Ii absolute return_fixed_income_outlook


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Ii absolute return_fixed_income_outlook

  1. 1. FOR PROFESSIONAL CLIENTS ONLY | NOT FOR RETAIL USE OR DISTRIBUTION ABSOLUTE R ETUR N FIXED INCOME OUTLOOK 20 13INVESTMENT Scaling the cliffs using beta tailwinds,INSIGHTS alpha ladders and hedge safety netsJanuary 2013OUTLOOK & OPPORTUNITIES IN BRIEF • 2012 was kind to fixed income investors who benefited from declining rates andPLEASE VISIT tightening spreads.www.jpmam.com/insight • As rate and credit betas become increasingly exhausted, investors will have to mutefor access to all of our Insights their expectations for future fixed income returns.publications. • As broad market-wide beta opportunities recede, fixed income investing success will hinge more on managers’ ability to rotate out of systematic, beta-oriented positions into more idiosyncratic, alpha-oriented opportunities. The opportunity for traditional bond investors continues to shrink as rate markets run out of steam and the price appreciation portion of core bond returns approaches zero. Going forward, with virtually no price appreciation left, returns from core bonds may start to resemble their sub-2% coupon. EXHIBIT 1: PRICE APPRECIATION OF CORE BOND RETURNS 1976 - 2012 35% 16% 30% Index coupon return (LHS) 14% 25% Index price return (LHS) Ten-year treasury yield (RHS) 12% 20% 10% 15% Return Yield 10% 8% 5% 6% 0% 4% -5% 2% -10% -15% 0% 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 Source: Barclays, as at 31 December 2012 • Hedging portfolios against continued market volatility, driven largely by policymakers’ rhetoric, will sustain itself as one of the main areas of focus for prudent, flexible investors.AUTHOR • While staying defensive is important, one should not rule out the possibility of a risk to the upside, as 2012 proved an inflection point for some important economic indicators.Bill EigenHead of the Absolute Returnand Opportunistic Fixed Income Group
  2. 2. INVESTMENTINSIGHTS Scaling the cliffs using beta tailwinds, alpha ladders and hedge safety netsRecap of 2012: Policymaker experimentation EXHIBIT 3: BOTH THE SUCCESS AND THE FAILURE OF FED POLICY IMPLY HIGHER RATESbreeds complacency Fed Growth Rates . . .When the world faced a financial crisis of multigenerational Successful Accelerates . . . rise to offset inflation riskproportions several years ago, most investors supported the Unsuccessful Stagnates . . . rise as the yield curve steepens in response to the longer-term fiscaldeposit guarantees, bank bailouts and the many other implications of an economy with slowerextraordinary measures undertaken to try to contain it. Those than expected growth potentialinvestors, however, probably would have been incredulous at thetime had a forecaster insisted that, not only would these policies In fact, starting this year, the Fed board members and regionalstill be in place four years later, but that the pace (and cost) of bank presidents are publishing their own projections, which notpolicymaker experimentation would have hardly slackened since only show that they expect rates to rise, but that they expectthe crisis (Exhibit 2). them to rise faster than the futures market is currently forecasting (Exhibit 4).Securities markets have reacted positively to theseunconventional measures during the past year, even though EXHIBIT 4: FED BOARD MEMBERS’ PUBLISHED RATE FORECASTS (SIMPLEmany questions remain as to how the programmes will be AVERAGE OF 19 PARTICIPANTS SURVEYED)unwound, and even though they largely sidestep the underlying 2.0 The Fedstructural reforms necessary to ensure long-term stability and 1.8 Historical Fed Funds market forecast expects rates Forward-looking Fed Funds xgrowth. Continuous policymaker tinkering gives rise to investor 1.6 market forecast to rise faster than thecomplacency. Investors believe, for instance, that a risk market 1.4 Fed governors projections futures (Percentage, %) (as at September 2012)sell-off will be met with monetary easing designed to re-inflate 1.2 market is predictingasset prices. Likewise, they believe that central banks, 1.0particularly the US Federal Reserve (the Fed), want rates to 0.8 xremain low for a long time. That is an incomplete understanding 0.6of their intentions, however. In the case of the US, what the Fed 0.4 xreally wants is employment growth; and progress toward that 0.2 xgoal implies higher rates eventually (Exhibit 3). 