Opportunities in the fixed income markets

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Joseph R. Baxter

Senior Vice President, Head of Municipal Bond Department, Senior Portfolio Manager

For us, the most attractive sector of the municipal market at present resides in the lower-rated, higher yielding categories. If macroeconomic conditions remain similar to those of 2012 in which the stock market would rise amid modest economic growth, forcing investors to continue their search for yield, we can potentially envision a scenario in which BBB-rated and high yield bonds continue to generate strong performance. These securities have historically outperformed in a rising rate environment in which rates tend to rise in a slow, controlled manner. If the economy grows much faster than the roughly 2% growth seen in recent quarters, however, and if rates move significantly above current levels, all rating tiers could face significant headwinds.

In addition, ongoing fiscal negotiations on the debt ceiling, sequestration, and the annual budget process could cause volatility in the financial markets. More specific to municipal bonds, the tax-exempt market may experience some volatility, as it did in December 2012, due to the ongoing possibility of proposals that call into question the sector’s tax-exempt status.

All of these things — the threat of higher interest rates, the uncertainty of fiscal policy negotiations, the specter of tax policy changes — may cause ebbs and flows during 2013 in the municipal bond market. However, markets tend to overreact to short-term headlines, which may provide opportunity for patient investors.

Roger A. Early, CPA, CFA, CFP

Senior Vice President, Co-Chief Investment Officer — Total Return Fixed Income Strategy

Overall, yields in the domestic bond market are very low on a nominal and real basis, but we believe there are pockets of opportunity. We especially like investment grade corporate bonds and mortgage-backed securities, the latter of which is currently yielding about 2.25% (source: Bloomberg). On the Delaware Investments Fixed Income team, we often buy mortgage debt through a delayed settlement procedure, looking to take advantage of various anomalies in the market. In many cases, we’ve been able to end up with a mortgage bond that’s rated the same as a Treasury but with a 100 – 150 basis point spread in the 5 – 7 year area of the curve (note that 100 basis points equal one percentage point).

That yield pickup speaks to the benefits of active management. The low rate environment that we have endured for several years now provides very little cushion for price volatility. Over time, though, our credit research capability has added measurably to total return. It’s a matter of blending all the pieces of a multisector asset class together in a way that attempts to maximize yield while dampening volatility, such as by including some short-duration plays to build a defensive component to a portfolio. Looking at interest rates generally, we think yields are expected to end 2013 a little higher than they are today. But rates won’t head up in a straight direction, in our opinion. There are too many difficult economic and political issues left to be settled in the United States, China, and Europe to expect an abrupt spike in yields.

Paul Grillo, CFA

Senior Vice President, Co-Chief Investment Officer — Total Return Fixed Income Strategy

Given the massive amounts of liquidity central banks continue to inject into the global financial system, we believe higher-beta areas of the market currently provide the more favorable opportunities. This assumes, of course, that the Federal Reserve and other major central banks continue to keep the liquidity “spigot” open. We specifically look to emerging market corporate debt as an area of opportunity. It’s important to note, though, that this is not simply a top-down (macroeconomic) sector call. For the last year-and-a-half to two years, the more attractive opportunities have been generated by individual security selection. Company- and issue-specific research has made the difference in relative performance during this time frame.

We continue to believe that developed market sovereign bonds will face challenges in 2013. We expect yields to rise at least slightly in some nations, a process that already is under way. Currencies also could come under pressure. Shinzo¯ Abe, the new Japanese prime minister, has been outspoken about wanting the Bank of Japan to crank up the printing presses — and not in a half-hearted way this time. We also expect the British pound to move lower after Mark Carney takes over at the Bank of England and further eases monetary policy as we expect him to do. The recent rally in the euro has some characteristics of a temporary move, but at least the peripheral nations like Greece, Spain, and Portugal do become more competitive at that level. When you add up all these factors, we think there is a strong case to be made for taking some money off the table in developed countries.

We also are not finding much value at present in the U.S.-dollar sovereign emerging market space. This government sector had an exceptionally strong 2012, posting gains of about 15%. The rally compressed spreads to levels that no longer represent good value, in our opinion. Notably, however, the corporate emerging market sector remains attractive to us. We believe it still offers a reasonable yield of about 4.5% and perhaps up to 50 basis points of spread compression left to go this year, thanks to the massive amount of liquidity created by world central banks. There should also be less pressure on currencies in the emerging world because of their higher interest rates. Those yield levels make local-currency emerging market government bonds attractive to us. Currency plays among the high yielders can be attractive in the forward market as well. The currency forward instruments can give an investor a more liquid entrée into these markets. Relying on currency levels can be a tricky game to play, however, since some countries — most notably Brazil in late 2012 — have tried to talk down their currencies to remain competitive. On balance, though, we think the combination of yield and currency could make emerging market debt one opportunity to consider in the global fixed income markets this year. (Source: Bloomberg.)

Thomas H. Chow, CFA

Senior Vice President, Senior Portfolio Manager

A little perspective is in order, in my opinion, when looking at investment grade corporate bonds. We’ve just experienced several very good years and at least one great year, and the sharp downward move in yields over that period has removed what once was, in my opinion, a terrific opportunity in the corporate bond space, at least from a tactical standpoint. In the current environment, we believe investment grade corporate bonds may be viewed by some investors as a nice complement to a diversified fixed income portfolio.*

Even with yields near all-time lows, however, we believe there is room for some additional compression, especially in the high yield space, where the outlook for defaults remains very positive. At the height of the financial crisis, credit spreads on high yield bonds (or, their yield above a risk-free Treasurys) peaked at around 2,000 basis points. Currently, they are around 500 basis points, which is still slightly above the long-term average. (Source: Bloomberg.)

Those figures mask a broad range of spreads, however, and the purpose of our research is to identify value. For 2013, we believe total returns within the high yield and investment grade markets should largely depend upon whether the Fed stays the easy-money course as indicated, and whether investors’ risk appetite remains healthy. As has been the case for quite some time, however, we continue to believe that the potential for significant volatility in both yields and spreads remains across the entire corporate fixed income sector.

The views expressed in each outlook represent the Manager’s assessment of the market environment as of January 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s current views. The views expressed in each outlook are general in nature and do not relate to a particular mutual fund.


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International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

Fixed income securities can lose value, and investors can lose principal, as interest rates rise. They may be affected by economic conditions that hinder an issuer's ability to make interest and principal payments on its debt. Bonds are also subject to prepayment risk — the risk that the principal of the bond is prepaid prior to maturity, potentially forcing the investor to reinvest that money at a lower interest rate. High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.

High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.

Securities in the lowest of the rating categories considered to be investment grade (that is, Baa or BBB) have some speculative characteristics.

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