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Bryan C. Krug, CFA
Portfolio Manager
Ivy High Income Fund
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Ivy High Income Fund – October 2011
Investor uncertainty seemed to rise with this year’s summer heat. After a protracted debt ceiling debate in Washington and an evolving debt crisis in Europe, the idea of a slow but continuing U.S. economic recovery wilted away and was replaced by predictions of a recession. The outlook has curbed investor risk appetites, resulting in a flight to safety as investors seek lower volatility and greater liquidity in their portfolios.
What is the outlook for the U.S. economy and are there places where investors can get both a degree of safety and potentially higher returns? Bryan Krug, portfolio manager of the Ivy High Income Fund, shares his views.
In recent weeks, we have certainly seen across-the-board risk aversion in the markets in response to events in Europe, which is the biggest issue facing the markets, and fears of a U.S. recession. Even with Standard & Poor’s downgrade of the U.S. credit rating, investors from around the world moved into the safety of U.S. Treasuries, driving yields down to historic lows and boosting returns on U.S. government debt.
The question as to whether we are actually in a recession — which will be determined after economists have had an opportunity to review the economic data — may garner a lot of headlines, especially as we head toward next year’s presidential election. Is the U.S. heading into a recession? We think the chances of either the U.S. entering or narrowly avoiding a mild recession are about equal. However, we would emphasize the word “mild.”
Stuck in the “muddle?”
We base this view on several factors. Notably, the current levels of activity in many areas of the economy simply do not have the room for the kind of steep declines we experienced during the financial crisis in 2008. For example, prior to the financial crisis and recession, we saw new housing starts in the U.S. at more than 1 million in 2007. In recent months, the number has been closer to 300,000, which is near the lowest level seen since data tracking started in 1959. Similarly, auto and truck sales, which were well above 17 million vehicles in 2006, were below 12 million last year — or about the level we saw in the early 1980s.
It is also important to recognize that U.S. banks are extremely well capitalized compared with three years ago and the degree of financial leverage is nowhere near what we saw at that time. Not only are banks better prepared to handle — and mitigate — a potential downturn, corporations are also in better shape and are, in fact, profitable. Firms have done little hiring — as evidenced by the current U.S. jobless rate — and are basically staffed at levels to meet 2008-09 demand. At that level, a soft economy should not foster a substantial further rise in unemployment. In addition, we have seen a number of firms take advantage of opportunities to reduce their financing costs. Businesses, overall, are in a fairly strong position.
For investors, rather than worrying about a recession, we believe it is more important to recognize that we will spend some time in what we call a “muddle through” economy. We will be somewhere between mild recession and slow growth, and we believe investors who cling to the same safe havens they sought in 2008 will be shortsighted. In fact, we strongly believe that investors can benefit by taking advantage of opportunities in the corporate bond and bank loan markets as they present themselves.
Credit opportunities
We see demand for high-yield credit funds increasing over the next year as investors recognize these opportunities. A major reason is retail investors have few other options for generating any kind of income stream — this is especially important to the baby boomers nearing retirement. Treasury yields are near historic lows. Currently, two-year Treasury yield is below 0.2 percent, the five-year is below 1 percent, and the 10-year is hovering around 2 percent. Meanwhile, investment grade bonds are yielding around 3.5 percent. In this environment, and with an average yield on high-yield credit above 8 percent, we are seeing a willingness by investors to take on increased credit risk instead of duration risk. Investors are starting to realize that it does not make sense to lock up their money for 10 years at 2 percent yield when they can opt for a shorter investment period with a greater income potential.
Further, we see increased high-yield demand from institutional investors. Pension funds are seeing a larger percentage of the U.S. population moving toward retirement, increasing the need for income. As a result, investors are moving away from duration-based assets and into more yield-based instruments. Along the same lines, insurance companies are increasing their exposure to the high-yield markets as the need for income in annuity products increases.
We currently see a lot of value in the high-yield market. Skittish investors, fearing a series of defaults, caused a wave of redemptions in high-yield funds over the summer, creating liquidity issues for fund managers. We believe this fear has been overdone and has, in fact, created opportunities. The market is pricing in a default rate of about
7 percent for the high-yield market. However, based on current fundamentals, we expect defaults will actually continue to run below 2 percent for the next 12 to 18 months.
Our view is based on many of the same factors that will limit the depth of any recession — especially that corporations, overall, remain profitable. These companies are also telling us that they are simply not seeing the same things that they saw in 2008. To be clear, these firms are not experiencing phenomenal growth — it is not that type of environment — but they are not seeing things fall apart either. Like many individuals, they tell us they are looking at what has happened in the markets in recent weeks, such as some of violent swings in stock prices, and say that the markets are not reflecting of what they are observing in their businesses. We are hearing this same view from a broad spectrum of businesses, including areas that would seem to be hit the hardest by a recession. For example building companies, which suffered greatly in the 2008 recession, have told us that while business is not great, it is not worse than it was six months ago.
The same volatility that has captured a lot of headlines in the equity market is also having an impact on credit markets. Uncertainty has driven borrowings costs higher — substantially in some cases — for some borrowers. For example, we have seen recent issues come to market with yields of around 10 to 12 percent that, had they come on the market a month earlier, would have had a coupon of around 8 percent based on what we saw at that time. It is important to stress that this rise in financing costs is not driven by fundamentals of the borrowing businesses, but we believe is instead a creation of the increased risk aversion in the markets.
Investors should have ample opportunity to take advantage of this opportunity as we head into the fall. Bond issuance, which has been slow in the current environment, is expected to pick up in coming weeks with several issues on tap.
The opinions expressed in this commentary are those of Mr. Krug and are current through October 7, 2011. The manager’s views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results.
Investment return and principal value will fluctuate, and it is possible to lose money by investing. 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 high-income 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 Fund’s prospectus.
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.