Fixed income markets: Improving, but risks remain
June 13, 2013
On positioning for a potential rise in interest rates
Although we don’t believe that rates will move up any time soon, we do believe the next significant move may be higher, given today’s historically low levels and our outlook for continued economic improvement over the long term. We therefore have measures in place to seek to address an increase in rates over the long term.
Historically low interest rates
Effective Federal Funds Rate (FEDFUNDS)
With U.S. interest rates at historically low levels, rates have only one direction to go: up. Data: U.S. Department of Labor, April 2013
Federal funds rate refers to the interest rate banks charge each other for overnight loans to meet reserve requirements.
Chart above is for illustrative purposes only, and not meant to predict actual results.
For example, within Delaware Diversified Income Fund (DPDFX), we own high yield bonds and bank debt, which are the senior debt of high-yield bond issuers. When rates are rising because of an expanding economy, the more credit-oriented bond investments, which include high yield bonds and bank debt, have historically performed well.
Traditionally, high yield bonds have outperformed all the high-quality tiers of the market in a rising-rate environment, whether it's investment-grade, mortgages or, as an extreme example, Treasury bonds. We believe this has been the case because the issuers of high yield bonds tend to improve their own health as the economy expands. With this, price increases on high yield bonds have historically been enough to partially offset the impact of rising interest rates (Source: St. Louis Federal Reserve Bank).
Across several of our bond funds, we’ve also increased credit exposure in high yield, bank loans, and within the BBB-rated component (that is, the lowest of the rating categories by Standard & Poors considered to be investment grade with some speculative characteristics) of the investment-grade corporate-bond universe. Those are all designed as relatively defensive ways to hedge against an eventual climb in interest rates. In the meantime, we're also receiving higher interest payments than we could have by investing in higher-quality segments of the market.
On corporate credit: Our team's best investment idea in the current environment
We continue to have a notably positive view of U.S. corporate credit, particularly intermediate-range corporate bonds. Whether it's high yield or investment-grade bonds, the sector continues to have favorable credit measures.
We believe a combination of factors has resulted in record-high credit quality and record-low default rates. These factors include:
- Cost-cutting efforts undertaken in response to the credit crisis
- A refinancing wave of interest rates not seen in 60 years
- Near-record-high cash balances as a result of subdued investment spending
For these reasons, we believe that intermediate corporate bonds may have the potential to outperform other fixed income instruments, including floating-rate bonds and bank loans, possibly through the remainder of 2013, simply due to their higher yields.
On bond markets today: Diversification may offer a favorable risk-return trade-off
We've had a 30-year decline in interest rates as a driver of bond returns. We believe that trend could be over. All the spread widening that took place in 2008 has almost entirely re-corrected and, in most cases, is well inside long-term averages.
Whether it’s high yield, investment grade, mortgages, or emerging markets, yields above Treasury bonds are once again very narrow. We don’t believe there are any major drivers of capital appreciation left in the bond market, meaning once again bonds should no longer have the potential to provide equity-like returns in the coming years, as they often have in the recent past. Therefore, we view the current situation as a time to focus on coupon payments.
Given our outlook for subdued economic growth, we believe fixed-rate intermediate-term instruments in a diversified investment portfolio may outperform Treasury inflation-protected securities (TIPS) and floating-rate bonds, possibly through 2013. But when the economy eventually gains traction and rates potentially move up, we think floating-rate options could become attractive to some investors.
Because interest rate moves cannot be predicted with precision, we believe bond investors may be better served by considering an actively managed diversified portfolio that provides the flexibility to move in a number of directions.
On the U.S. economy: Continued pressure on spending and consumption
On the Delaware Investments® Fixed Income team, we don’t believe the economy is much above stall speed. We estimate growth could be about 2% to 2.5% for 2013. The reason for this estimate is that the main drivers of gross domestic product — consumer spending, government spending, corporate spending and, to a lesser extent, exports — seem likely to remain subdued.
Despite a recent decline in the unemployment rate to 7.5%, we believe tremendous slack remains in the labor market. Looking at the U-6 measure produced by the U.S. Labor Department, which we believe is a more accurate picture of unemployment, the number of unemployed, underemployed (part-time workers looking for full-time work), and dropouts from the labor force is roughly 14%. (Data: U.S. Department of Labor, April 2013).
With higher taxes, we don’t expect consumer spending to climb rapidly. As for state and federal government spending, both measures appear to be trending downward. Despite some glimmers of light in the last six months or so, corporate and investment spending has been muted, with many companies hoarding cash in the face of so much uncertainty out of Washington, Europe, China, and the Middle East.