0.0 Dec-08 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Source: Bloomberg, Federal Reserve, as at 31 December 2012EXHIBIT 2: NOTABLE POST-CRISIS POLICY EXPERIMENTS Twist: Fed program initiated in QE2: USD 600 billion of September 2011 to sell short-term QEternity: Fed program to purhase Twist halts; Fed continues to buy monetary stimulus announced Treasuries and buy longer-term Agency MBS securities without long-term Treasuries but without by the Fed in November 2010 Treasuries in order to flatten the specifying an end date. selling short-term Treasuries. yield curve.2010 2011 2012 Securities Market Program European Financial Stability Outright Monetary (SMP): the ECB’s first attempt European Stability Fund (EFSF): lending Transaction (OMT”): ECB to provide liquidity EFSF increased to EUR 780 Mechanism (ESM): and guarantee facility purchases of Eurozone to dysfunctional markets by policies established as a established with EUR 440 member bonds purchasing bonds of troubled successor to the EFSF billion in funding capacity European sovereigns.J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N DSource: J.P. Morgan Asset Management2 | Absolute return fixed income outlook 2013
  3. 3. Policymakers believe their intervention will work. Although the As a result of this complacency, yield-hungry investors have bid market reflects some scepticism, risk assets generally rally in up the price of fixed income instruments, in many cases response to policy action, and this positive feedback provides a substantially above par. For example, the average price of the basis for policymakers to justify continued activity. The chart in Barclays Corporate Index stood at around USD 113 at the end of Exhibit 5 shows that pattern. Policymakers take steps to relieve 2012 (Exhibit 7). Investors should be realistic about the prospects short-term market stress until investor confidence returns. An for further price appreciation from here. unforeseen event reminds investors of the rationale for their prior fears, which triggers further policy action, and the cycle Investor complacency has pushed up the price of risk assets, pushing repeats. The cumulative result of this behaviour has been an yields towards all time lows. explosion in the size of the Fed’s balance sheet (Exhibit 6). EXHIBIT 7: BARCLAYS US CORPORATE CREDIT INDEX 120 10 Policymakers reliably rescue investors, resulting in complacency 112 EXHIBIT 5: CITIGROUP ECONOMIC SURPRISE INDEX 8 Yield to maturity (%) Average price (USD) 150 104 Euphoria Euphoria Barclays US Corporate - YTM 100 6 Euphoria Euphoria Barclays US Corporate - Price 50 96 0 4 88 -50 80 2 -100 Shock, despair Reflate (QE2) 2009 2010 2011 2012 Shock, despair -150 Reflate (Twist2) Source: Barclays, as at 31 December 2012 Shock, despair Reflate (Twist) -200 Dec-09 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 While the book has yet to be written on the unprecedented Source: Bloomberg, J.P. Morgan Asset Management as at 31 December 2012 monetary policy, investors are running out of options for acceptable returns in fixed income. When we look back at the most lucrative opportunities of 2012 they emanated from not fighting the EXHIBIT 6: TOTAL FED BALANCE SHEET Fed and riding out the rate and credit rallies, as well as capitalising 3 on a housing bottom. Now that these beta calls have largely run their course, investors must come to terms with future returns that are both more muted and more challenging to find than they have 2 been in a generation (please refer to Exhibit 1 again).Trillions of dollars Having laid out some of the characteristics of the current economic environment, allow us to take a quick detour to look at 1 the merits and relevancy of absolute return investing, before proceeding to our market views for 2013. We see those two topics as closely linked for reasons outlined below. 0 2007 2008 2009 2010 2011 2012 The relevance of absolute return investing in Source: Bloomberg as at 31 December 2012 2013 This unfailing pattern of bailouts by policy action inevitably As simply allowing rate and credit markets to carry a strategy is creates investor complacency. Investor conviction that rate risk becoming less and less reliable, an absolute-return-oriented and spread risk have departed the market has created an investment process can transition to more alpha-oriented unrelenting rush into rate and ‘safe spread’ investment products, sources, as well as beta opportunities outside of traditional such as investment grade bonds and the upper tiers of high yield markets – in alternatives and even private markets. and emerging market debt. J.P. Morgan Asset Management | 3
