Capital Markets Coaching Clinic: The New (Ab)Normal: Oddities in Today's Bond Market

Capital Markets Coaching Clinic: The New (Ab)Normal: Oddities in Today's Bond Market


Delaware Investments - Capital Markets Coaching Clinic

Erica Kay
Our event today is part of the Delaware Investments Evolving Advisor practice management program. Whether it's keeping you ahead of the curve when it comes to technology and social media trends, helping make your work day a little more efficient, or learning about the markets from our team of experts, we strive to be your partner in growing your business and serving your clients. Now we'll get started. Our panel today is from our fixed income team. To kick off the event here is our moderator, fixed income product manager, Bryan Favilla.

Bryan Favilla
Thank you very much Erica. We have some great points to discuss today, and I am here with four individuals from our fixed income team that you might recognize as portfolio managers and authors of our popular insight pieces on our Delaware Investments website.
I am joined by Paul Grillo, ' Hello everyone'.
Cynthia Isom, ' Hi Bryan, hi everyone'.
Ion Dan, ' Hello everyone'.
And David Hillmeyer, 'Good afternoon'.

Here are the main points we will be covering today. The duration drift of the Barclays U.S. aggregate index, how the Federal Reserve may move short term rates, Bond market liquidity and Negative yields that we are currently seeing in the marketplace. These factors have already introduced volatility in 2015 and may continue to do so for the remainder of the year. Here are some additional things that may impact fixed income. You may recognize them from some of our commentaries leading into this year. Divergent central bank policy, deflationary forces affecting the economy and China which is currently going through an economic transition. Let's start with the topic of the longer interest rate sensitivity of the popular bond indices, like the Barclays Aggregate Index. Paul can you give us a short history of the index's interest rate sensitivity.

Paul Grillo
Sure Bryan. The Barclays Aggregate Index is meant to represent the opportunities set of high quality bond investments in the taxable universe. It includes things like U.S. treasury bonds and notes, high quality corporate bonds, Agency Mortgage backed securities (MBS) and other high quality structured investments like asset backed securities and commercial mortgage backed securities. It generally has an intermediate maturity average and the interest rate sensitivity measure is at an intermediate level as well. Throughout the last two and a half decades much of this time before the graph that you are looking at right now, the duration measure for this index was between four and five years. Because of certain events the duration or interest rate sensitivity measure has moved out to about five or six years in duration, as you can see on the graph. You are getting more interest rate sensitivity from this index.

03:10 - Bryan
Okay why did it extend, how can this be explained Paul?

03:15 - Paul
The first explanation comes from the nature of bond mathematics and how you discount future cash flows. With global overall yield levels you get longer duration or interest rate sensitivity. Quite simply there is a lower discount rate with lower yield levels. That means that the far out cash flows of a bond like maturity payments, count more and give a bond investment more duration and more price sensitivity. The second explanation has to do with cash flows in the mortgage market. The mortgage backed sector is a big part of this index, it's about 28%. When you are in a refinancing period which happens when rates are moving lower, the refinancing of mortgages are returning principals to investors and creating shorter term cash flows which have less interest rate sensitivity. You can see that on the first part of this graph here. The lower interest rate levels that we got to in 2009/2010 and a big refinancing period. After the big refinancing period you are left with new mortgages that people have refinanced into. They have lower coupons which trade at longer duration or higher interest rate sensitivity levels, and they are less likely to see refinancing unless we get another significant move in rates. This mortgage environment has had a big effect on the interest rate sensitivity of the index. The third effect here is the refinancing of outstanding corporate debts. These new corporate bonds carry lower coupons and are removing the older higher coupon debts, just like mortgage refinancing. The lower coupon bonds have more interest rate sensitivity. On the table on page 7 here you can see two bonds with the same maturity, two ten-year bonds. One bond carries a 2% coupon the other bond carries a 5% coupon. You can see the effect of the lower coupon payments throughout the 10-year maturity life. That bond has a duration of about 9-years and has more interest rate sensitivity than the 5% coupon with the 10-year maturity as well.

05:30 - Bryan
Why is this a problem?

05:32 - Paul
It's not a problem for investors per se but they should be very mindful of how their managers are adjusting their portfolios in this environment. You are getting more interest rate sensitivity from bond investments right now. So adjustments can and should be made in some circumstances, depending on the customers risk profile.

05:53 - Bryan
This certainly explains a lot about duration but what is Delaware doing to take this into account in its portfolios?

