Ivy VIP Bond

Ivy VIP Bond
06.30.17

Market Sector Update

  • The second quarter of 2017 produced solid performance for virtually all U.S. fixed income sectors with corporates, Treasuries and securitized assets leading the way. 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 first half of 2017, as has been the case for the past several quarters. The strong global demand for U.S. fixed income investments is a result of accommodative Central Bank policies outside of the U.S. as well as confidence in the U.S. economy. Despite record new issuance in the credit sectors, the demand for yield and positive fund flows continued to dominate questionable fundamentals, leading to tighter spreads.
  • 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.
  • 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 overall macro-economic 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 worst performing major sectors were Energy (2.13%), Consumer Cyclicals (2.14%), and Financials (2.14%). Lower credit quality (BBB’s and Crossovers) continued to out-perform higher credit quality in the first half of 2017 as well as for all of 2016.

Portfolio Strategy

  • The Portfolio’s overall asset allocation changed slightly during the second quarter. The Portfolio increased exposure to credit from 81% to 90% during the quarter. The increase to credit exposure was made across a number of subsectors in both the financial and industrials sectors. The additions to the credit sector was funded by a higher than normal cash balance at the end of 1Q due to a late quarter inflow. The securitized assets were reduced from 9% to 7% and Treasuries from 2% to 1% during the quarter. The Portfolio’s effective duration increased slightly from 5.5 years to 5.8 years, ending the quarter essentially neutral duration vs. the benchmark. The Portfolio was also positioned to benefit from a flattening trend of the yield curve, which did occur in the second quarter. The yield-to-worst of the Portfolio was 3.07% at quarter-end, 6 basis points higher than prior quarter-end. The significant over-weight to the credit asset class was the most significant contributor to the quarterly out-performance of the Portfolio relative to the benchmark.
  • The credit quality of the Portfolio remained largely unchanged during the second quarter. The average credit quality of the fund was “A” as measured by Standard & Poor’s at the beginning and end of the quarter. The credit quality distribution of the Portfolio was as follows at the end of the quarter: 7% AAA, 13% AA, 31% A, 41% BBB, 1% BB, and 5% not rated. Cash was approximately 3% of the Portfolio at quarter-end. Roughly 92% 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 quarter. 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.

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 to the financial markets. Despite concerns about the effectiveness of the Trump administration, slowing growth expectations, and geopolitical risks, investor sentiment remains bullish for risk assets as of the start of the third quarter. Although impossible to predict precise timing, geopolitical events seem to be stacked to the downside and could impact market sentiment and lead to volatility in risky assets, including stocks and bonds.
  • 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.
  • Whether it is justified or not from a fundamental standpoint - the U.S. credit market has settled into complacency mode. There has not been significant price volatility or sector dispersion thus far in 2017. Currently there are no obvious signs that the fixed-income markets will change course in the near-term. Despite the complacent investor sentiment that exists right now, there are several risks that could prove to be disruptive at some point in the future. 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. In financial markets like we are currently experiencing, it generally is not prudent to take excessive risk.

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 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.

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.

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.