Notes from the desk

Thomas Chow, Chief Investment Officer — Corporate Credit

William Stitzer, Assistant Portfolio Manager

Investment grade bond issuance has spiked recently, with the first week of March posting the second-largest weekly supply on record (behind only the $65 billion week in September 2013, which included the record-breaking deal completed by Verizon Communications).

Despite this recent flood of new supply, we believe the technical backdrop for credit markets remains positive for a number of reasons, including:

  • Supply forecasts for 2014 are down from the record issuance of 2013, which came in at roughly $850 billion. Some issuance has likely been pulled forward due to benign market conditions, but there are still wildcards that could influence supply levels in the coming year. Among them: interest rates, M&A activity, share buybacks, and financial supply.
  • Investment grade markets have been a relative safe haven from global volatility, particularly the recent turmoil in emerging markets.
  • Interest rates remain low on a historical basis, and with yields on 10-year U.S. Treasurys recently close to eight-month lows, conditions are currently favorable for issuers. The downside has been an increase in shareholder-friendly use of proceeds to the disadvantage of bondholders.
  • Credit metrics within the investment grade sector remain satisfactory. Revenue, EBITDA1, net leverage, and other metrics have shown improvement recently. What's more, financial services companies have recovered from the financial crisis with much stronger balance sheets and defaults remain at historic lows.
  • Demand for long-duration bonds is steady, driven in part by improvements in pension plans' funding status, which has motivated them to lock in gains by switching from equities to fixed income.
  • Traditional asset/liability management buyers such as insurance companies are expected to continue to drive demand for long dated assets, especially if rates rise.
  • Global financial institutions are transitioning from government debt (sometimes referred to as sovereign debt, especially in international markets) toward corporate allocations.
  • While absolute annual returns will be predicated on interest rate moves, investment grade corporate bonds offer a measure of diversification when complemented by other investment grade alternatives.

Data noted above are based on materials published by sources that include: Moody's; Barclays; Federal Reserve Bank of St. Louis; and Dealogic (via Dow Jones).

A few words about risk

It's important to understand that despite numerous headwinds, the U.S. economy is showing signs of steady — albeit slow — progress. With that in mind, we believe that when it comes to risks, the bigger challenge is related to mark-to-market risk, certainly more so than fundamental risk (at least in the intermediate term).2

To help explain what we mean: We believe that in the coming months, risk appetites will be influenced by factors such as rising shareholder activism and rising M&A activity. Other determinants of risk tolerance could likely include: (1) China's growth prospects and the consistency of its economic performance, (2) continued economic recovery in Europe, and (3) geopolitical unrest around the world (particularly in emerging markets).

1Earnings before interest, taxes, depreciation, and amortization.

2In other words, if investors experience temporary bouts of anxiety, market prices for financial assets could fall below their actual intrinsic values.

The views expressed represent the managers' assessment of the market environment as of March 2014, 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.

Investing involves risk, including the possible loss of principal.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

Funds that invest in bonds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.

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.

3/14 (12293)

Penghui Sun, Equity Analyst — Real Estate Securities and Income Solutions

A 3 billion renminbi ($492 million) trust loan with the potential to default by the end of January could mark the first case of trust-product default in China — a development that we believe could have far-reaching implications. The product in question was issued by China Credit Trust (CCT) in 2011 with the promise of a 9.5–11.0% yield and a maturity of 3 years. ICBC, the largest bank in China, sold the product to 700 of its wealthy private banking clients.

Historically, the Chinese government has stepped in to prevent or mitigate large defaults or reorganizations, creating the perception of a moral hazard. This time, it appears the Chinese government will again step up to rescue the investors, but how far it will go remains a question. The CCT product was issued to finance an unlisted coal mining company, which is currently undergoing bankruptcy procedures; however, the asset value that has been recovered so far is much less than the company’s outstanding debt. One-third of China’s outstanding 4.6 trillion renminbi trust loans ($760 billion) are due to mature in 2014. In the second quarter of 2014, 6 billion renminbi in trust loans that financed the notoriously deadly mining industry are coming due.

While trust products have attracted China’s high net worth individuals and institutions with double-digit yields and 2-3 year maturities, wealth management products (WMPs) have been by far the most popular investment vehicle for ordinary Chinese savers looking for higher returns. WMPs share certain characteristics with structured investment vehicles (SIVs) and collateralized debt obligations (CDOs), both of which were used by U.S. banks before 2008 to keep loans off–balance sheet. A considerable portion of WMPs were also invested in the affected trust business. WMPs have typically yielded 4–6% (1–2 percentage points higher than bank deposits, on average) with 3–6 months of maturities, and generally are sold by banks to retail investors as low-risk investments. Rating agency Fitch estimated that around 13 trillion renminbi ($2.2 trillion) of WMPs were outstanding by mid-2013. Since then, growth has slowed after the government imposed new regulations on banks.

Given some of the risks that we see within the Chinese marketplace, we currently hold no direct exposure to China within the global real estate investment trust (REIT) portfolios that we manage.

Unless otherwise noted, developments cited throughout this commentary are supported by data published by Bloomberg.

The views expressed represent the Manager's assessment of the market environment as of January 2014, 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 views.

REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.

Structured investment vehicles are pools of investment assets that attempt to profit from credit spreads between short-term debt and long-term structured finance products such as asset-backed securities (ABS). A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors.