  4. 4. INVESTMENTINSIGHTS Scaling the cliffs using beta tailwinds, alpha ladders and hedge safety netsOur portfolio construction process involves differentiating Analysing the macro backdrop: Beta in the USbetween sources of expected return. We categorise returns interms of beta, alpha and hedges. The macro environment, while providing plenty of challenges, leads us to be more constructive on the US. Therefore, broadly• Beta is the return we expect to earn by choosing the sectors speaking, the beta part of our portfolio is US credit-based. The within fixed income where we expect to see a broad-based next few paragraphs outline some of the main reasons for this. move. Beta returns involve relying on a market to ‘carry’ a strategy. For example relying on the multi-decade rate rally to As we discussed above, 2012 and the prior years since the generate returns in fixed income has been a fortuitous source financial crisis have been consumed by monetary policy of beta return for traditional fixed income investors. In our manoeuvres. As we enter 2013, the focus is clearly shifting to portfolios, the high yield sector over the past year was a fiscal policy. Though no ‘grand bargain’ was achieved when powerful driver of beta returns, as spreads tightened. Non- Congress opted for a last minute budget deal around the pending Agency mortgage-backed securities (MBS) is another sector fiscal cliff, we see this as symptomatic of the way our whose beta we saw as attractive coming into 2012 given policymakers will tackle the long-term deficit – via a number of expectations of a housing bottom. smaller bills. In spite of the fact that the process could be long and at times quite painful, we believe this transition is healthy.• Alpha strategies are those that do not rely on the broad-based We do, however, advocate for identifying hedges to dampen the behaviour of a sector. They are specific, carefully tailored market volatility that can result from various stages in the long trades, intended to work regardless of market directionality. resolution process. (More on that in the hedging section.) For instance, we may observe two retailers that are fairly similar and ought to be valued similarly, but that are trading at Fiscal and monetary policy have impacted the housing sector very different price levels. This can give rise to a pair trade through mortgage refinancing programmes, outright MBS opportunity in which we establish a long position in the purchases, foreclosure abeyance initiatives and a variety of other undervalued company and a short position in the overvalued activities. Improving home prices have been an important company. Because one position is long and the other is short, a contributor to economic growth in recent quarters. Furthermore, dramatic beta move that affects the entire subsector will be as people exit unemployment and get new jobs, they quickly effectively canceled. Instead, as the valuations of the positions choose to stop cohabiting with family members and form normalise and the trading patterns converge, we capture the households of their own. Household formation involves a return from the idiosyncratic nature of the trade. This type of tremendous number of goods and services, from cable TV long/short opportunity is not limited to the corporate sector, subscriptions and landscaping to new furniture and paint. As but may also arise in the securitised or rate markets, as well as these service and retail businesses add to staffing to satisfy the among different sectors of the fixed income market. For new demand, they create even more prospective homeowners. example: US high yield versus euro high yield, sovereigns Thus strength in housing and strength in labour markets are versus financials, etc. interconnected and self-reinforcing.• Hedging is something that we approach on a systematic basis. We are also seeing other evidence of a more confident US As an absolute return focused investor we are not content with consumer, which is crucial to growth prospects in the US. positioning portfolios for a base case scenario only. We are in Whereas Japan’s lost decade was triggered by the reversal of a relentless pursuit of hedges against a variety of tail risks to corporate debt bubble, and the current weakness in Europe is that base case. In general, these positions are liquid and cheap rooted in a long-running expansion of government borrowing, the to carry. We expect them to have a modest cost in an US financial crisis was driven by strained balance sheets at the unchanged rising market, but produce meaningful gains in a individual household level. Much of the household leverage has sudden market shock. unwound since the crisis, and consumers are thus starting to moderate their tendency to save in favour of spending some ofAs rate and credit beta opportunities continue to decline, we see their growing incomes (Exhibit 8).alpha emerging as the more viable source of return, andtherefore a more pronounced area of focus for us as investorsheading into 2013. As we stated at the outset, hedging continuesto be crucial as policy uncertainty remains.4 | Absolute return fixed income outlook 2013