05:59 - Paul
For us at Delaware Investments, neutral is considered the new long. So if we believe that rates are moving lower Bonds are going to rally, our duration measure will be near the index level. Formally it would have been higher than the index level but with the index so far out on the duration curve right now our long is going to be neutral to the index. If we have no big conviction on interest rate movements our durations will reflect the index duration levels that existed before this new environment - say at about a 4.5 year duration level. If we fear higher rate moves we will be well short of the current index level. We have many tools to affect the interest rate sensitivity in our portfolios. You can see a few of them on the slide. So we can use interest rate futures, they are a very fast and economical way to move our exposure to interest rate movements and to position ourselves along the more quality or valued parts of the yield curve. We can ship our bonds from lower coupon bonds into premium coupon bonds or higher coupon bonds. Those premium coupon bonds absorb interest rate moves a little bit better than the lower coupon bonds. We could also move into sectors that in the past have absorbed interest rate moves better. These can be things like the levered loan market or the traditional high yield bond market. Sometimes you can get good interest rate insensitivity in some of the international markets. Or quite simply we can move Maturity adjustments in the portfolio. If we fear higher rates we can go from higher maturity bonds to lower maturity bonds.

07:51 - Bryan
Thank you for that Paul. We are going to pivot the conversation a bit and look at the Federal Reserve's involvement in the bond market. Specifically its role in the current rate environment. Cynthia what are the major issues the Fed is faced with today.

08:06 - Cynthia
Well Bryan let's first take a look at what the Federal Reserve looked like before the recession. Prior to the great recession of '08 the Fed held between 700 to 800 billion of treasury notes on its balance sheet. In response to this crises the Fed embarked on a campaign of expending capital and liquidity in U.S. financial markets. The most prominent element of this campaign was its quantitative easing program. This program went through three phases. The first phase QE commenced in November '08 with the purchase by the Fed of 600 billion of MBS in five months. By March '09 through subsequent purchases the Fed amassed one and three quarter trillion in bank debts, MBS and treasury notes. By the end of the second quarter 2010 this amount reached 2.1 trillion. In phase two of QE announced in November of '10 the Fed targeted further purchases of 600 billion of treasury securities by mid 2011. The third and final phase of QE commenced in December 2012. It involved a program of monthly purchases of Agency MBS initially at the rate of 40 billion per month and increased in December 2012 to 85 billion per month. As a consequence of the three rounds of asset purchasing under the six year regime of QE the Feds balance sheet has ballooned five fold from pre '08 levels to 4 and a half trillion today. In conjunction with QE the Fed has maintained a target rate for Fed funds of 0 to 25 basis points. Keeping the capital liquidity created through QE low to no cost.

10:00 - Bryan
That certainly gives us a thorough overview of what has occurred since the financial crises and the Fed certainly have a lot on its plate. What specific tools does the Fed have at its disposal to affect rates?

10:12 - Cynthia
Bryan, prior to the financial crises the FOMC conducted monitory policy by setting a target for the overnight Federal Funds Rate. Movements in this rate influenced other short term rates, such as the money market rates, commercial papers, certificates of deposit. Given the challenges created by QE and the desire to restore, at some point, market dynamics and reinstate normal monitory policy the Fed will have to fashion new tools and redeploy existing instruments to influence interest rates. Ultimately the Feds objective is to encourage the lifting off of rates from the QE regimes target range. To accomplish this objective the Fed through the FOMC will make use of the overnight Federal Funds Rate. It also has at its disposal interest on excess reserves, a policy instrument created in 2008 in conjunction with QE, IOER is managed by the FOMC similarly to the overnight Federal Funds Rate. Currently the IOER is set at 25 basis points in concert with the federal funds target range. The expectation is that the overnight rate and the IOER can be utilized in tandem in an effort to reverse QE related interest rates. To strengthen its hand the Fed has created other monitory policy instruments. Prime among them is a new tool the 'overnight reverse repurchase agreement' which went into testing phase in late 2013. A term 'Repo' was introduced in 2014. In September 2014 the FOMC announced in its 'Policy Normalization Principal and Plans' that it will include an overnight reverse repo facility as needed, as a supplementary policy tool to help control the Federal Funds Rate. The Committee made it clear that it would use this facility only to the extent necessary and intends to phase it out when it is no longer needed to control the Funds Rate. Additional tools are available to the FOMC. For example the Fed could compliment the use of overnight repos with the term deposit facility. Making it possible for banks to maintain term deposits with the Federal Reserve at interest rates higher than the IOER rates. Such innovations could provide arbitrage opportunities for depositors and ultimately exert upward pressure on money market rates. As of January of this year the counter parties for the reverse repo facility included banks with 30 billion or more in assets as well as money funds with at least 5 billion a month in net assets. The Fed does not anticipate expanding this group of counter parties unless increasing their number would promote the effective implementation of Fed policy. The Fed appears set to shrink and normalize its balance sheet passively by not reinvesting proceeds from Treasury and Agency debt it holds. The passive run-off approach is in keeping with the Feds broadly gradualist approach to reversing QE and restoring interest rate markets. A caution however, seventy eight years ago the Fed embarked on a similar program in which it raised interest aggressively and tightened monitory policy in a few discreet steps. The result was a wholesale sell off of bonds and a 50% slump in the Stock market. The Fed today faces a possibly more complex three-fold challenge. The increase in interest rates consequence on backing away from its QE target range, the abundance of reserves held by financial institutions and the inflation of its balance sheet. The repair manual required to fix these problems has yet to be written and risks abound as progress is assessed and policy is developed, refined and implemented. And finally Bryan, in my humble opinion, these tools are all new to the Fed and everything is subject to change. It does not inspire confidence.

