Ivy Pictet Targeted Return Bond Fund

Ivy Pictet Targeted Return Bond Fund
06.30.18

Market Sector Update

  • The second quarter of 2018 witnessed divergence between the U.S. and German rates. While German bunds rallied across the curve, the U.S. Treasury continued its selloff, especially in the front end.
  • The two-year yield differentials between the two government markets widened by more than 30 basis points, reflecting a diverging path of a hawkish Fed and an increasingly dovish European Central Bank (ECB). At its June meeting, the Federal Open Market Committee (Fed) raised its fed funds rate as expected and showed more confidence in its inflation outlook. The median dots for this year also point to two more rate hikes instead of one. In Europe, the June ECB meeting was dovish. First, a data-dependent quantitative easing (QE) tapering was announced, shifting the tone. Second, contrary to the Fed, which just dismantled its forward guidance (rates to remain below neutral for some time), the ECB introduced new forward guidance which indicates that the key ECB interest rates are expected to remain “at their present levels at least through the summer of 2019 and in any case for as long as necessary”. Such pre-commitment reflects higher downside risks to the economy in ECB’s assessment and also suggests the ECB can still push back the date for its rate hike if such downside risks materialize.
  • The long-end of the German Bund curve was also supported by the political turmoil in Italy in May and a recent news report on ECB’s “twist” in its QE reinvestment starting next year. According to the report, the ECB is considering recycling more of its maturing assets into longer-term bonds to keep Eurozone borrowing costs low even after the end of QE.
  • The long-end of the U.S. Treasury curve was more immune to the idiosyncratic European news, although the flipflopping between constantly evolving trade-war related headlines did introduce volatility. Higher commodity prices, in particular the 15% rise in the oil price over the quarter was the main driver of the U.S. yields, as the 10 basis points increase in the 10-year bonds came entirely from higher break-even inflation, supported by the Fed’s inflation outlook.

Portfolio Strategy

  • The portfolio underperformed its cash benchmark in the second quarter. The contribution from our rates positions was broadly neutral, as our long German bund duration and Italian curve flattener positions mitigated the loss from our long U.S. duration. Our spread positions detracted from performance, with most of the loss occurring in May from our European subordinated bank holdings. The contribution from our foreign exchange positions was positive this quarter, primarily from our long U.S. dollar versus short selected emerging markets currency positions and from our long Japanese yen versus short euro positon.
  • In rates, we reduced both U.S. and German duration after their outperformance in May. We took profit on our Italian curve flattener position while adding to German curve flattener. In credit, we reduced some investment grade holdings in Europe, as we believe the sector would be less supported when the ECB ends its QE program. While remaining cautious, we added some emerging market credit, which suffered in the recent emerging market selloff despite sound fundamentals. In European peripherals, we initiated a Portuguese spread tightening position when the spreads widened on Italian-contagion fears. We also added to Italian senior financials on attractive valuations, as they lagged the recovery in the Italian government bonds.

Outlook

  • At the end of the first half of this year we see a number of divergences that will make the second half of the year very interesting from the macro point of view. First of all, the market seems to be concerned that the Fed’s policy is tight as shown by the widening of credit spreads, the almost flat Treasury Yield curve and the poor performance of emerging markets. This stands in sharp contrast with the Fed’s own assessment of the economic situation which, from the Fed’s point of view, is strong enough to withstand a few more rate hikes and further balance sheet reduction. There also seems to be a growing differential between U.S. growth and growth in the rest of the world, as the Fed has made it clear that its priority is to achieve its dual mandate despite the weakening of economic conditions outside the U.S. The Peoples Bank of China seems to be the only major central bank in the world willing to ease policy at the same time that the U.S. tightens policy, in a sharp reversal of the so-called “Shanghai Agreement” of 2016. As a result the Chinese yuan has weakened and U.S. rates have moved up, a particularly disliked combination for emerging markets in general.
  • Add to all this that the trade war between the U.S. and a number of its main trading partners is beginning to affect business confidence. The Fed and the ECB have been trying to give themselves more flexibility, the Fed by moving away from strong forward guidance, tempering its inflation view and increasing the number of meetings followed by press conferences, and the ECB by setting an end to QE but guiding rates lower for longer. This combined dovish stance from the two main central banks should support risk markets during the summer but should not distract us from the lingering tensions in the global economy.

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, 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. Past performance is not a guarantee of future results.

Diversification does not guarantee a profit or protect against loss in a declining market. It is a method to manage risk.

Sarah Hargreaves served as a portfolio manager on the Fund until May 31, 2018.

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. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. 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, 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. The Fund may seek to manage exposure to various foreign currencies, which may involve additional risks. The value of securities, as measured in U.S. dollars, may be unfavorably affected by changes in foreign currency exchange rates or exchange control regulations. Investing in foreign securities involves a number of risks that may not be associated with the U.S. markets and that could affect the Fund's performance unfavorably, such as greater price volatility; comparatively weak supervision and regulation of securities exchanges, fluctuation in foreign currency exchange rates and related conversion costs, adverse foreign tax consequences, or different and/or less stringent financial reporting standards. Mortgage-backed and asset-backed securities in which the Fund may invest are subject to prepayment risk and extension risk. The Fund employs investment management techniques that differ from those often used by traditional bond funds, including a targeted return strategy, and may not always perform in line with the performance of the bond markets. The Fund is also non-diversified and may hold fewer securities than other funds and a decline in the value of these holdings would cause the Fund's overall value to decline to a greater degree than a more diversified fund. The Fund expects to use derivatives in pursuing its investment objective. The use of derivatives presents several risks including the risk that fluctuation in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative's value is derived. Moreover, some derivatives are more sensitive to interest rate changes and market fluctuations than others, and the risk of loss may be greater than if the derivative technique(s) had not been used. These and other risks are more fully described in the Fund's prospectus.