  5. 5. A growing willingness to spend among consumers could boost growth The corporate sector continues to have ample cash reserves in 2013 (Exhibit 10). If consumption rises, it is clear that companies have EXHIBIT 8: US CONSUMER SPENDING the resources to increase capacity through business investment 1.16 9 Personal income and satisfy the new demand. Corporate capital expenditures 1.14 Savings rate as % of personal income 8 since the financial crisis have remained depressed longer than Personal Income Index (Starts at 1) 1.12 7 many observers expected (Exhibit 11). Capacity utilisation levels 6 (Exhibit 12) indicate these expenditures could materialise soon, Savings Rate (%) 1.10 5 and when they do, they may have a sizable impact on growth. 1.08 4 1.06 3 Reported S&P 500 corporate current assets remain at record levels, 1.04 2 so corporates have the financial wherewithal to expand 1.02 1 EXHIBIT 10: S&P 500 CORPORATE ASSETS 500 1.00 0 2008 2009 2010 2011 2012 450 Source: Bloomberg as at 30 November 2012 400 (USD Billions) A re-leveraging consumer could dramatically boost the velocity of 350 money in the US, an important economic health indicator that has been largely overlooked by investors. Slower and slower 300 money has been a major headwind since the financial crisis (Exhibit 9). We believe this trend may be approaching a bottom. 250 As employment prospects and asset prices show signs of life, 200 growth in consumer willingness to spend should follow. A 2000 2003 2005 2007 2009 2011 coinciding acceleration in the velocity of money would create a Source: Bloomberg as at 31 December 2012 multiplier effect that even further boosts the consumer’s contribution to a virtuous cycle of economic growth. Little growth in non-defence capital goods new orders suggests that An uptick in the velocity of money could be a powerful accelerant to corporate fixed capital is aging growth EXHIBIT 11: CAPITAL GOODS NEW ORDERS INDEX EXHIBIT 9: VELOCITY OF MONEY 100 2.1 90Ratio of quarterly GDP to M2 money supply 2.0 80 (USD Billions) 1.9 70 60 1.8 50 1.7 40 1.6 30 1.5 2006 2007 2008 2009 2010 2011 2012 2000 2002 2004 2006 2008 2010 2012 Source: US Census Bureau via Bloomberg as at 30 November 2012 The velocity of money is the number of times a dollar is recycled into new goods and services during a particular period of time. If a farmer fixes his tractor, and the mechanic uses his fee to buy some bread, and the baker buys a watch, the same dollar has been used in three transactions. Any one of the three participants could have instead decided to postpone a transaction and leave the money in the bank, slowing the velocity of money. The index is the ratio of quarterly GDP to M2 money supply, ie, the number of times a dollar is recycled in three months on average. Source: Bloomberg as at 30 September 2012 J.P. Morgan Asset Management | 5
  6. 6. INVESTMENT INSIGHTS Scaling the cliffs using beta tailwinds, alpha ladders and hedge safety nets With capacity utilisation approaching peak levels, the trigger point for Credit: Beta ages gracefully a capital refresh / expansion may be sooner rather than later EXHIBIT 12: US CAPACITY UTILISATION % OF TOTAL CAPACITY SA INDEX Credit returns, whether investment grade or high yield, have 85 been significant in 2012, and are not likely to remain as robust going forward. The return prospects from here are more on the 80 side of clipping a coupon, and much less on price appreciation. We have reduced our high yield exposure as the market has(Percentage, %) 75 rallied, but continue to like elements of the high yield sector from a risk-adjusted return standpoint. We do not have much 70 enthusiasm for generic investment grade credit (though there are select exceptions), given the inherent interest rate risk here in 65 the absence of substantial coupon to offset an even very modest move up in rates. 60 2009 2010 2011 2012 Much of the rationale for our preference for high yield during the Source: Federal Reserve via Bloomberg as at 31 December 2012 last several years still remains well-supported by fundamentals: • Companies have taken advantage of the low rate environment to refinance debt and extend maturities, reducing the likelihood of a default wave in the near or medium term (Exhibit 13). • he trailing 12-month high yield par-weighted default rate of T 1.14% (as at 31 December 2012) still remains well below the long-term average of 4.1% . • efault-adjusted spreads remain attractive for most reasonable D default scenarios (Exhibit 14). As a result of refinancing, there is a limited amount of debt maturing in the next few years at risk of default. EXHIBIT 13: HIGH YIELD BONDS DUE TO MATURE AT THE START OF 2009 (LEFT PANEL) AND AS OF THE FOURTH QUARTER OF 2012 (RIGHT PANEL). 500 500 400 400 USD billions USD billions 300 300 200 200 100 100 0 0 2020 or 2020 or 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 later 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 later Source: J.P. Morgan Investment Bank, Markit as at 12 October 2012 6 | Absolute return fixed income outlook 2013