14:44 - Bryan
Yes, Certainly if anyone has been reading about the some of the reform that is taking place and everything going on with the Fed they would certainly agree with you. A lot of the media and popular press seem to focus quite a bit on the FOMC's forward guidance as they call it. Can you speak a little bit about this?

15:02 - Cynthia
Yes, last week the Federal Reserve made subtle changes in its quarterly policy in that statement. The headline change was dropping the word 'Patience' from its pronouncement about its attitude towards dropping interest rates. It said that it would be appropriate to tighten rates "When it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2% objective over the medium term". This opens the door potentially for increasing rates as early as June of this year although some prognosticators believe that the Fed will hold off until the end of the summer. The implication of the Feds abandonment of patience have to be put in the context of the change and its estimate of the medium funds rate at year end. Which Fed analysts dropped from one and an eight last December to five eights of a percent. Markets appear to have focused on the implied delay on a rate increase, which they welcomed with both a stock price rally and a steep drop in bond yields. At a different level last week's fed announcement also indicates that policy will be reviewed and reset at each meeting. Responding to current economic data it views through its dual mandate for price stability and full employment and the long term policy objective of 2% inflation. At the end of this winter the data is giving conflicting signals. Anticipation of future Fed actions may become more open ended as it responds to an economy striving to become more robust.

16:45 - Bryan
On the topic of short term rates, many people on the call probably know and may be concerned with, is the significant reform taking place within money market funds. Can you go over some of these changes Cynthia.

16:59 - Cynthia
Sure Bryan, among the components of the 2008 crises was the collapse of the reserve prime fund which broke it's buck when it's NAV fell from a dollar to ninety seven cents because of its exposure to Leman Brothers commercial paper. The fund was unable to meet the ensuing rush of redemptions, assets fell by two thirds after 24 hours and the fund was ultimately liquidated. In the broad meltdown of the commercial paper market in the crises other funds, even those with strong investments, weakened. Requiring sponsors to set in and support funds in more than a dozen cases, so that they could maintain their dollar NAV Ultimately the Federal Government stepped in and guaranteed investors the value of each money market fund through its temporary guarantee program. This extraordinary measure stabilized the market place. It also raised questions about the role of government, the structure of money market funds and regulation. In 2010 the SEC took a first step by adopting new rules designed to increase the resilience of money market funds during times of stress and reduce the risks of runs on the funds. These rules focused on tightening maturity and credit quality standards and imposing liquidity requirements. In 2014 the SEC took further steps. New rules required a floating NAV for institutional prime funds and municipal funds. Additionally the rules introduced liquidity fees and redemption gates which a fund's board are able to impose at times of financial market duress. The floating NAV does not apply to prime retail funds but other rules, including the liquidity fees and redemption gates, do. Together these rule changes alter important historical features of these funds making their value and liquidity conditional on market conditions.

19:07 - Bryan
And what are the approximate size of the money markets funds basis?

19:11 - Cynthia
It's about 2.6 trillion. And let me go through some of the industry and shareholder reaction to these rule changes.

19:23 - Bryan
Perfect, thank you.

