Market Sector Update

• A number of factors that began in October led to a sharp sell-off in both equities and credit in the quarter. Concerns around the Federal Reserve (Fed), trade tensions with China, oil’s decline and a flattening yield curve all left the markets in a state of uncertainty and kept investors worried about the domestic and global outlooks.
• The risk-off environment in credit during the quarter resulted in higher quality bonds outperforming for the year, a reversal from the rest of the year. For the year, B and BB returned -1.6% and -2.5%, respectively, while CCC ended down -2.9%. High yield bonds ended the year returning -2.45%, only the fourth loss in the last 25 years. In 2018, leveraged loans were among the top performing asset classes by posting a 1% gain, outperforming investment grade and high yield.
• Although credit spreads touched a decade low last quarter, spreads widened over 200 basis points (bps) in the fourth quarter. Yields in the high yield asset class increased by 170 bps to 8.23%, a level not seen since April 2016. Yields in the leveraged loan asset class increased by 75 bps to end the year at 7.5%.
• In 2018, high yield experienced the largest retail withdrawals on record (-$45.1 billion). Leveraged loans experienced inflows of $737 million, even after taking into account record outflows in the fourth quarter. Loan funds reported -$9.9 billion in outflows in the month of December, the largest monthly outflow on record.
• High yield new issue activity in the quarter was $19.1 billion and $187.4 billion for full-year 2018. Full-year volume decreased 43% compared to $328 billion in 2017. Notably, zero deals priced in December, which was the first time that happened since November 2008 and only the second time since 1990. Leveraged loan new issue volume was $109.4 billion and $704 billion for the quarter and 2018, respectively. The issuance in 2018 was the second highest on record, only behind last year’s $974 billion.

Portfolio Strategy

• Broadly reflecting the risk-off environment, the Fund’s closed-end fund peer group was under pressure during the quarter. The group produced mid-to-high single digit negative returns on a market price and NAV basis. The Fund’s return was in line with its peer group.
• Given our philosophy to find credits that we think can outperform throughout a credit cycle, when bouts of extreme volatility occur, such as this quarter, we tend to stay the course on our current investments and scour the markets for additional opportunities that may occur as a result of the volatility.
• The portfolio composition between bonds and leverage loans stayed constant in the quarter, at 74% and 20%, respectively. While leverage loans saw higher than normal outflows and experienced negative returns, especially in December, our exposure to leverage loans still outperformed the index. Leveraged loans ended the year as one of the best performing asset classes. In contrast, our allocation in bonds underperformed in the quarter and for 2018.
• During the quarter, CCC credits came under pressure and are now averaging distressed spread levels (1,100 bps). Given the almost -9% return that CCC credits had in the quarter, the lack of compensation (spread) prior to the quarter has vanished and has caught our attention as a possible opportunity to pick up some CCC credits at attractive valuations.
• Positive contributors to performance for the quarter were an underweight to the energy sector and an overweight allocation to leverage loans.
• Detracting from performance was a credit event in the gaming sector and the risk-off psychology in the market which disproportionately impacted the prices of some of our larger holdings relative to the index.

Outlook

• We believe the high yield market has moved to fair value following the more than 200 bps widening in the high yield index during the quarter. We are cautiously optimistic that over the next 12 months that potential returns in the high yield market may improve. That said, we are closely monitoring potential areas of concern, including slowing earnings growth, flattening yield curve, the government shutdown, Brexit vote, possible Fed policy mistake and a yet-to-be-seen China trade deal. On the flip side, after the pull back in the quarter, most asset classes, including high yield, seem to have priced in the large majority of negative headwinds into the market.
• We have already seen the Fed take a more dovish tone with a “wait and see” attitude towards further rate hikes. Oil prices have stabilized after the OPEC meeting where an agreement to cut production was reached, and talks between the US and China on a new trade pact seems to be progressing. Details are few, but clarity would be a welcome outcome to the market.
• We think there is favorable probability that several uncertainties plaguing the market may come to resolution giving investors and company executives more clarity on the macro environment. We believe this should lead to tighter spreads and positive returns versus wider spreads and a full-blown recession in 2019.
• As always, our focus when evaluating investments is to focus on a company’s business model and competitive advantages in order to weather a recession and perform throughout the cycle. We will continue to focus on the fundamentals of our investments as that has served us well in the past and should do so in the future.

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, 2018, 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.

Risk factors: The price of the Fund’s shares will fluctuate with market conditions and other factors. Fund shares are not guaranteed or endorsed by any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation. Closed-end funds frequently trade at a discount from their net asset values (NAVs), which may increase an investor’s risk of loss. At the time of sale, shares may have a market price that is below NAV, and may be worth less than the original investment. There is no assurance that the Fund will meet its investment objective. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than with 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.

The ICE BofAML US High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. It is not possible to invest directly in an index.

An investment in the Fund is not appropriate for all investors and is not intended to be a complete investment program. The Fund is designed as a long-term investment and not as a trading vehicle.

Ivy Investment Management Company (IICO) serves as the Fund’s investment adviser. IICO is a wholly-owned subsidiary of Waddell & Reed Financial, Inc.

The Fund is a closed-end exchange traded investment company. This material is presented only to provide information and is not intended as investment advice or recommendations for trading purposes. Closed-end funds, unlike open-end funds, are not continuously offered. After the initial public offering, shares of closed-end funds are sold on the open market through a stock exchange. Investment policies, management fees, risks other than those mentioned above, and other matters of interest to prospective investors may be found in the closed-end fund prospectus used in its initial public offering. For additional information, contact our sales desk at 800-532-2780.