  7. 7. EXHIBIT 14: DEFAULT ADJUSTED EXCESS SPREAD OF THE HIGH YIELD EXHIBIT 15: LEVERAGE REMAINS AT MODERATE LEVELSSECTOR UNDER VARIOUS DEFAULT RATE/RECOVERY ASSUMPTIONS (LONG-TERM ASSUMED RANGE SHADED) 5.0x Leverage (trailing 12-month debt/EBITDA) 4.8x Recovery rates 4.6x 25% 30% 35% 40% 4.4x 2% 150 140 130 120 4.2x 4.0x 3% 225 210 195 180 3.8x Annual default rate 4% 300 280 260 240 3.6x 5% 375 350 325 300 3.4x 6% 450 420 390 360 3.2x 7% 525 490 455 420 3.0x 3Q12E 4Q11 1Q11 2Q11 3Q11 4Q09 4Q10 4Q08 1Q09 1Q10 2Q10 1Q08 2Q09 1Q12 2Q08 2Q12 3Q09 3Q10 3Q08 8% 600 560 520 480 9% 675 630 585 540 Source: JPMorgan, Capital IQ as at 12 November 2012. Note: includes debt- weighted metrics for 291 high yield companies – financials and utilities excludedSource: J.P. Morgan Asset Management; JPMorgan Global High Yield Index as at31 December 2012 • Technicals have also been supportive of this market, as• orporate behaviour continues to be fairly conservative. We C investors have sought out yield, and we expect this trend to have seen very few of the merger and acquisition (MA) deals continue. We note that our high yield allocation has a down in or leveraged buyouts (LBOs) that signal a more aggressive quality bias, which we believe has not yet reaped all the stance among company managers. benefits of flows that higher quality high yield has seen.• lthough there has been much talk lately of the debt issuances A being used to fund shareholder dividends, leverage remains moderate on the whole (Exhibit 15).EXHIBIT 16: AS ASSETS HAVE COME INTO HIGH YIELD FUNDS, THEY HAVE SHIFTED OUT OF LOWER QUALITY INTO HIGHER QUALITY ISSUANCE 36 68 67.9 BB and above rated 35.0 67.2Credit quality breakdown (%) B and below rated 34.2 34.0 34 33.4 66 32.4 65.0 32 30.6 63.9 64 30 29.6 63.3 63.1 62.3 28 62 2011 2012 2011 2012Source: Morningstar as at 30 September 2012 J.P. Morgan Asset Management | 7
  8. 8. INVESTMENTINSIGHTS Scaling the cliffs using beta tailwinds, alpha ladders and hedge safety netsTighter valuations and a fragile global economy certainly pose the crisis, and this so-called put-back risk is also being priced-inrisks. We note, however, that cycles of corporate default are by the banks and paid indirectly by borrowers.generally not triggered by panics in the financial sector. Rather,they coincide more frequently with traditional recessions. A The above may eventually provide for some interesting relativetypical inventory correction-driven recession in the US is unlikely value trades in the sector. In the meantime, it has continued toin the near-to-medium term. be largely dominated by rate risk. Therefore, from a systematic risk standpoint, our preference has been for non-agency residential MBS. This space continues to benefit from improvingSecuritised beta: Favours from a friendly Fed credit fundamentals. Increasing home prices will continue to support the market, while shadow inventory has steadilyMortgage refinancing is a popular policy measure because, by decreased. However, we expect to further reduce this position inreducing the mortgage rate and thus the homeowner’s monthly 2013, as increasing demand for a finite pool of assets has madepayment, it puts more dollars in the homeowner’s pocket every valuations less attractive in our view.month, which can then be spent on higher rates of consumption. Commercial mortgage-backed securities (CMBS) is another sectorThe Fed’s extension of quantitative easing activities into the MBS where we see select opportunities, though not unlike othermarket already represents a dramatic step to boost refinancing, spread sectors, much of the spread compression has occurredbut the pace of such activity has disappointed policymakers. One here and investors will have to accept far less returns in thereason is that the Fed’s MBS purchases act to reduce secondary future. The asset class has benefited from a number of strongmortgage rates, meaning the rate at which banks can sell supportive technicals, including negative net supply as 2012 wasmortgages into the MBS market and finance subsequent lending. the fifth consecutive year of declining market share. 