19:25 - Cynthia
Because it is wildly mixed. A City Group survey indicates that institutional prime funds could lose between 200 to 400 billion of the 940 billion in assets in those funds or 35% of all money fund assets. Retail funds could see 200 billion of their 510 billion exit, which is about 19% of all money fund assets. Firms are reviewing their product offerings as well. Options include simply closing their money market funds altogether, which may happen to the smaller money funds. Becoming government funds only or converting funds to ultra short funds, which would fall outside the SEC Rule 287 which governs money market funds. Somewhat contradictorily prime funds may become more attractive from a yield prospective because with assets leaving the funds yields are likely to go up. Such a development would curtail outflows. In short market sentiment is inconclusive as to how much will lead prime funds at this time. Estimates range broadly running from 100 billion to a trillion out of the 2.6 trillion held in funds today.

20:52 - Bryan
Well this is certainly going to have a significant impact on the market. What impact will this have on short term rates.

20:59 - Cynthia
Well there will be more demand for treasury and agency securities as fund complexes move to government funds to avoid the floating NAV. Fidelity's prime funds are becoming government funds. This alone could place an additional 100 billion in demand for government and agency securities. This market is already struggling with a depletion of supply, for example the 1.4 trillion in the U.S. bill market accounts for the smallest share of treasuries in six decades. And all government securities which includes treasury bills, notes and bonds maturing in four weeks to one year account for just 11.5% of the 12.1 trillion market for treasuries which is the smallest portion going back to 1952. As recently as 2008 those accounted for more than a third of the total. Meanwhile the repo market a major source of liquidity for government money funds has contracted by 7.5% last year and 18% since 2012. This lack of supply plus the additional demand for monies flowing in the government money funds means short term treasury and agency rates will remain low. The largest debtor nation will contain its own funding cost as the Federal Reserve moves to raise interest rates. Meanwhile as money moves out of prime funds banks, finance companies and corporations will find the scarcities demand for their short term products such as commercial paper and certificates of deposit. Their short term funding costs will rise and they may forced to issue that further out on the curve.

22:49 - Bryan
I think we would encourage everyone to be on the look-out for changes to their client money market funds and to keep an eye out for market or industry related updates to the short term interest rate environment. Let's change gear slightly and talk about another popular topic that has become almost somewhat of a buzz word in the popular press 'Liquidity'. Ion could you give me a solid definition of liquidity as it pertains to the bond market.

23:18 - Ion
Sure Bryan, liquidity is a financial institutions capacity to meet its cash and collateral obligations without incurring unacceptable loss. The last portion is a very important point that basically highlights the fact that liquidity is the ability to transact in the market place quickly and in enough size to minimize losses, not just being able to sell, as bonds can almost always clear.

23:46 - Bryan
And once again we have seen the regulatory environment have significant impact. Could you describe this impact.

23:52 - Ion
Yes indeed, before 2007 many banks operated with too little capital and were over reliant on short term financing to fund higher risk and often illiquid investments. That unraveled as we all know and since the crises regulators have made a series of changes in a global effort to improve the safety and solidness of the financial system. Macro potential policies under the new faculty Basel III framework impose higher capital requirements, constraints leverage and requires certain liquidity coverage ratios. For example beginning this year large banks were required to report supplementary leverage ratios of 5% minimum tier 1 capital for bank holding companies and a 6% minimum for FDAC assured. This means that banks will be required to hold five or six dollars of capital for every hundred dollar of assets independent of the riskiness of the assets. Which basically lowers the return on capital for securities. Especially repo which is at the lower end of the return spectrum. And increases this for riskier investments such as locks. However, at the same time that those three liquidity coverage ratio aims to ensure sufficient liquidity via cash or high quality assets, such as treasuries and agency MBS, to meet short term outflows in stress denials. It basically pushes the banks preference towards liquidity. Finally the Volcker rule restricts proprietary trading and limits banks abilities to take trading positions in markets where demand is expected to diminish. Notably regulators chose to exempt treasuries and muni securities from this restriction. More recently some Fed officials suggested that the SEC should actually consider imposing higher capital requirements on Broker dealers which are not owned by banks and would not fall under the regulations of the Fed, in a further effort to limit the usage of short term repo. This is a very long way of saying that the regulation pendulum has now shifted into fairly restrictive territory. While prior to the crises de-regulation or a lack of regulation was the norm.

26:26 - Bryan
What have all these changes done to the market?

