Index is a market capitalization-weighted index, representing most U.S. traded investment grade bonds. The Standard & Poor's (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.

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.