2013 isAlthough this has impacted the rate banks charge to the actual expected to be more robust with issuance estimated at USD 45 -homeowner (the primary rate), the spread between these two 60 billion (+50%). We expect spreads to tighten modestly at therates has widened, and is now near its widest levels in recent top of the capital stack, as investors continue to grab for yieldhistory (Exhibit 17). and invest further down in credit.EXHIBIT 17: SPREAD BETWEEN PRIMARY AND SECONDARY MORTGAGE Overall the opportunity in CMBS for 2013 is predicated on carefulRATES NEAR AN ALL-TIME HIGH security selection as the pace of commercial real estate 200 improvements is very much dependent on property types and location. For example, multi-family is by far the strongest of the 150 sectors and has evidenced a continued decline in vacancy rates and modest rent growth. On contrast, retail continues to be 100 weak, except for dominant regional malls, driven by lukewarmbps consumer spending, weakened retailer balance sheets and an 50 abundance of retail store spaces. Between the two ends of the spectrum are office, industrial and hotel sectors, which have seen 0 very modest improvement and are likely to stay that way with the possibility of slight weakening in 2013. -50 1998 2000 2002 2004 2006 2008 2010 2012 Overall, we see value in mezzanine bonds and mezzanineSource: Bloomberg as at 31 December 2012 investments on single asset or crossed pool portfolios where we can employ our whole loan underwriting process to fully analyseBanks face higher costs when originating new loans than they did the underlying real estate and the legal structure of the security.pre-crisis, and these costs clearly contribute to wider primary/ (More on that in the Alpha section below.)secondary spreads. Higher government guarantee fees are beingimposed on mortgage bonds, and these fees are paid by thebanks and passed along to borrowers. Mortgages that are Alpha: Methodically ascending the ladderpackaged by banks into government guaranteed bonds can also As we stated at the onset, this is an area of much focus as webe put back to the banks under certain circumstances; the move into 2013. The opportunities here are not limited to credit,government has been more active in exercising this option since though it certainly provides quite an expansive playing field given8 | Absolute return fixed income outlook 2013
  9. 9. the depth of that market. These trades are intended to work even they are both in the grocery industry, any shift in market riskif the beta momentum reverses and the credit market weakens. appetite should be neutralised, and because they are matched-We have seen more volatility in the credit markets since the crisis maturity credit default swaps, they should move independently(Exhibit 18). More volatile markets tend to be more susceptible from the rates market or changes in credit curves. The trade isto mispricings and thus tend to offer tactical trading designed to benefit from a return to the relationship betweenopportunities more frequently. Kroger and Safeway that persisted for more than two years before rumours of a Safeway LBO created a panic amongEXHIBIT 18: STANDARD DEVIATION OF MONTHLY RETURNS IN THE HIGH Safeway creditors. These fears have abated somewhat alreadyYIELD CASH AND SYNTHETIC MARKETS since we entered the position, and should continue to decline, as an LBO is unlikely given current Safeway valuations. As these Barclays high yield High yield CDX (cash market (synthetic market fears subside, the relationship between the two credit default benchmark) benchmark) swap spreads should compress and generate alpha returns for Pre-crisis, Sept 2005 1.32% 2.03% the strategy. We can scale out of the position as the relationship to Dec 2007 returns to normal. Post-crisis, Jan 2009 2.87% 3.63% to Nov 2012 As policymakers continue to use the housing market as a lever of economic stimulus, the securitised market will present a numberSource: Barclays as at 31 December 2012 of alpha opportunities. On the one hand, investors are fearfulVolatility allows patient investors with liquidity at the ready to be that policymaker focus on residential mortgage refinancingcompensated for providing that liquidity to an irrational market. means that mortgage securities bear a heightened risk ofThe synthetic market allows us to carefully tailor exposure. For cashflow curtailment. On the other hand, they are desperate forinstance, credit default swaps allow us to isolate a particular yield in a low interest rate environment. Derivatives offer acompany’s default risk from the rate and spread risk present in means to benefit from a close analysis of these competing forces.the same company’s bonds. Credit default swaps (CDS) also allowus to specify the timeline of the exposure. Whereas a company EXHIBIT 20: COMPARISON OF LOW-LOAN BALANCE SECURITIES TO THEmay only have ten-year bonds outstanding, a variety of credit BROADER COHORT OF MBS, AND TO A PARTICULAR INVERSE INTEREST- ONLY MORTGAGE DERIVATIVE BOND IN OUR PORTFOLIO.swap tenures will trade actively, and it is thus possible to shorten 45a credit exposure to the company from ten years to five years or Mortgage cohort 40 LLB cohorteven just a few months. Portfolio bond 35 30EXHIBIT 19: VOLATILITY IN CREDIT MARKETS CREATES ALPHA TRADINGOPPORTUNITIES 25 550 20 15 Safeway 5 year CDS Kroger 