Given the sluggishness of the economy, we believe the United States could be vulnerable to a potential shock coming from some geopolitical cause, such as an unexpected slowdown in China or problems in the Middle East, for example.
A challenging unemployment picture
Broad (U6) Unemployment Rate
This chart, which depicts the U-6 unemployment rate, shows a much more significant unemployment problem than the popular estimate currently suggests. U-6 refers to those unemployed and looking for work, part-time workers looking for full-time work, and discouraged workers who have dropped out of the labor force. Data: U.S. Department of Labor, April 2013
On U.S. inflation: Outlook remains subdued
We do not expect inflation to rise much above a nominal 2% level for the foreseeable future. The significant resource slack in the U.S. economy, coupled with a sluggish growth rate, suggests that it will be very difficult for inflation to become structurally embedded in the economy. In addition, we believe there is no expectation of inflation on the part of consumers, which is essential for inflationary pressures to take root.
Furthermore, from a monetary perspective, the record-breaking liquidity injected into the banking system by the U.S. Federal Reserve has largely remained trapped within bank reserves. We believe the economy needs aggressive bank lending in order to provide capital and boost growth rates. With banks exceptionally risk-averse right now, we just don't see much of an inflation threat.
In our view, the weaker dollar, combined with heightened geopolitical event risk (particularly from the Middle East), implies the potential for spikes in energy prices that could affect consumer spending. However, energy prices constitute a small portion of the final cost of goods and services, and given the low growth rate that prevails today, we see little likelihood that hikes in oil prices will ignite a broader inflation problem.
On the global economy: Downside risks outweigh growth prospects
In our view, there are more downside risks at present than catalysts for growth. We generally expect global economic output to remain well below its full potential, as still-robust growth in Asia is offset by recessionary conditions in Europe, sluggish growth in the U.S., and slowing growth in several of the larger emerging market economies.
In particular, the potential for slower-than-expected growth in both the U.S. and China, and a disruptive worsening of the European situation, could potentially affect output and consumer and business sentiment on a global basis.
On the European Union: Continuing headwinds, difficult solutions
In our view, the European crisis seems to us an outgrowth of forming a monetary union without an accompanying fiscal union. With too much fiscal autonomy at the national level, inadequate centralized oversight, broadly different national economic identities, and generally different goals between the northern and southern tier countries, fissures that were largely under the surface finally emerged under the stress of the 2008 credit crisis.
Greece, Portugal, Spain, and Italy share (to various degrees) the same common problems, which include the following:
- excessive government spending that has led to unsustainable levels of debt
- high unemployment and unaffordable public sector wage and benefit structures
- inefficient, unbalanced, and overregulated economies
- an undercapitalized banking sector burdened with loan losses associated with inadequate risk management and overly aggressive lending
The most likely outcome, in our opinion, remains a protracted, but ultimately successful, package of concurrent measures aimed at addressing the issues listed above. At the national level, we believe countries will need to pursue fiscal austerity and a broad package of legislation aimed at decreasing regulation and improving national competitiveness. At the regional level, much tighter fiscal coordination will be necessary, albeit at the expense of some degree of sovereignty.
In addition, the range of European Central Bank (ECB) funding mechanisms established during the last several years will need to be sustained and increased in order to provide breathing room for fiscal reforms to gain traction. The process may be measured in years, not months, in our opinion, and should certainly be accompanied by economic contraction as government spending and bank lending declines. This process will likely be uneven we believe and could contribute to heightened equity and bond market volatility until true progress is achieved.
The views expressed represent the Manager’s assessment of the market environment as of June 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.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
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. Fixed income securities may also be subject to the risk that principal is repaid prior to maturity.
The Fund may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for the Fund to obtain precise valuations of the high yield securities in its portfolio.
International investments entail risks not ordinarily associated with US 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.
International fixed income investments are subject to currency risk. Adverse changes in foreign currency exchange rates may reduce or eliminate any gains provided by investments that are denominated in foreign currencies and may increase losses.
If and when the Fund invests in forward foreign currency contracts or uses other investments to hedge against currency risks, the Fund will be subject to special risks, including counterparty risk.
Because the Fund may invest in bank loans and other direct indebtedness, it is subject to the risk that the Fund will not receive payment of principal, interest, and other amounts due in connection with these investments, which primarily depend on the financial condition of the borrower and the lending institution.
Interest payments on inflation-protected debt securities will vary as the principal and/or interest is adjusted for inflation.
The Fund may invest in derivatives, which may involve additional expenses and are subject to risk, including the risk that an underlying security or securities index moves in the opposite direction from what the portfolio manager anticipated. A derivatives transaction depends upon the counterparties’ ability to fulfill their contractual obligations.
Diversification may not protect against market risk.