Ivy Advantus Bond Fund

Ivy Advantus Bond Fund
09.30.17

Market Sector Update

  • Markets are behaving as if we’ve entered a Goldilocks economic environment that is neither too hot nor too cold. The third quarter delivered promising results for the economy and the markets, with stocks yet again reaching new highs. Neither the Federal Reserve’s (Fed) plan to reverse quantitative easing, nor saber rattling between President Trump and North Korea have derailed markets. U.S. stocks were propelled by strong corporate earnings, lower inflation, a weaker dollar and positive economic signs.
  • While stocks are now seen by many as overvalued, fundamentals continue to improve in support of valuations. Adjusted for today’s low interest rates and inflation, stocks aren’t considered in dangerous territory, in our opinion. Interest rates barely moved in the U.S. and in most other developed markets, reflecting diminishing concerns about inflation and expectations that central banks will only slowly raise rates.
  • Second quarter growth bounced back from a weak first quarter, despite the lack of fiscal boost from Washington policymakers. Damage caused by the hurricanes in Houston, Florida and the Caribbean in September were disasters, but are likely to have only a modest impact on U.S. growth. Any negative impact on growth in the current or coming quarter will likely be met with a rebound from rebuilding efforts in 2018. Growth in developed and developing economies outside of the U.S. is also showing signs of renewed strength.
  • At its September meeting, the Fed announced it would begin to taper its bond purchases, slowly reversing the quantitative easing program it began in 2008, which grew its balance sheet from $858 billion to $4.5 trillion. Based on the Fed’s plan, its balance sheet will slowly decline over the next three years, with a remaining projected terminal balance approaching $3 trillion in assets. While the Fed’s reversal of its bond purchases could be considered “quantitative tightening”, we don’t expect a significant rise in longer-term interest rates as a result of the program’s reversal. Inflation has continued to disappoint policymakers and appears to have had a bigger impact on long-term yields than have any moves in the Fed’s policy this year. The Fed reaffirmed its expectations of another rate hike in December and three more hikes in 2018.
  • The Fed raised rates 25 basis points in June, following a similar rise in March and last December. Markets paid little attention other than to drive longer-term Treasury yields lower. The big story in bonds this year has been that longterm rates have fallen as growth expectations and inflation have disappointed. This, along with the Fed raising the federal funds rate, has contributed to a significant flattening in the bond yield curve (difference between long and short yields). The difference between 30-year and 2-year bonds was 145 basis points at the end of the quarter, the flattest yield curve spread between these two rates since September 1, 2016.
  • The markets finished the quarter with momentum, as Trump finally introduced a tax reform plan that many had been waiting to see since early in the year. It proposes to cut corporate tax rates substantially, reduce income tax rates and ease complexity for individuals.
  • Spreads relative to Treasuries on corporates, mortgage-backed, asset-backed and commercial mortgage-backed securities narrowed again in the quarter after a brief spike in August. Spreads on high-yield corporate bonds are at or near their tightest levels all year.

Portfolio Strategy

  • We reduced the Fund’s corporate bond exposure over the quarter, primarily in the financial sector. In particular, we reduced positions in the banking space. The Fund remains overweight the sector, but we sold several positions that reached their valuation targets. We added exposure in the utility sector in positions of both electric and gas utility companies, purchasing attractively priced new issues in a defensive sector. The utility sector is now one of the Fund’s largest overweight positions. We added exposure to the Industrial sector, particularly in capital goods and communication industries. The Fund remains underweight the benchmark in those industries, due to fundamental concerns, but we had an opportunity to add exposures at attractive levels. Exposure to non-Agency mortgage-backed securities increased 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 kept the duration of the Fund slightly short of its benchmark.

Outlook

  • We expect growth to remain at trend or above for the remainder of 2017 and surpass the meager 1.6% real gross domestic product (GDP) growth posted in 2016. Third quarter GDP growth was trending in the mid-2% range before storm damage curtailed consumer and business activity in Texas and Florida. Consumer confidence and business confidence remain strong, as they have been for most of the year, and we expect that this sentiment will continue to support spending, investment and growth. Despite the horrible disasters from hurricanes in terms of both human life and property destruction, the impact on GDP is expected to be modest. .
  • Falling inflation has been one of the big surprises this year, and while we could see a reversal of this trend, we no longer expect inflation to reach or exceed the Fed’s target in the near future. Wage inflation is the most important driver, and it is not substantively picking up. Where wages are rising, the costs are not being passed through to the consumer, as firms are able to maintain their margins by cutting other costs to offset any rise in labor costs.
  • The outlook is surprisingly stable in the economy and the markets, except for the geopolitical market risk due to continued saber rattling between President Trump and North Korea’s leader, Kim Jong-un. The uncertainty of the situation dented stock gains and pressured interest rates lower from time to time over the quarter. We remain more concerned about these type of endogenous factors negatively impacting the markets than we do about a natural end to the current conditions.
  • The fixed income market keeps chugging along with stable long-term interest rates and strong demand for corporate and other non-government bonds. Institutional and retail investors continue to put more investment dollars into bonds. Strong inflows into retail mutual funds have been one of the big surprises of the year. Demand has been propelled by developed country age demographics and a global reach for yield. We expect the continued rise in the number of retirees to support investment in safe, income-bearing investments for some time to come.
  • Demand for non-government bonds remains supported by the same strong fundamentals that are supporting equities: steady growth, low inflation and strong earnings. The high demand has been met with another year of strong supply. We are expecting this to be the fifth year in a row of over $1 trillion in investment-grade corporate bond issuance. While valuations appear rich, spreads are nowhere near their tightest levels, reached during the 1990s. Should current conditions persist as they did then, spreads could indeed go lower.
  • After eight years of a slow recovery and expansion, we continue to see good sailing ahead for the market as the economy and markets put up steady gains into a gradual Fed tightening. We expect more of the same like we experienced in the third quarter, as we move through the end of the year and into 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 Sept. 30, 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.

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.