The great realignment

Transcription

1 INVESTMENT STRATEGIES The great realignment One approach to unconstrained fixed income investing April 2014 Connecting you with our global network of investment professionals AUTHORS IN BRIEF A trend we are seeing among investors is best described not as a great rotation from fixed income into equities, but as a great realignment a shift from traditional, benchmark-oriented fixed income strategies to more benchmark-agnostic, flexible approaches. Looking forward, there are three key challenges with traditional fixed income benchmark strategies: Duration: Significant sensitivity to changes in interest rates Concentration: Highest allocation to the most stressed and frequent borrowers Constraints: Limited flexibility to capture returns outside the confines of the index Employing an unconstrained approach to fixed income investing can address each of these issues. Active management allows sector and duration exposures to shift based on changing market conditions, irrespective of a benchmark allocation. By not being bound to an index, strategies can take advantage of all sectors and geographies across the global fixed income universe. These extended sectors also offer additional diversification benefits, with lower correlation to each other and U.S. Treasury rates. In this Strategy Insights we look at one approach to unconstrained investing and examine the potential effects on risk and return when benchmark-agnostic strategies with more flexibility to change duration and sector exposures are blended with traditional core fixed income allocations. Dick Oswald Managing Director Client Portfolio Manager Global Fixed Income, Currency and Commodities richard.oswald@jpmorgan.com Investors are increasingly looking to next generation debt strategies, investing more globally and leaning to more benchmark-agnostic strategies. This quote from a recent FUNDfire article points to a trend we are recognizing in our own business: not a great rotation from fixed income into equities, but rather a great realignment of fixed income portfolios from more traditional, benchmark-oriented strategies to more unconstrained and flexible approaches. Our paper examines one approach to unconstrained investing and highlights the impact on risk and return when unconstrained strategies are incorporated into existing traditional core fixed income portfolios. Marika Dysenchuk Associate Client Portfolio Manager Global Fixed Income, Currency and Commodities marika.dysenchuk@jpmorgan.com FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY NOT FOR RETAIL DISTRIBUTION

2 The great realignment A tiring bull? For three decades, investors in traditional fixed income strategies such as the Barclays U.S. Aggregate Index (the Agg ) have enjoyed positive returns in all but three years: 1994, and In 1994, the Federal Reserve hiked the overnight fed strategies rate by 250 basis points from 3.00% to 5.50%, which pushed the yield on the 10-year Treasury up by 203 bps. The Agg returned -2.92% that year. From May to August 2013, the Fed kept the overnight rate unchanged, but talk of tapering the pace of its asset purchases and it was just talk at the time drove the 10-year yield up 111 bps. The return on the Agg over these four months was a loss of 3.67%. The episode in 2013 cost Agg investors 75 bps more than the six hikes of 1994 combined, yet the 10-year rate rose nearly twice as much in 1994 than in Why was the return on the Agg so much worse in the spring and summer of 2013 than in 1994? The short answer is yield and duration. Exhibit 1 highlights the difference between 1994 and In 1994, the Agg had less exposure to changes in interest rates (duration) and a much bigger yield cushion to offset the effect of rising Treasury rates. A more vulnerable Agg: Less yield cushion and a greater sensitivity to rising rates EXHIBIT 1: CHANGING CHARACTERISTICS OF THE BARCLAYS U.S. AGGREGATE BOND INDEX Yield ; Duration (years) Dec 94 YTM: 8.21% Dec 94 Dur: 4.68 yrs Source: Barclays Live; data as of December 31, That yield cushion is critical going back to 1980, the bulk of the Agg s return has come from yield (or coupon), not from capital gains or price appreciation (Exhibit 2). However, this fact does not mean that capital appreciation had no role in the 1 In 1999, Barclays Aggregate Index returned -0.80%. Duration (yrs) Yield to maturity Dec 13 Dur: 5.55 yrs 2 Eroded yield cushion 1 Dec 13 YTM: 2.49% 0 May-93 May-97 May-00 May-03 May-06 May-09 May-12 bull market, for yields have fallen significantly since the 1980s. On September 30, 1981, the yield on the 10-year Treasury hit a peak of 15.84%; nearly 31 years later, on July 24, 2012, the rate bottomed at 1.39%. Protective padding: Historically, coupons have accounted for the greater part of Agg returns EXHIBIT 2: COMPONENTS OF RETURN FOR BARCLAYS U.S. AGGREGATE Return Barclays U.S. Agg coupon return Barclays U.S. Agg price return 10-yr U.S. Treasury yield Source: Barclays Live, Bloomberg; data as of December 31, A wake-up call from the sleep-at-night investment The summer of 2013, a period when rates rose and spreads widened, brought unaccustomed volatility to the entire fixed income asset class. All sectors underperformed, and the only safe place to hide was in cash. This experience, on top of the unconventional monetary policies implemented by central banks around the globe, historically low yields, and the prospect of rising rates, has led investors to reassess the dependability of traditional fixed income portfolios. Interest in unconstrained strategies has grown apace. These strategies offer access to a broader opportunity set than core strategies that are benchmarked to the Agg, in order to create more favorable portfolio yield and duration characteristics. They also tend to be benchmark-agnostic and flexibly allocate across all fixed income sectors, dialing up risk only when compelling investment opportunities arise. Investors considering unconstrained strategies often feel, however, that they are trading some degree of clarity for the advantages of flexibility. Most conventional fixed income strategies start from a well-recognized benchmark with published characteristics such as composition, yield, duration and credit Yield 2 The great realignment: One approach to unconstrained fixed income investing

