Ivy VIP Bond

Ivy VIP Bond
12.31.17

Market Sector Update

  • The U.S. Investment Grade Credit Market posted positive return performance again in the last quarter of 2017. According to Bloomberg Barclay’s fixed income indices, several other sectors also posted positive returns during the fourth quarter, including U.S. corporates, U.S. high yield, U.S. government securities and emerging markets. Domestically, investor sentiment for risk assets continued to be bolstered by expectations that the Trump Administration would be successful at reducing taxes and regulations, thus providing a boost to corporate earnings. Demand for yield in the low global yield environment has remained firmly in place throughout 2017, just as was the case for 2016. The strong global demand for U.S. fixed income is a result of the yield advantage U.S. fixed income provides over both Europe and Asia. Despite record new issuance in the U.S. credit sectors in 2017, the demand for yield and corresponding positive fund flows continued to overwhelm supply, leading to tighter credit spreads.
  • As was largely expected, the Federal Reserve Board (Fed) raised short-term rates in December, after raising rates by 25 basis points in both the first and second quarters. The move by the Fed led to short term rate increases but had little impact on the longer end of the Treasury curve, as inflation expectations remain muted. Market expectations going forward are for the Fed to raise short term rates two to three more times in 2018. The Treasury curve experienced a significant flattening trend during the fourth quarter. The often-cited two-year to 10-year Treasury spread relationship flattened from 85 basis points to 52 basis points during the quarter. On the long end of the curve, the 30-year Treasury ended the quarter at 2.74 percent, which was 12 basis points higher than at the end of the third quarter. Central Bank policies around the globe are not currently in sync, which could introduce risk and/or volatility into the financial markets in 2018.
  • Investment grade spreads tightened 7 basis points (to 89 basis points) in the fourth quarter. High yield spreads widened 14 basis points (to 364 basis points) during the fourth quarter after tightening the same amount in the third quarter. The overall macro-economic environment continued to be generally supportive and stable for U.S. corporate credit. Corporate leverage (as measured by debt to cash flow) declined slightly, but remained at elevated levels in Investment grade, partially as a result of five consecutive years of record new issuance. Thus far, the credit market has largely ignored high leverage, due to the overwhelming demand for yield by both domestic and global investors. Credit spread tightening is being driven by investors’ strong demand for yield, not improving fundamentals. Sector return dispersion remained very low in the fourth quarter. The best performing major sectors in high grade credit during the quarter were basic industry and energy. The worst performing major sectors were technology and banking. Lower credit quality (BBB’s and Crossovers) has continued to out-perform higher credit quality throughout 2017.

Portfolio Strategy

  • The Portfolio’s asset allocation changed very little during the quarter. The Portfolio decreased exposure to credit slightly from 90 percent to 89 percent during the fourth quarter. Within credit, 49 percent was allocated to industrials, 33 percent to financials, and just 5 percent to utilities. The securitized assets were reduced from 4 percent to 2 percent and Treasuries increased to 5 percent at quarter end. The Portfolio’s effective duration increased marginally during the quarter from 5.9 to 6.2 years, which is slightly more than the benchmark’s duration. The Portfolio was also positioned to generally benefit from a flattening trend of the yield curve, which did occur during the fourth quarter. Given the uncertainty associated with the Trump Administration, precise timing of the Fed’s short-term interest rate decisions, and unpredictable nature of Central Bank policies outside of the U.S., making significant bets on duration (or yield curve shape) didn’t seem prudent during the quarter and throughout 2017.
  • The credit quality ratings distribution of individual bonds (as measured by Standard & Poor’s) in the Portfolio was as follows at the end of the quarter: 8 percent AAA, 11 percent AA, 32 percent A, 46 percent BBB, 1 percent BB, and 2 percent not rated. The rating’s distribution of individual bonds was little changed during the quarter. Standard & Poor’s doesn’t provide an overall rating for the Portfolio, just the ratings of individual bonds in the Fund. Cash was approximately 4 percent of the Portfolio at quarter-end. Roughly 91 percent of the Portfolio’s assets have an effective duration of less than 10 years. The yield-to-worst of the Portfolio was 3.19 percent at quarter-end, up 14 basis points from the prior quarter end. The significant overweight to the credit asset class was the most significant contributor to the quarterly and yearly out-performance of the Portfolio relative to the benchmark, the Bloomberg Barclays U.S. Aggregate Bond TR USD Index. The Portfolio did experience a significant inflow in December.

Outlook

  • The financial markets have had remarkable performance in the past several quarters, both in fixed income and equities. Despite that, there are many indications that the market is in the late stages of the credit cycle which has lasted since the Great Recession. From a longer term perspective, the current risk-reward relationship in the credit market is not particularly attractive. 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. Therefore, conservative positioning within the credit market seems to be a prudent strategy in the coming quarter. It can be argued that the financial markets are priced close to perfection in multiple asset classes and taking significant risk does not appear to provide adequate risk-adjusted returns.
  • How the financial markets react to potentially higher interest rates is perhaps the biggest risk to market stability in coming months. 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 in the near term. As has been the case for several quarters, Central Bank policies inside and outside of the U.S. continue to have a profound impact on the U.S. fixed-income market, both in Treasuries and credit markets. 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 has provided a 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. Longer term, it seems likely that the yield differential will get smaller as Central Bank policies converge in coming quarters and years. 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.

The opinions expressed are those of the Portfolio’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, 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.

Diversification and asset allocation are investment strategies that attempt to manage risk within your portfolio but they do not guarantee profits or protect against loss in declining markets.

The Bloomberg Barclays Multiverse Index is an unmanaged index comprised of securities that represent the global bond market. It is not possible to invest directly in an index.

Risk factors: The value of the Portfolio’s shares will change, and you could lose money on your investment. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. 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. 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. These and other risks are more fully described in the Portfolio’s prospectus. Not all funds or classes may be offered at all broker/dealers.

Annuities are long-term financial products designed for retirement purposes. Annuity and life insurance guarantees are based on the financial strength and claims-paying ability of the issuing insurance company. The guarantees have no bearing on the performance of a variable investment option. Variable investment options are subject to market risk, including loss of principal. There are charges and expenses associated with annuities and variable life insurance products, including mortality and expense risk charges, management fees, administrative fees, expenses for optional riders and deferred sales charges for early withdrawals. Withdrawals before age 59 1/2 may be subject to a 10% IRS tax penalty and surrender charges may apply.