5 year CDS 10CDS spread (bps) 5 0 300 Trades Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec designed to benefit as Source: J.P. Morgan Asset Management as at 18 January 2013 this spread compresses The top line in the chart shown in Exhibit 20 represents the pace of refinancing for a broad cohort of mortgages originated in 50 2010 2011 2012 2006 and 2007 with 6% or 7% coupons. As these mortgagesSource: Bloomberg as at 31 December 2012 refinance, the cashflow of the associated mortgage securities is curtailed. We have focused on finding securities that are protected from this curtailment. So-called ‘low loan balance’The above example illustrates a credit relative value trade in the (LLB) mortgages, for instance, offer such protection. Becauseportfolio (Exhibit 19). A long position in five-year Safeway CDS is these mortgages have already nearly been repaid, thepaired with a short position in Kroger five-year CDS. Because homeowners have very little incentive to pay the up-front costs J.P. Morgan Asset Management | 9
  10. 10. INVESTMENTINSIGHTS Scaling the cliffs using beta tailwinds, alpha ladders and hedge safety netsrequired to refinance into a lower-rate mortgage. Careful security The worst case scenario of a fiscal shock leading to a recessionselection can identify LLBs that pay even slower than the average was avoided, but a significant source of downside risk remains.LLB – we have depicted in the chart above such a security from Budget sequestration was postponed for two months, whichour portfolio. coincides with the US Treasury reaching its limit under the current debt ceiling. The deal that was recently agreed uponAs investors have become more and more desperate for yield focuses heavily on revenue generation, so expect the Republicanduring the past year, prices on LLB bonds have rallied strongly. party to focus the debt ceiling negotiations on substantialBecause our portfolio bond has been prepaying slowly, we have spending cuts.benefited both from the slow curtailment of our interest cashflows as well as from the rally in prices. Investors are aware that Most of the other downside risks we are mindful of, whether inthe Fed is buying MBS, and thus will continue to trade in this the US or abroad, are also related to politics and policymakers’market actively. Given this favourable technical backdrop and the rhetoric. While it is difficult to ‘trade’ politics, the reigningmarket’s breadth and depth of the market, we believe mortgages euphoria/complacency provides attractive hedging opportunities.and mortgage derivatives will continue to offer attractive alpha We are approaching tights in credit indices, which we feel offeropportunities. asymmetric risk/reward to be long protection in the event of debt ceiling or other macro-driven volatility.Hedges: Finding shelter in the brightest stars An example of such a hedge, and one that inevitably raises eyebrows, is shorting a basket of emerging debt sovereigns. AnAs fixed income markets become scarcer in opportunities and important trend in recent years has been the economic progressmore plentiful in risks, we see hedging as an indispensable part of emerging market countries. In line with this trend, theof investing in 2013. There are plenty of macro risks to hedge emerging market debt (EMD) indices trade at very tight levels toagainst, catalysts that may spark a dramatic risk-off shock to the developed market debt relative to their past history (Exhibit 21).market. Prominent among them is the remote likelihood ofWashington’s ability to arrive at any sort of grand bargain. We agree, of course, that the emerging markets hold greatInstead, as we mentioned earlier, the tackling of the US long-term promise over the long term, and we see merit in the argumentdeficit will likely be turbulent and punctuated by a series of that many emerging market countries have handled theirsmaller deals.Recent CDS levels (left panel) suggest that emerging markets trade in a fairly stable relationship to developed markets. However, the financialcrisis revealed that they are much more predisposed to panic (right level).EXHIBIT 21: EMERGING MARKET VERSUS DEVELOPED MARKET CREDIT DEFAULT SWAP LEVELS1200 1200 Emerging market CDS Emerging market CDS Developed market CDS Developed market CDS1000 1000 800 800 600 600 400 400 200 200 0 0 2010 2011 2012 2008 2009Source: Bloomberg as at 31 December 2012. Note: developed market CDS data series is the simple average of United States, German, and UK CDS10 | Absolute return fixed income outlook 2013