3 quality. Managers can then position portfolios around the benchmark, adding or reducing risk relative to the benchmark, as conditions warrant. In most cases, the majority of risk and return in these traditional strategies is driven by the performance of the underlying benchmark. As a result, investors have a reasonably good idea of how a benchmark-oriented strategy will perform as interest rates and credit spreads react to changing market conditions. In contrast, the performance of unconstrained strategies is driven largely by the manager s view on the future path of rates and spreads and how the manager chooses to position the portfolio in light of these market views and the investment objectives. As a result of the additional discretion awarded to the manager in these unconstrained strategies, the subsequent risk and return dynamics of these approaches is likely to vary to a much greater extent than for strategies tied to a benchmark. As indicated in Exhibit 3, the dispersion of returns across absolute return and multi-sector income strategies has been much greater than that of intermediate investment-grade and U.S. government mandates. Management matters: The fewer the constraints, the more important the choice of manager EXHIBIT 3: DISPERSION OF RETURNS ACROSS DIFFERENT MANAGER TYPES 1-year return Absolute return Multi-sector income Source: Lipper; data as of August 31, Unconstrained evaluation Intermediate investment grade Top quartile 25th percentile 50th percentile 75th percentile Bottom quartile Intermedite U.S. Gov t With no benchmark against which to measure this diversity of unconstrained strategies, one way to evaluate managers is to see how they maneuvered during market conditions that could recur in the future. The following analysis provides a framework to help investors think about the safety of their current benchmark-oriented strategy, the risk/reward dynamic of unconstrained strategies, and how their fixed income portfolios might perform with the addition of a benchmark-agnostic strategy. Exhibit 4 shows the relationship over the past three years between 10-year U.S. Treasury yields and option-adjusted spreads (OAS) for investment grade (IG) and high yield (HY) credits during both rising and falling rate periods. As this graph depicts, U.S. Treasury yields and credit spreads do not always maintain their typical inverse relationship with one another. As a result, we have conducted our analysis using multiple different time periods which capture both the traditional inverse relationship between rates and spreads, as well as more unusual market environments in which correlations increase significantly, causing spreads to widen as rates rise. Spread surprise: Spreads don t always narrow when rates rise EXHIBIT 4: INVESTMENT GRADE AND HIGH YIELD SPREADS VERSUS 10-YEAR U.S. TREASURY YIELD RISING RATE ENVIRONMENTS Yield yr U.S. Treasury yield (LHS) High Yield OAS Investment Grade OAS 9.0 Rising rate periods Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Source: J.P. Morgan Asset Management, Bloomberg; data as of December 31, The periods we selected include two periods of rising rates and two periods of falling rates over the 17 months ended in August 2013 as a proxy for the conditions that an investor might encounter in the coming months and years. This judgment is influenced by our view that despite the onset of tapering by the U.S. Federal Reserve, the Fed and other developed market central banks will keep interest rates low for an extended period, suggesting that investors will continue to search for yield. We also believe that economic growth will likely remain below trend and that inflation will stay under control as long as worldwide excess production capacity persists Option-adjusted spread J.P. Morgan Asset Management 3