26:29 - Ion
If we go onto the slide for this particular topic we see dealer inventories are at very low levels. Especially when compared to the increasing assets on management on the buy-side. For example deal holdings in corporate debts are currently running at the lowest level since 2001. Additionally trading volumes have decreased dramatically. Average daily trading volumes adjusted for market size are down 37% since 2001 for agency MBS and 54% for corporate bonds over the same time frame. Additionally monitory policy around the world has pushed investors into riskier assets as the search for yield dominates the investment mentality in a low rate environment. This causes prices in risky assets to increase and spread to compress in a viciously enforcing loop that leads to more risk taking and concentration for positioning on the buy-side. The proliferation of credit ETF's has basically opened the gain up to retail investors as well. So going back to the slide the dynamic of diminishing risk taking ability on the sell-side versus increasing AUM and marginal risk taking on the buy side makes the market as a whole more vulnerable to shift and flow. The taper tantrum of May 2013 and more recently the high yield exodus in the second half of last year both followed by impressive rebounds. But just the market as a whole is very susceptible to the loss flow.

28:17 - Bryan
And Ion what are we doing at Delaware Investments to attempt to manage these risks?

28:20 - Ion
Sure Bryan, generally speaking medium size managers operating with a longer term bottom up credit research style are better positioned to exploit market in-efficiencies and avoid heightened transaction costs. Specifically answering your question - maintaining adequate liquidity pools is vital. At Delaware we keep liquidity scorecards for all our funds, this is a marketability scorecard or a liquid nameless, if you wish. Additionally portfolio stress testing is important and nourishing long term relationships with the sell-side.

29:01 - Bryan
Thank you Ion, it was a pleasure getting some color from you around your views on the current state of liquidity in the market and ways to account for this issue. Now we are going to examine one of the extreme results that has resulted from extraordinary monitory policy and some of these regulatory changes 'Negative yields'. David why do negative yields exist in the market and where are we seeing them?

29:25 - David
Negative yields, Bryan, quite frankly exist on the market because investors have completely lost their minds. I don't know why at the end of the day why negative rates can actually be justified, we'll talk a little bit more about that as we go through our discussion today but I think first of all its important to remember that much of what has really created the environment that we are in today over the past six or seven years has really been too much debt. The debt hasn't been paid down and it tempts to spur growth and exhausted the traditional monitory policy tool that Cynthia was talking about and instead they are resorting to untested non-traditional methods. Including buying open securities, Quantitative Easing or interest on excess reserves or the reverse repo facility that Cynthia was talking about. The primary methodology at the end of the day for central banks to control prices is to control demand and central banks raise rates to make borrowing more expensive and saving more attractive or on the other hand since the great financial crises they have injected liquidity in an attempt to spur growth by lower the borrowing costs to make saving less attractive and investing more attractive. I think we could probably call that just risk taking. So essentially the central banks have put in place a put and said 'Don't worry investors we've got your backs'. And as a result I think this has created an environment where these low yields or negative yields are considered to carry less risk but the reality is that low yields may actually create more investors risks. Remember the example that Paul was highlighting about the bonds with the coupon differential and how on a lower coupon you actually take on more duration risk. So there is an unintended consequence right there as an example. And low and negative results are really the result of the countries engaging in, I guess I would call them, currency devaluations. Some would probably call them currency wars that are spurred on by low growth or deflationary or disinflationary environments. The primary tool to affect the currency movements that the central banks have is to change the rates. And recently, just in the past few weeks, the European Central Bank has launched Quantitative Easing. There are three main rates that they would target. The first is going to be the main financing rate which banks can borrow from the central bank, there is the marginal lending rate which is the overnight lending rate to banks but more importantly there is the deposit rate and this is the rate that is received by banks for funds that are parked at the central bank. The whole idea here is that the central bank is hoping that those excess reserves in the system get loaned out into the economy and result in real growth. Negative rates are a new concept though. Even here in the U.S. customers that had non-interest bearing demand deposit accounts over the last several years that were not earning any interest on their deposits are facing negative rates when you factor in fees. Negative rates are essentially a tax on savings. So keep that in mind.

32:25 - Bryan
Thank you David. We are also seeing this with negative yields on foreign countries sovereign bonds, isn't this correct?

