Ivy Crossover Credit Fund

Ivy Crossover Credit Fund
06.30.17

Market Sector Update

  • The second quarter of 2017 produced solid performance for the U.S. credit markets, with the crossover sector doing well and out-performing both the high yield and investment grade sectors. Investor sentiment for risk assets continued to be bolstered by expectations that the Trump administration would be successful at reducing taxes and regulations on corporate America, despite very limited results thus far. The global search for yield remained in place throughout the second quarter, as has been the case for the past several quarters. The strong global demand for U.S. credit is a result of accommodative Central Bank policies outside of the U.S. as well as confidence in U.S. economy. Despite record new issuance in the credit sectors, the demand for yield and positive fund flows continued to dominate lessthan- stellar fundamentals, leading to tighter spreads.
  • Investment grade spreads tightened 9 basis points (to 103 basis points) and high yield spreads tightened 48 basis points (to 364 basis points) during the second quarter. The spread differential between BBB and BB rated credits at the end of the quarter was 86 basis points, which is considered very tight on an historical basis. The overall macroeconomic environment continued to be generally supportive for U.S. corporate credit, despite some continuing erosion in credit metrics. 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 improving fundamentals. The best performing major sectors in high grade credit during the second quarter were communications (3.48%) and transportation (3.48%). The best performing major sectors in high yield were consumer non-cyclicals (3.16%) and financials (3.67%). Lower credit quality out-performed continued higher credit quality in both the investment grade (BBB’s) and high yield (CCC’s) bond sectors.
  • The Federal Reserve Board (Fed) raised short-term rates by 25 basis points in June, after doing the same in March 2017 and December 2016. The move was largely expected by the market and didn’t have a material impact on Treasuries. Market expectations going forward are for the Fed to continue to apply a “measured” pace for future rate increases. The Treasury curve continued to flatten during the second quarter, pivoting around the 4-year point on the curve. The often cited 2-year to 10-year Treasury spread relationship flattened from 113 basis points to 91 basis points during the quarter. On the long end of the curve, the 30-year Treasury ended the quarter at 2.82%, or 19 basis points lower than at the end of 1Q. 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.

Portfolio Strategy

  • Given the tight spread differential between BBB and BB rated credits cited above, more conservative positioning within the crossover market seemed to be prudent, with the rationale being that the market is not properly compensating for credit risk from a longer term perspective. Debt to cash flow for investment grade rated credit is near an all-time high due to the massive amounts of new issuance that have 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 not-too-distant future, the increased leverage will likely lead to a significant amount of bond downgrades from investment grade to high yield. When the downgrade cycle occurs, better risk-reward opportunities in the crossover market should develop. As rated by Standard & Poor’s, the average credit quality of the Fund at the end of the second quarter was “BBB” and 87% of the Fund’s individual bonds were rated “BBB”. Cash was 4% at quarter end, which is in the average expected range of Fund assets (2-5%).
  • The Ivy Crossover Credit Fund’s inception date was April 3, 2017. The Fund was fully invested within 3 weeks of the inception date. At quarter end, the Fund was invested in 40 different names, with the largest investment in any single name at 4.5%. 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 second quarter was 7.6 years, which was essentially neutral vs. the benchmark (Bloomberg Barclays U.S. Corporate Index). Approximately 91% 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 second quarter. The Fund’s biggest sector exposures at second quarter-end were: banking (21%), consumer cyclicals (15%) and energy (14%).

Outlook

  • As we entered the second quarter, uncertainty regarding the realization/timing of the Trump administration’s potential policies and reforms began impacting the financial markets. The market’s expectation for robust growth has softened, but the macro-economic environment remains generally supportive of the credit markets. Despite concerns about the effectiveness of the Trump administration, slowing growth expectations and geopolitical risks, investor sentiment remains constructive for risk assets at the start of the third quarter. Although impossible to predict precise timing, geopolitical events seem to be stacked to the downside, which could impact market sentiment and lead to volatility in risky assets, including the credit market. We think OPEC’s action in November effectively set a floor for oil prices at about $50 per barrel. We think it’s unlikely that oil will fall below that floor price for any prolonged period. However, we think the move will cause existing inventories to be drawn down more quickly than they otherwise may have been.
  • Whether it is fundamentally justified or not, the U.S. credit market continues to be in complacency mode. There has been an absence of significant price volatility or sector dispersion throughout 2017. As of the beginning of the third quarter, there are no obvious signs that the fixed-income markets will change materially in the near-term. Despite the complacent investor sentiment that currently exists, there are multiple risks that don’t appear to be adequately priced into the market. It can be argued that the financial markets are priced close to perfection in multiple asset classes, which would generally indicate less-than-attractive risk/ reward opportunities for investors. Taking significant risk in the credit market does not appear to provide adequate returns currently.
  • Central Bank policies in Europe and Asia continue to impact the U.S. fixed income market significantly, both in Treasuries and credit. Interest rates outside of the U.S. remain significantly lower than U.S. rates, making it somewhat unlikely that Treasury yields will go materially higher in the near term. 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 for yield provides a boost to the credit market in the near term, it is highly uncertain how sustainable this demand will be longer-term. Credit metrics for U.S. companies (such as leverage and interest coverage) have been eroding for several quarters, as corporate bonds are issued to meet investor demand. Credit fundamentals indicate that the market seems to be in the late innings of the credit cycle, but the global demand for yield seems to be extending the cycle. Should foreign investors reduce their appetite for U.S. Treasuries and credit, the market could potentially experience volatility.

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 June 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 High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. 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.