Keep it Short? The Limited-Term Fixed Income Market
Concern about interests rates has made fixed income investors more aware of the potential for interest rate risk – or the risk that a rise in rates will reduce the value of their longer-maturity securities. This risk, which is often expressed as a bond or bond fund’s “duration,” has led some investors to consider investments believed to have less potential risk. These securities, which are considered to have a lower duration, are seen as less vulnerable to market volatility.
Below, Ivy Limited-Term Bond Fund Portfolio Managers Mark J. Otterstrom and Susan K. Regan, share their views on the market and the outlook for low-duration securities.
Higher or not?
One of the biggest challenges for many fixed income investors in recent years has been positioning relative to expected moves in interest rates. When the benchmark 10-year U.S. Treasury ended 2013 with a yield above 3%, most market watchers predicted rates would continue climbing in 2014, fueled by the strength of the U.S. economy and the expectation that the Federal Reserve (Fed) would begin to unwind some of the monetary stimulus measures implemented during the credit crisis and recession.
Instead, we saw U.S. economic weakness early in 2014 with mounting geopolitical and global economic concerns emerging later in the year. As a result, the 10-year yield ended 2014 nearly 100 basis points lower than where it started the year, despite the Fed ending its bond-buying stimulus program. During the fourth quarter, we saw another dramatic rally at the long end of the Treasury bond market. Continued weakness in Europe, and a dramatic sell-off in emerging market bonds, led to a strong flight-to-quality trade into the Treasury market, flattening the yield curve.
In the U.S., the policy focus has turned to the potential timing of the first increase in the Fed’s key interest rate, known as the fed funds rate. General expectations have been for a 25-basis-point rate increase in June or July of 2015. However, the timing of any move is very dependent on the data and some have now begun to see a summer rate increase as unlikely. Fourth quarter U.S. gross domestic product (GDP) growth was somewhat disappointing and global economic uncertainty continues, particularly in Europe. If the Fed is concerned that U.S. economic growth is being brought down by the extreme weakness in Europe and the emerging markets, then the lift-off date for Fed tightening could be delayed.In January, the International Monetary Fund (IMF) significantly lowered its global growth projections for 2015. The expected better economic growth in the U.S., while still rather anemic, is one of the few bright spots in their forecasts.
Portfolio positioning
As we move forward in a very unpredictable market, it is our view that the elevated level of volatility of the last few years could easily persist. With the short end of the yield curve anchored by the low fed funds rate, we expect to see continued volatility in the middle and longer end of the curve. We believe that even slight changes in the U.S. economic outlook could have significant short-term effects on longer-duration securities.
While the Fed still appears to be willing to keep rates low for a long time, some policymakers have indicated a growing desire to begin normalizing monetary policy. They have indicated the risk of higher inflation is less of a concern than the threat of renewed economic weakness. The Ivy Limited-Term Bond Fund’s portfolio’s duration is currently neutral its benchmark duration and we expect to maintain this position for at least the near-term.
Even when the Fed begins to raise its key fed funds rate, we believe a strong flight-to-quality trade will continue keeping Treasury yields at the long end of the yield curve relatively low. In the fourth quarter of 2014 we began to shift the Fund’s portfolio to a barbell structure to take advantage of the yield curve flattening. It is our belief that the dynamics leading to this flatter yield curve will be with us for some time to come.
For the last few years, the Ivy Limited-Term Bond Fund has been overweight its benchmark in corporate securities. and we plan to continue this overweight position favoring corporates over government securities. We think investment-grade corporate credit offers the best risk-adjusted spread cushion of the major sectors in the high-grade fixed income market. With economic conditions improving in the U.S., we expect to see relatively stable corporate bond spreads on investment-grade bonds.
Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through March 1, 2015, and are subject to change due to market conditions or other factors. Holdings and weightings are subject to change.
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. 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. These and other risks are more fully described in the Fund’s prospectus.
Not all funds or fund classes may be offered at all broker/ dealers.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus,or if available a summary prospectus, containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.
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