32:31 - David
That is correct and I think in many ways it's more a function of liquidity rather than the fundamentals . You know up until recently the investors in Europe were differentiating by credit quality since the euro-zone didn't share a consolidated bond market like we have here for instance in the United States. This left core countries well bXXX at the expense of the peripheral sovereign bonds. We talked a lot about how in the markets German bonds have traded so well throughout the crises at the expense of the peripheral nations. Well now the ECB is buying bonds across the entire euro-zone and investors are not differentiating by credit quality and now in many ways they simply reach for yield and blindly take more risks by buying those longer dated assets. So it is in part, I think in my opinion, irresponsible for central banks to encourage this risk taking by moving out the curve because ironically if they are in fact successful at the policies they are trying to implement the very behavior they are encouraging will result in monitory losses for the investors that they are asking to take more risks. Many European yields have been affected. You can see that on the slide right now on the screen. And what is fascinating is that the U.S. is now one of the higher yielding instruments when you look at it on a two or ten year basis. So there have been significant changes over the past few years. If you think about Swiss rates are now negative after ten years. Finland became the first European Union country to issue a bond with the negative rate. That doesn't mean that their bonds are trading with a negative rate, that in fact means that they issued a bond with a negative rate. The German government followed suit shortly thereafter. Several lenders in Denmark are even announcing plans to charge their retail customers to hold money in their deposit accounts. Once again it's a tax on savings. You can get an adjustable rate mortgage in Denmark now at a negative yield because banks aren't incentivized to hold assets with the central bank at a negative yield and instead they are encouraged to lend so they are willing to lend at a negative rate in order to avoid those losses that would be much greater by keeping them with the central bank.

34:32 - Bryan
For all our participants, yes you heard that correctly. New issue sovereign bonds are actually coming out at a negative yield not just trading at a negative yield in the secondary. Some countries are charging their depositors to hold savings accounts and some mortgage lending is taking place at negative yields. Pretty crazy stuff. We have seen some foreign currencies act pretty volatile over the last couple of years as well. Can you explain how this has affected yields?

34:59 - David
Well once again let's talk about the central bank policies. They have significantly impacted market flows. Take the United States and Quantitative Easing, we really were the first to fire the shots. QE in the United States, 3+ trillion in new money generate based on upon what Cynthia was talking about a little bit earlier. And a lot of that money found its way into the emerging markets creating risks for those economies. As they slowed we have seen many other countries try to reduce the value or devalue their currencies with the goal of increasing their share of the export market, while supporting domestic economies. The result is that those economies are trying to import inflation and export deflation. That is one of the concerns that many investors have been talking about recently with the depreciating dollar is that here in the states we would now be importing deflation, once again making it hard for those rates to move higher. At the end of the day this export import game is a zero sum game and essentially one countries gain is another's loss. The struggle to achieve the growth through currency moves by one central bank is resulting in increased volatility in currency markets and impacting sovereign yields as these risks are changing and increasing in many instances.

36:12- Bryan
Can we look at this from a supply and demand prospective too. What is being pushed and pulled here?

36:17 - David
Well the problem with many central banks today is that their policies encourage complacency. We saw it with the outcome for investors that were short the Swiss Franc and long Euro trade. The complacency can be seen in Japan where a larger share of the revenue from taxes continues to go in to service the debt. And if interest rates double and a significant amount of the budget now goes towards servicing this debt. This is an example of complacency that exists in the market. This is in part as a result of central bank policy driving yields lower and encouraging investors to take more risks. Investors could be concerned with the negative outlook in a country that is carrying a low or negative nominal yield on a bond but this could possibly offer positive real rate returns similar to what Japanese investors have been experiencing for an extended period of time because of deflation or disinflationary pressures. I think, quite frankly, that the debate could become much more complicated as the ECB pursues money printing for QE What they are doing is they are buying bonds across the Euro-zone. Germany which is going to be its largest targeted market, just because it's the largest country in the union, is running a surplus which is leading to less supply of an asset which is in real demand not only by the market place but by the central bank. Just this week Draghi, the president of the European Central Bank, sent a letter to the parliament in Brussels re-iterating that he can in fact execute this strategy. But I think we need to watch this closely to see if he is able to source enough liquidity in the market place to actually buy and generate the additional money supply that he has talked about given the head wind that he is facing. The bottom line is that central bank policies have caused a separation between the fundamentals and valuations. And this search for yields has driven yields and safer investments lower. But more importantly it has taken riskier investments yield significantly lower.

38:19 - Bryan
So we can certainly see the reasons why demand has been created for these negative yielding investments. But a little more specifically who is buying these securities and why?

38:29 - David
Well think about it from the prospective - I guess one, as ironic as it sounds, you could have a flight to quality investor. Investors who are concerned about safety, investments that are fully guaranteed by governments. That could be one source of market demand. Passive investors, those that have these instruments as part of their bench mark. They are going to have to buy them regardless of whether or not they think there is value and that could be building in risks into portfolios that investors don't fully understand. Furthermore investors who do not want to hold cash or need to actually stay invested, or investors who are concerned with deflation. But the bonds still offer real returns. Remember the example I was talking about where if you have positive real returns you could actually make an argument as to why you would hold a low or negative yielding instrument. Or it could be something as simple, Bryan, as just a trader looking for price appreciation. Even when bond yields are negative on the investment that a trader is targeting perhaps they could hedge into a different currency. A lot of what we have been seeing lately is that they have been taking exposure in Euro denominated debt and hedging it back into U.S. dollars. And where this price appreciation, where the Euro depreciates, can easily off-set the negative carry associated with the bonds. Or lastly perhaps we could look at banks buying to avoid even greater negative yields through deposit rates. Remember they had to deposit excess reserves with the central bank and they are getting charged to do that. They might be looking at the sovereign bonds as an example and saying 'that we could actually own these with perhaps even a small amount of positive carry instead of paying the negative rates that we are experiencing through the Central Bank'.

