03.31.18

Market Sector Update

  • The U.S. Investment Grade Credit Market had a difficult first quarter of 2018 from a total return perspective, as credit spreads widened and interest rates moved higher. According to Bloomberg Barclay’s fixed income indices, several other sectors also posted negative total returns during the first quarter, including U.S. Aggregates, U.S. corporates, U.S. high yield, U.S. Treasuries U.S. securitized and emerging markets. Investor sentiment for risk assets was volatile starting at the beginning of February, triggered by concerns of future trade conflicts and valuation concerns. Financial market volatility continued throughout the remainder of the quarter. Despite the volatility, global demand for U.S. credit remained somewhat firm, as a result of the yield advantage U.S. fixed income provides over both Europe and Asia. New issuance in the first quarter was a bit lower than in the prior year, but remained at historically elevated levels.
  • Investment grade spreads widened 14 basis points (to 103 basis points) in the first quarter. High yield spreads widened just six basis points (to 370 basis points) during the first quarter, outperforming high grade spreads. The macro-economic environment continued to be supportive for U.S. corporate credit, but market sentiment did soften, as volatility increased. Corporate leverage (as measured by debt to cash flow) declined slightly, but remained at elevated levels in Investment grade, as a result of five consecutive years of record new issuance. Until very recently, the credit market has largely ignored leverage, due to robust demand for yield by both domestic and global investors. With increased financial market volatility, sector return dispersion increased slightly in the first quarter. The best performing major sectors in high grade credit during the quarter were communications and energy. The worst performing major sectors were utilities and transportation. Lower credit quality (Crossovers) out-performed higher credit quality again in the first quarter.
  • The Federal Reserve Board (Fed) raised short-term rates 25 basis points in March, after doing the same three times in 2017. The move by the Fed contributed to the flattening of the yield curve in the latter part of the quarter. The common measure of the shape of the yield curve, the yield difference between the two-year and 10-year Treasuries, declined to 47 basis points by quarter-end. This relationship at the beginning of the year was 52 basis points, but had steepened considerably earlier in the quarter. On the long end of the curve, the 30-year Treasury ended the quarter at 2.97%, which was 23 basis points higher than at the beginning of the year. Finally, the Fed got a new Chairman during the first quarter, Jerome Powell. Although Chairman Powell is not expected to act significantly different than his predecessor, a new Chairman does introduce a bit of uncertainty and potential volatility into the financial markets.

Portfolio Strategy

  • The Portfolio’s asset allocation changed only slightly during the quarter. The Portfolio's exposure to corporate credit increased from 89% to 92% of the portfolio. Within credit, 52% was allocated to industrials, 34% to financials, and just 5% to utilities. The securitized assets also remained unchanged and Treasuries remained unchanged at just 2% each of the Portfolio's assets. The Portfolio’s effective duration held steady at 6.2 years, which is underweight relative to the benchmark. The Portfolio was also positioned to benefit from a flattening trend of the yield and credit curves, which did occur in the latter part of the first quarter.
  • 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: 1% AAA, 12% AA, 21% A, 55% BBB, 7% BB, and 2% not rated. Standard & Poor’s doesn’t provide an overall rating for the Portfolio, just the ratings of individual bonds in the Portfolio. Cash was approximately 2% of the Portfolio at quarter-end. Roughly 90% of the Portfolio’s assets have an effective duration of less than 10 years. The yield-to-worst of the Portfolio was 3.78% at quarter-end, up 59 basis points from the prior quarter end.
  • The Portfolio slightly out-performed its benchmark during the first quarter. Both asset allocation and security selection contributed to the modest outperformance. Outperformance within investment-grade corporates accounted for the majority of the excess returns. Within corporate credit, all three major sectors, financials, industrials and utilities marginally outperformed. Flows in and out of the Fund remained fairly stable throughout the quarter. Given the uncertainty associated with the current administration’s trade policies, timing of the Fed’s short-term interest rate decisions, and unpredictable nature of global Central Bank policies, making significant bets on the shape of the yield curve and overall duration continued to not seem prudent during the first quarter.

Outlook

  • The financial markets experienced a period of extremely low volatility for most of 2016 and virtually all of 2017. This period of low volatility came to an end in the early part of February 2018. Reasons for the increased volatility include short-term interest rate increases and the threat of potential trade conflicts, as well asset price valuations that seemed stretched in both the debt and equity markets. Given the magnitude of the equity market volatility, the credit markets have remained fairly orderly. Credit spreads have widened in both high grade and high yield since the beginning of February, but we have yet to see panic or significant distress. Fundamentally, credit metrics for U.S. companies such as leverage (debt to cash flow) have stabilized in recent quarters but remain near record high levels. Technically, global demand has provided a key technical support for the credit markets in the U.S. for the past several quarters. Should this demand soften materially, we are likely to experience some weakness in credit spreads.
  • The Fed has repeatedly signaled its desire to raise the fed funds rate at a measured pace. Current market expectations are for the Fed to raise short term rates two to three more times in 2018. Should the Fed execute on its stated goal of a gradual pace for short-term interest rate hikes, the yield curve is expected to remain fairly flat in coming months. However, if the Fed acts inconsistently with market expectations, the financial markets could experience considerable volatility throughout 2018. The new leadership at the Fed (Jerome Powell) may increase the probability of sustained volatility occurring. How effective the Fed is at navigating the transition to a more “normalized” interest rate policy is crucial to how the financial markets behave 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 Mar. 31, 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.

The Bloomberg Barclays U.S. Aggregate Bond TR USD Index is a market capitalization-weighted index, representing most U.S. traded investment grade bonds. It is not possible to invest directly in an index.

The Ivy VIP Bond portfolio was renamed Ivy VIP Corporate Bond on April 30, 2018.

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 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. These and other risks are more fully described in the Portfolio's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.

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