  11. 11. finances better in recent years than some of their developed A portfolio fit to weather any forecastmarket counterparts. We have no doubt, however, that a globalmacroeconomic downturn, or even a short-term macro-related The last several years have witnessed numerous reversals ofmarket shock, would impact the emerging markets severely. In fortune, and we believe 2013 will extend this pattern. As a result,the first scenario consumption in developed markets, which we remain long volatility across our platform. We see significantdrives the export-led economies of the emerging market, would opportunities to benefit if investors become skittish, either due tofalter. In the second – technicals would turn negative quickly as the renewed debt ceiling debate, continued tumult in Europe, ainvestors who were in EMD for the sake of chasing yield and had slowdown in China or one of a host of other potential, largelylacked a deep understanding of these countries would flee those political, threats. We are able to remain patient due to ourmarkets on risk-aversion and need for liquidity. healthy cash reserves which allow us to act as a liquidity provider when heightened risk aversion causes investors to unload assetsYet when we examine EMD spread levels they seem to imply that at cheap prices.such an event is impossible, even though it has happenedroutinely every few years for the last several decades. The While these trends in market beta evolve, we continue to pursueoverconfidence of the market in the EM story translates into a alpha trades actively. By acquiring investments with attractivecheap hedge. price, carry, convexity and risk characteristics, we position the portfolio to continue to generate returns as traditional fixedFinally, cash remains our largest, cheapest and most efficient income managers squeeze the remaining benefits of long-onlyhedge. We will continue to maintain that buffer in the context of spread and long-only rate exposure out of the instruments theycontinued macro-dictated market volatility. In addition, with all of trade. In addition to our beta and alpha positions, we continue tothe complacency we have seen in fixed income markets, cash actively hedge the portfolio, knowing that market shocks areallows investors to get long volatility, and become a liquidity periodic, and the background of unprecedented policymakerprovider in times of stress. experimentation and global financial imbalances could trigger such a shock at any time. We continue to advocate an approach that is flexible and diversifies an investor’s risk by allocating exposure to a variety of risk factors, rather than wholly relying on policymakers to deliver adequate future risk-adjusted and inflation-adjusted returns. J.P. Morgan Asset Management | 11
  12. 12. INVESTMENTINSIGHTS Scaling the cliffs using beta tailwinds, alpha ladders and hedge safety nets To learn more about the Investment Insights programme, please visit us at www.jpmam.com/insightFOR PROFESSIONAL CLIENTS ONLY | NOT FOR RETAIL USE OR DISTRIBUTION.This document has been produced for information purposes only and as such the views contained herein are not to be taken as an advice or recommendation to buy or sellany investment or interest thereto. Reliance upon information in this material is at the sole discretion of the reader. Any research in this document has been obtained andmay have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and donot necessarily reflect the views of J.P. Morgan Asset Management. Any forecasts, figures, opinions, statements of financial market trends or investment techniques andstrategies expressed are unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing,may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. Both past performanceand yield may not be a reliable guide to future performance and you should be aware that the value of securities and any income arising from them may fluctuate inaccordance with market conditions. There is no guarantee that any forecast made will come to pass.J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase Co and its affiliates worldwide. You should note that if you contactJ.P. Morgan Asset Management by telephone those lines may be recorded and monitored for legal, security and training purposes. You should also take note that informationand data from communications with you will be collected, stored and processed by J.P. Morgan Asset Management in accordance with the EMEA Privacy Policy which can beaccessed through the following website http://www.jpmorgan.com/pages/privacy.Issued in Continental Europe by JPMorgan Asset Management (Europe) Société à responsabilité limitée, European Bank Business Centre, 6 route de Trèves, L-2633Senningerberg, Grand Duchy of Luxembourg, R.C.S. Luxembourg B27900, corporate capital EUR 10.000.000.Issued in the UK by JPMorgan Asset Management (UK) Limited which is authorised and regulated by the Financial Services Authority. Registered in England No. 01161446.Registered address: 25 Bank St, Canary Wharf, London E14 5JP, United Kingdom.LV–JPM5676 | 01/13