40:11 - Bryan
Let's shift a little bit more to the problems associated and look at the risks associated with having securities offering a negative yield both from a market prospective and to the actual holder of the negative yielding investment.

40:24 - David
Well the bottom line is we do not fully understand the risks of these non-traditional policies. Cynthia walked us through a lot of new policies that haven't been tested. You know Stanley Fisher, in his presentation yesterday to the Economic Club of New York, he re-iterated that they are in unchartered waters. They recognize that there are risks that come with these policies. I think they down play them through confidence and saying that we have back tested and studied things such as the reverse repo facility and the effectiveness of it but the bottom line is that when it really comes to it and push comes to shove we have to see how these instruments are going to perform. Other risks could be that consumers curb spending through concerns over financial security or even just slow economic growth.Think about how pension managers or insurance companies that are asset liability driven struggle with an environment of low yields or even negative yields. How do their models handle that and how do they deal with that risk. Perhaps banks could be discouraged from lending as the margin between the lending and the deposit rates shrink. Once again slowing growth and applying more disinflationary or deflationary pressure. Or it could encourage investors to reach for yield by investing in riskier assets similar to what we have been seeing over the last several years. Creating asset inflation, or even worse, leading to asset bubbles.Negative or low yields can affect certain corporate behavior as well. When we are looking at investments in the investment grade corporate space we see a lot of companies that are being very shareholder friendly, meaning they are issuing debt to increase shareholder payouts or buy back stocks instead of investing in the business. If you look at just the underlining statistics the capital investment growth is lagging cash flow growth. And the difference between those two metrics in many instances is going into financial assets, or another way of saying the company is buying back their own stock. These can continue to contribute to deflationary concerns which can increase risk premiums for equities. Remember equities are supported by low rates given a discount applied and a low rate environment. So they can get away with carrying a higher multiple with that as a back drop. With a flattened yield curve which negatively impacts the health of financial companies may lead to lower lending. It might not be as profitable for them to lend therefore they might be more conservative. And if you factor in some of the macro prudential policies that we have been talking about today as well that can make it more challenging for banks to lend in this environment. So investors may just choose to hold cash and there are opportunity costs certainly holding cash but they could put this cash under their mattress, just to think about it generically. And if they do that essentially it takes money out of the system and it can decrease the velocity of money and slow down inflation and economic growth. Perhaps savers are forced to save even more by the low yield environment. We don't talk much about that but in a low yield environment investors needing income might actually save more rather than spending as you need to have more principal invested than income generating assets to generate the same amount of income to support their living. So some of the risks today may be on the list in the future, meaning some of these risks that we are going through right now. But in all likelihood the list of risks that come to fruition in many instances could be very different to what we are talking about today because we just don't know where we are headed.

43:36 - Bryan
David as I have asked the other speakers, how at Delaware can we respond to some of these risks?

43:43 - David
Well I think first of all our strategy generally offer tremendous amounts of flexibility. Using as an example Diversified Income as our flagship fund, it is important to highlight at this time although we are not faced with negative rates here domestically we are dealing with low yields across many asset classes. But we have the luxury of investing all in U.S. dollar assets if we choose or we can look at other markets around the globe. So we aren't faced with a lot of the challenges that specific investors in Europe would be faced with. I think as it pertains to the broader market though Bryan the largest risk is the misallocation of capital. As investors are encouraged to move out the risk spectrum. We have talked a lot about that. Investors are taking leverage positions and building out a strategy in many instances on hope or trust in central bank policy. Remember despite central bank portraying these policies of negative rates as natural this does not make it acceptable. It isn't normal to extend credit to a sovereign or company and actually have to pay to lend. The experiment is untested. What happens if , as in the example we were talking about, negative rates with the European Central Bank the deposit rate at negative .2 or 20 basis points below zero doesn't work. Do they lower the floor further? Do they go negative 75? Where does it end?