1/14 (12012)

J. David Hillmeyer, CFA, Senior Portfolio Manager — Fixed Income

December 19, 2013 - In our opinion, the Federal Reserve had to offer something up to get the market’s permission not to “spike the punch bowl” as aggressively as it had been doing. This included strong language around the expectation of rates remaining unchanged “well past” the threshold of 6.5% unemployment being reached. Additionally, the Fed’s Summary of Economic Projections showed the median forecast of federal funds for both 2015 and 2016 declined by 0.25%, implying rates will remain lower for longer. Furthermore, slowing purchases by $10 billion a month is a drop in the bucket relative to how much liquidity it will continue to inject into the system.

Prior to initiating a reduction in the amount of bonds purchased, the Fed had to avoid a repeat of the so-called “taper tantrum” this summer, when investors pulled forward a rate increase, despite the Federal Open Market Committee’s (FOMC’s) forward guidance on rates. Back in May, when tapering talk began, Eurodollar forwards and fed fund futures priced in a tightening as early as next year. In our view, however, the Fed couldn’t allow that tightening to happen again, particularly because the effectiveness of quantitative easing is being called into question by market participants and Fed officials alike.

The recent spate of better economic data certainly provides a more constructive backdrop for the Fed to initiate the taper. However, keep in mind the pattern of the past few years, which showed economic optimism increasing into year-end only to be met with subpar growth. At the end of the day, we believe excessive liquidity, which leads to asset inflation, isn’t a fundamentally sound long-term policy for successful economics.

The views expressed represent the Manager's assessment of the market environment as of December 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 views.

Eurodollars are U.S. dollar–denominated deposits at foreign banks or foreign branches of American banks. Forwards and futures refer to types of derivative contracts in which a buyer agrees to purchase an asset (or the seller to sell an asset) at a predetermined future date and price.

12/13 (11779)

Joe Baxter, Head of Municipal Bond Department, Senior Portfolio Manager

Delaware Investments municipal bond funds have no exposure to Detroit bonds, as had been the case prior to the bankruptcy filing. Our first take on the ruling issued earlier this week is that allowing pension systems to be included in the proceedings is a positive factor for other creditors (such as bondholders) because it distributes the burden of haircuts that are likely to be part of any settlement. (It bears repeating that we are not Detroit bondholders and will not be personally involved in these negotiations.)

In our opinion, the ruling had no effect on valuations within the municipal market. Bonds did move slightly lower, but we believe it was due primarily to interest rate movements. We think the bigger risk to the broader municipal market is that other distressed cities and localities could claim bankruptcy in order to resolve budget shortfalls. However, we think this may only happen to a limited degree, and do not think it will be systemic. Bankruptcy is a complicated process; not all states allow local municipalities to file, and there are severe market access issues for those that do so.

As we have been doing for some time, we have maintained underweight allocations to local general obligation bonds versus state general obligation bonds, largely because we believe states have more remedies available to them when it comes to shoring up finances. They can also defer some of their fiscal problems down to the local level.

Investing involves risk, including the possible loss of principal.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

Funds that invest primarily in one state may be more susceptible to the economic, regulatory, and other factors of that state than funds that invest more broadly.

The views expressed represent the investment manager's assessment of the market environment as of December 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 investment manager's current views.

Chris Beck, Chief Investment Officer — Small-Cap Value / Mid-Cap Value Equity

The real U.S. economy increased at an annualized rate of 2.8% in the third quarter of 2013, according to the latest estimate from the U.S. Commerce Department.

The continuation of positive growth, coupled with falling unemployment and a rising stock market, has provided a nice boost to U.S. consumer confidence and spending. The majority of economically sensitive stocks continue to meet or exceed profit estimates, which is an additional signal that the United States appears to be in a moderate but more sustainable economic recovery. This recovery, now in its fifth year, has been particularly strong for domestic small-cap stocks. Part of the reason is that small-cap companies derive 81% of their revenue from the U.S., while that figure is 64% for large-caps. (Source: FactSet Research Systems; BofA Merrill Lynch Small Cap Research.)

The views expressed represent the investment manager's assessment of the market environment as of November 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 investment manager's current views.

10/13 (11670)

Todd A. Bassion — Portfolio Manager, Global and International Value Equity team

In early October, the International Monetary Fund warned Japanese Prime Minister Shinzo Abe's government that the structural reforms proposed as part of its “Abenomics” program weren't sufficient to achieve sustainable growth.

Although structural reforms pose the greatest challenge, we believe there may be progress soon. Abe will present a reform package to Parliament in December that includes measures to boost capital investment by smaller companies, labor reform, spending for the 2020 Olympics, payments to low-income earners, and tax incentives for home purchases. Abe will also recommend that Japan join the Trans-Pacific Partnership, which is a free-trade partnership between the United States and several other countries.

We believe Abe has a better chance of achieving meaningful change than his predecessors. His approval rating is close to 70% and his party controls both chambers of Parliament. In any event, we will continue monitoring Japan's changing policy landscape.

The views expressed represent the investment manager's assessment of the market environment as of October 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 investment manager's current views.

11/13 (11618)

Roger A. Early, CPA, CFA, CFP, Co-Chief Investment Officer — Total Return Fixed Income Strategy

October 9, 2013 - Should President Obama has announced the nomination of Janet Yellen to succeed Ben Bernanke as chairperson of the Federal Reserve come as no surprise to us, especially following Larry Summers' decision last month to withdraw his name from consideration for the post. We expect that the confirmation process will be a smooth one and that, once confirmed, Yellen continue the easy money policies that have characterized the latter years of the Bernanke Fed. While we are wary of the long-term consequences of such policies (particularly of quantitative easing), it is possible that the very fact that a nomination has been made may be of some modest consolation to the markets. That said, our more immediate concerns are related to the on-going stalemate in Washington D.C. surrounding the continuing resolution and the debt ceiling.

The views expressed represent the Manager's assessment of the market environment as of October 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 views.

10/13 (11491)