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A conversation with Paul Matlack The supercycle and how it can impact fixed income

One important issue in the current fixed income environment is the debt supercycle, the rapidly growing assumption of debt by consumers, businesses, and governments. The fixed income team at Paul Matlack, CFA Delaware — a group known for its frank and Senior Portfolio Manager, candid exchange of investment ideas and diversity of Fixed Income Strategist thought — has focused on the debt supercycle as just one of the key issues facing fixed income investors today. To gain perspective from a central member of the team, we spoke with senior portfolio manager Paul Matlack about the debt supercycle’s impact on the .

From your vantage point, what’s the situation with global debt levels? Without dispute, we have high debt levels in many major markets — the United States, Japan, and China among them. And there’s little doubt that those high debt levels are a headwind to growth. But overall, my view of the debt supercycle is that it’s akin to climate change: It’s definite, it’s real, and it’s a threat. While this is concerning, I’m not convinced that it necessarily poses a doomsday scenario. Rather, I look at how we can live with the debt supercycle and invest around it. Still, it’s hard for me to see how a problem of that magnitude gets solved short of reaching and sustaining strong growth rates — rates that will generate tax revenues and lead to debt being paid down. I recognize that a path for sustained, strong growth isn’t immediately clear, especially not in this environment where we’re assuming a U.S. growth rate of

May 2016 Page 1 of 3 The debt supercycle and how it can impact fixed income

about one and half percent. While a debt supercycle can What are you telling clients and partners about how end badly, I’m hopeful that the worst-case scenarios won’t to answer that question about investing in the current come to fruition. environment? In general, our team is very unified about the fact that Structurally, is there anything about the economy and the debt supercycle warrants a cautious approach. It’s the debt situation that makes you think we can grow always constructive to review clients’ investment policies or out of this? objectives, and then have a dialogue about how potential Yes. First, I believe it’s possible to be too focused on economic scenarios, or outcomes, could affect portfolios. only one dimension of debt — the size of the pile that’s In recent visits with clients and partners, one theme that outstanding. It can be more constructive to think about the I’ve brought again and again to the discussion is this: While ability to service that debt. Let’s look at the cost on one can see many potential economic resolutions with the debt around the world. It is, in fact, the lowest it’s been in 60 multitude of factors at play, I think the role of bonds should years. We’ve had historically low rates here and even lower be solving a problem in your portfolio, and not inadvertently rates abroad. creating one. In the post-financial crisis period between If we consider just the U.S. alone and look at statistics, 2009 and 2015, many bonds delivered returns that were we see that we’ve reached a post-financial-crisis high in reminiscent of equities.* In my opinion, that’s no longer the terms of corporate debt. But that’s not looking at the entire case. I don’t see us mathematically getting there anymore. situation. If we look at cashflow coverage of the interest So bonds seem to be back in a more traditional role, and expense on that debt, that number is also at the highest offer an opportunity to balance out volatility in an equity it’s ever been. That’s important: The aggregate operating portfolio with potential stability and diversification. cash-flow of corporate America divided by interest expense Until we get clarity on China, until we get clarity on the U.S. is high. And that measure suggests that the ability to service growth and what the is up to, and until the debt is as great as it’s ever been. That’s an important we know where Europe is going and the status of some dimension of this whole debt discussion, which at least emerging market countries — I believe we need to build a minimally leads us to believe that this is not an imminent portfolio that’s the equivalent of “hunkering down.” problem. That means intermediate-duration bonds, higher quality How about on the growth side? Are there signs that investment grade bonds, higher quality mortgages, and sustained growth might not be as elusive as some U.S. Treasurys. Investors need to recognize that the income suggest? stream from those securities isn’t going to be much — but we believe it will provide balance for the portfolio. So, while I think so. Notwithstanding what has happened recently an investor might see the equity portion of their portfolio go with the fracking sector because of low oil prices, we are down 15%, the fixed income part of a portfolio might be flat on the cusp of energy independence for the U.S. Further, or possibly even up. Although there is always the risk that wage rates are beginning to equalize around the world, the bond portion could lose money as well, the scenario I which means a lot of manufacturing could come back to the described is where we believe we are in the . States. Add on technical innovations in a number of fields and there’s a strong case to be made for the U.S. growth So the days of the double-digit bond gains are over? rate to advance out of this mediocre trend that we’re stuck in right now. Furthermore, Europe doesn’t have the debt If rates fall from here dramatically, then we’ve all got bigger overhang to the degree that we do, or Japan does. So, I do problems. The way I see it, there was a roughly 30-year think there is a way out of this economic malaise and the run-up in interest rates between 1950 and 1980. Then the debt supercycle. Again, it’s a headwind and there is a lot market completely reversed course and we’re back at the of debt out there. But right now, I think people have to get bottom. We enjoyed the tailwind from falling interest rates invested and the question shouldn’t be “Should I invest?” over the past 30 years and that’s led to some of those but rather “Where is the best opportunity to invest?”

*Source: Barclays Aggregate Index annualized return for period Dec. 31, 2008 – Dec. 31, 2015.

Page 2 of 3 The debt supercycle and how it can impact fixed income

double-digit returns in high-quality securities. Between 2009 and 2015, you could almost throw darts — it didn’t matter what kind of bond you bought, there was a potential to make positive gains. But I think now, the recovery in bond prices since the 2008 financial crisis is over, and this generally brings us back to a place where, we believe, investors would be better served with the goal of viewing fixed income assets as income stream. That’s not to say there aren’t certain sectors — certain parts within the high market or within emerging markets and even in the Treasury market and financials — where we can’t earn more than the . But in order to find those opportunities and capitalize on them, we think you need to be exceptionally tactical.

The views expressed represent the Manager’s assessment of the market environment as of May 2016 and should not be considered a recommendation to buy, hold, or sell any , 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. Past performance does not guarantee future results. 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 ’s ability to make interest and principal payments on its debt. The Fund 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 , potentially forcing the Fund to reinvest that money at a lower . • High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds. • Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to the state or local and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable. Delaware Investments, a member of , refers to Delaware Management Holdings, Inc. and its subsidiaries, including the Fund’s investment manager, Delaware Management Company (DMC), and the Fund’s distributor, Delaware Distributors, L.P. Macquarie Group refers to Macquarie Group Limited and its subsidiaries and affiliates worldwide. DMC, a series of Delaware Management Business Trust, is a U.S. registered investment advisor. Neither Delaware Investments nor its affiliates noted in this document are authorized deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of Macquarie Limited (MBL). MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities, unless noted otherwise. © 2016 Delaware Management Holdings, Inc.

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