Ivy Crossover Credit Fund

Ivy Crossover Credit Fund
09.30.17

Market Sector Update

  • The third quarter of 2017 produced another solid performance for the U.S. credit markets, with the crossover sector again outperforming both high yield and investment grade corporate sectors in the quarter. Positive investor sentiment for risk assets continued to be bolstered by expectations that the Trump Administration would be successful at reducing taxes on Corporate America, despite very limited results thus far. The global search for yield remained the dominant theme throughout the first three quarters of 2017. The strong global demand for U.S. credit is a result of the significant yield advantage the U.S. fixed income market enjoys over both Europe and Asia. Despite record new issuance in the credit sectors, the demand for yield and positive fund flows continued to dominate less than stellar fundamentals, leading to tighter spreads.
  • Investment grade corporate spreads tightened 8 basis points (to 101 basis points) and high yield spreads tightened 20 basis points (to 370 basis points) during the third quarter. The yield differential between BBB and BB rated credits at the end of the quarter was 56 basis points, tightening 30 basis points during the quarter. This is also considered an extremely tight spread from an historical perspective. The overall macro-economic environment continued to be generally supportive for U.S. corporate credit, despite some marginal erosion in credit metrics due to the massive amount of new issuance. Corporate leverage (as measured by debt to cash flow) remains near an all-time high. Thus far, the market has largely ignored this important fundamental due to the overwhelming demand for yield by both domestic and global investors. Credit spread tightening is being driven by investor demand for yield, not necessarily improving credit fundamentals. The best performing major sectors in high grade credit during the third quarter were basic industry and energy. The worst performing major sectors were capital goods and communications. Lower credit quality outperformed continued higher credit quality in both investment grade (BBB’s) and high yield (CCC’s) markets.
  • The Federal Reserve Board (Fed) didn’t raise short-term rates in the third quarter, after raising rates by 25 basis points in both the first and second quarters. The lack of Fed action in the quarter and continued extremely low rates outside of the U.S. led to little movement in the Treasury market during the quarter. Market expectations going forward are for the Fed to raise rates by 25 basis points in the fourth quarter and to potentially raise rates several times in 2018. The Treasury curve continued its flattening trend during the third quarter, however. The often cited 2-year to 10-year Treasury spread relationship flattened from 91 basis points to 85 basis points during the quarter. On the long end of the curve, the 30-year Treasury ended the quarter just 2 basis points higher than at the end of the second quarter. The probability of significantly higher interest rates in 2017 seems to be somewhat unlikely given the low (or negative) interest rate environment outside of the U.S. Central Bank policies around the globe are not currently aligned, which could introduce risk and/or volatility into the financial markets in later 2017 and 2018.

Portfolio Strategy

  • Given the tight spread differential between BBB and BB rated credits cited above, more conservative positioning within the crossover market continued to be the most prudent strategy. The underlying rationale was that the credit market is not properly compensating investors for taking excess credit risk. Debt-to-cash flow for investment grade rated credit is near an all-time high due to the unprecedented amounts of new issuance that has occurred over the last several years. Thus far, the market has overlooked the build-up of leverage as demand for yield has dominated fundamentals. At some point in the future, the increased balance sheet leverage will likely create a significant amount of downgrades, from investment grade to high yield. When the downgrade cycle occurs, better risk-reward opportunities in the crossover market will develop. As rated by Standard & Poor’s, the overall credit quality of the Fund at the end of the third quarter was “BBB” and 92% of the Fund’s individual bonds were rated “BBB” or higher. Cash was just 2% at quarter-end, which is in the average expected range of Fund assets (2-5%).
  • At the end of the third quarter, the Ivy Crossover Credit Fund was invested in 44 different names, with the largest investment in any single name at roughly 4%. Under normal circumstances, expectations are that the Fund will have 30 to 50 names. The effective duration of the Fund at the end of the third quarter was 7.4 years, which was essentially neutral versus the benchmark (Bloomberg Barclays U.S. Corporate Bond Index). Approximately 93% of Fund investments had an effective duration of 10 years or less at quarter-end. Given the uncertainty associated with the Trump Administration, precise timing of the Fed’s short-term interest rate decisions, and unpredictable Central Bank policies outside of the U.S., making significant bets on duration and yield curve shape didn’t seem prudent during the third quarter. The Fund’s biggest sector exposures at quarter end were: banking (18%), energy (13%), consumer cyclicals (12%), and communications (12%).

Outlook

  • As has been the case for several quarters, Central Bank policies inside and outside of the U.S. continues to have a profound impact on the U.S. credit market. The demand for positive yield from foreign investors is providing an opportunity for U.S. companies to borrow (issue bonds) at very attractive rates. Although the foreign demand provides a short-term boost to the credit market, it is uncertain how stable this demand will prove to be over the longer-term. Credit metrics for U.S. companies, such as leverage and interest coverage, have been eroding for several quarters as more corporate bonds are issued to meet demand. Should foreign investors reduce their appetite for U.S. credit, the credit market could experience some weakness. In the near term, however, as long as yield differentials between the U.S. and rest of the world remain at elevated levels, U.S. rates are not expected to go materially higher. Longer-term, it seems likely that the yield differential will get smaller, as Central Bank policies converge over time.
  • The Fed has repeatedly stated its desire to raise the Fed funds rate at a measured pace. Should the Fed execute on its stated goal of a gradual pace for short-term interest rate hikes, the yield curve is expected to continue to flatten throughout the coming months. However, if the Fed acts inconsistently with market expectations, the financial markets could experience some volatility in 2018.
  • There are many indications that the financial markets are in the late stages of the credit cycle which has lasted since the Great Recession. Therefore, conservative positioning within the credit market seems to be a prudent strategy in the coming months. The risk-reward relationship in fixed income does not appear to be very compelling currently. In general, investors are not getting adequately compensated for taking excess risk, as the market appears to be rich/over-bought to some degree. The financial markets have had a “risk-on” sentiment for an extended time period, at least partially fueled by global investors’ quest for yield in a very low yield environment. Whether it is justified or not fundamentally, the U.S. credit market continues to be in complacency mode.

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 Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. The U.S. Corporate Index is a component of the U.S. Credit and U.S. Aggregate Indices. The index was launched in July 1973, with index history backfilled to January 1, 1973. It is not possible to invest directly in an index.

Risk factors: The value of the Funds’ 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 30 to 50). 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.