Ivy VIP Bond

Ivy VIP Bond
09.30.17

Market Sector Update

  • The third quarter of 2017 produced yet another solid quarterly performance for virtually U.S. fixed income sectors. According to Barclay’s Indices, all major sectors posted positive returns, including U.S. corporates, U.S. high yield, Treasuries, and securitized assets. 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. Global demand for yield remained in place throughout 2017, just as has been the case for the past several quarters. The strong global demand for U.S. fixed income is a result the yield advantage U.S. fixed income provides over both Europe and Asia. Despite record new issuance in the credit sectors, the demand for yield and positive fund flows continued to dominate marginal credit fundamentals, leading to tighter spreads.
  • 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 third 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 91basis 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 2018 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.
  • Investment grade spreads tightened 7 basis points (to 96 basis points) and high yield spreads tightened 14 basis points (to 350 basis points) during 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) remains near an all-time high in investment grade credit as a result of five consecutive years of record new issuance. Thus far, the credit 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. Sector return dispersion was very low during the third quarter. The best performing major sectors in high grade credit during the quarter were basic industry and energy. The worst performing major sectors were capital goods and communications. Lower credit quality (BBB’s and Crossovers) has continued to outperform higher credit quality throughout 2017, as was also the case in 2016.

Portfolio Strategy

  • The Portfolio’s overall asset allocation changed very little during the third quarter. The Portfolio’s exposure to credit began and ended the quarter at 90%. Within the credit segment, 49% was allocated to Industrials, 34% to financials, and just 4% to utilities. The securitized assets were reduced from 7% to 4% and Treasuries remained at 1% during the quarter. The Portfolio’s effective duration increased slightly, from 5.8 years to 5.9 years, ending the quarter essentially neutral duration versus the benchmark. The Fund was also positioned to benefit from a flattening trend of the yield curve. The yield-to-worst of the Portfolio was 3.05% at quarter-end, 2 basis points lower than at prior quarter-end. The significant over-weight to the credit asset class was the most significant contributor to the quarterly outperformance of the Portfolio relative to the benchmark.
  • The credit quality of the Portfolio changed slightly, with the average credit quality going from “A” to “A-“ as measured by Standard & Poor’s at the end of the quarter. The credit quality distribution of the Portfolio was as follows at the end of the quarter: 4% AAA, 13% AA, 29% A, 42% BBB, 1% BB, and 6% not rated. Cash was approximately 5% of the Fund at quarter-end, which was a little higher than normal. Roughly 91% of the Portfolio’s assets have an effective duration of less than 10 years. Flows in and out of the Portfolio remained fairly stable throughout the third quarter. Given the uncertainty associated with the Trump Administration policies, 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 quarter.

Outlook

  • 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. 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. However, in the near-term,as long as yield differentials between the U.S. and the 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. How the financial markets react to potentially higher interest rates is perhaps the biggest risk to market stability in coming months

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 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.

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

Quality: Our preference is to always use ratings obtained from Standard & Poor's. For securities not rated by Standard & Poor's, ratings are obtained from Moody's. We do not evaluate these ratings, but simply assign them to the appropriate credit quality category as determined by the rating agency.

Risk factors: The value of the Portfolio's shares will change, and you could lose money on your investment. An investment in the Portfolio is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Portfolio 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. These and other risks are more fully described in the Portfolio's prospectus.

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.