45:08 - Bryan
Thank you for that. As we mentioned earlier there are a few other themes impacting the bond market in 2015. I'll hand it off to you Paul. Would you like to talk a little bit more about central banks diverging policies.

45:22 - Paul
Yes sure, David touched on some of this material and Cynthia touched on it as well. So before the introduction of tapering by Ben Bernanke in early 2013 most of the worlds important central banks were on the same side. Our Federal Reserve, the Bank of England, European Central Bank and the Bank of Japan were all providing significant stimulus to the market. Either with zero interest rates or with the purchases of securities. Like most of these central banks the European Central Bank was actually printing money and injecting it into their banking system via the long term re-financing operations. Ben Bernanke introduced the idea of tapering the Feds assets purchases in early 2013. The Bank of England wound down their purchases. And then in 2014 our Federal Reserve actually carried out a tapering of these asset purchases and now they are portraying an environment where they are going to be on a path to really short term rates. Cynthia expanded on this very well earlier in our session. The Bank of England is also portraying a path where they will raise short term rates as well. So two important central banks on a path of raising short term rates or moving into tighter monitory conditions. The Bank of Japan and ECB still providing very significant levels of stimulus. What that has done is created a big divergence in the major central banks. It has had massive effects on currencies, you have seen a much stronger dollar over this period you have seen a stronger British pound. You have had currencies like the Japanese Yen and the Euro being much weaker versus these two currencies and emerging market effects being much weakened as well. Many of these currencies are down a good 30% since their recent highs, only about a year and a half ago.So a huge effect on currencies, it's currently effecting the U.S. economy. It's thought that our exporters are having a little bit more trouble with this level of U.S. dollar currency level. And also it is having an effect on commodities and I think this leads into our next session which Ion Dan will take. There has been a big deflationary force thrown around the globe because of these currency wars. David Hillmeyer touched on the currency wars earlier. I am going to pass it over to Ion Dan to talk about the deflationary forces we are seeing now.

48:12 - Ion
Sure Paul, I think that the main point that we try to get across today is the fact that we live in a global world where macro factors influence outcome. We covered many of the relevant topics today which are also important in addressing these themes. But I would like to start with the Chinese economy. China had seen impressive growth during the last 20 years. Driven by a booming export model in which China imported raw goods, used cheap labor and exported finished goods. Investment, in particular in infrastructure, also contributed. Coming out of the financial crises China relaxed lending and monitory standards to engineer a soft landing and a debt boom followed which fueled unproductive real-estate investment. In 2012 China had a political change of guard which led to a new economic and social direction. The new president introduced macro potential policies to cool property markets and over investment. He also started cracking down on corruption and transitioning the economy from an investment focused model and an export focused model to something that is more reliant on domestic aggregate demand. Transitions are seldom smooth. In 2010 Chinese GDP peaked at 12%. and by 2013 official stats were showing GDP at 8%. In 2012 CRB, a broad commodity index, peaked at 3.50 and by 2013 the index was 15% lower. This was the first leg of the global disinflation story. The transition phase in China continues. More recently house prices are collapsing which brings into question the financial stability and markets are starting to anticipate monitory easing. This brings us back to the dollar which is the second driver of cost push disinflation. Divergent monitory policies which Paul mentioned are important in understanding what is driving the strengthening of the dollar via interest rate differential. On this I would note that the Chinese Yuan represents 21% of the (traded weighted dollar). Uneven monitory policy in China is likely to put downward pressure on the local currency and prop up the dollar. Weak global growth and a model scenario for the U.S. is the other driver behind the strength of the dollar. This is also getting more entrenched as long as the economic divergences continue.

51:09 - Bryan
Hopefully that brings everything full circle for everyone on the call and that wraps everything up for us here on the fixed income team. I'm going to hand it back to Erica.

Thank you again to Bryan and to panel for sharing this conversation with us this afternoon. We really appreciate all of your unique perspectives on this and I know our daily lives are made better by knowing that your expertise is here to support us. If there are any questions or more information about this topic please visit our dedicated financial advisor website at When you are there you can find under the insight section of the website some more regular commentary from the team you heard from today. And you can also subscribe to receive updates when that new content is made available. The views expressed represent the manager’s assessment of the market environment as of the date of this presentation, 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 performance quoted represents past performance and does not guarantee future results.

This information is provided with the understanding that Delaware Investments is not engaged in rendering accounting, legal, or other professional services.

Advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended to be used and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.

Charts shown throughout are for comparison purposes only. Source data are the most recent available data.

Investors should carefully consider the Delaware Investments 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 the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.

(14386) 3/2015

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