4 The great realignment Either/or... EXHIBIT 5: STRATEGY COMPARISON BENCHMARK FOCUSED VS. BENCHMARK AGNOSTIC Strategy Core Bond Strategy (traditional) Multi-Sector Income Strategy (unconstrained) Team Doug Swanson, Chris Nauseda Bob Michele, Nick Gartside, Matt Pallai, Iain Stealey Distinguishing features Value-driven approach with sector bias to Focus on managing downside protection mortgage- and asset-backed securities Target Return: Benchmark bps Risk: bps volatility Return: Cash bps Benchmark Barclays U.S. Aggregate Agnostic (Primary: Barclays U.S. Aggregate; Secondary: 3-month T-bills) Strategy inception date* January 1986 December 2010 Yield (as of December 31, 2013) 2.6% 3.1% Typical ranges Yield curve: +/- 10% of benchmark Duration: +/-10% of benchmark Mortgage-backed securities: 40 65% Agency (excl. MBS): 0-10% Credit and asset-backed: 15 35% Treasury: 15 33% 0 to 9 years duration Max 50% below IG Max 20% EMD Max 20% non-usd exposure Source: J.P. Morgan Asset Management. *The information shown for each strategy above is from a representative account that follows that strategy. The target returns are for illustrative purposes only and are subject to significant limitations. An investor should not expect to achieve actual returns similar to the target returns shown above. Because of the inherent limitations of the target returns, potential investors should not rely on them when making a decision on whether or not to invest in the strategy. For more information on the limitations of target returns see the full disclosure on the last page. Our analysis compares two of our own strategies, the JPMorgan Core Bond Strategy and the JPMorgan Multi-Sector Income Strategy. The Core Bond Strategy is actively managed against the Barclays U.S. Aggregate Index. The Multi-Sector Income Strategy is a benchmark-agnostic, best ideas strategy with the flexibility to allocate across all fixed income sectors and to actively manage duration within a broad range (from zero to nine years). Exhibit 5 lays out the characteristics of these two strategies. Particularly worth noting are the strategies respective targets. While the Core Bond Strategy aims for a return in excess of the Agg, the Multi-Sector Income Strategy targets a risk, or volatility, range in addition to a return target of cash plus 300 bps. Other unconstrained strategies may manage to different objectives a fact which defines the essence of unconstrained and helps to explain the wide dispersion of returns. It is also a fact that suggests why investors interested in the strategy may want to consider diversifying their allocation among several managers with differing objectives. 4 The great realignment: One approach to unconstrained fixed income investing

5 Ups and downs Since most investors are more concerned about rates rising rather than falling, let s begin with how the two strategies performed when rates rose. The two periods of rising rates and the coincident changes in yields and spreads, along with the relative performance of the Multi-Sector Income Strategy (MSI), Core Bond Strategy and Barclays U.S. Agg, are shown in Exhibit 6. In the first period, from August 2012 through January 2013, 10-year Treasury rates rose by 52 bps and 30-year rates by 63 bps, resulting in a mild steepening of the yield curve. Risk asset spreads generally tightened (by 118 bps for HY and 40 bps for IG), exhibiting the expected negative correlation to interest rate movements. In the second period, from May 2013 through August 2013, 10-year rates jumped by 111 bps while rates on 30-year Treasuries climbed 82 bps, flattening the yield curve. Uncharacteristically, this rise in rates saw credit spreads widen (by 20 bps for HY and 5 bps for IG) as the correlation of credit spreads increased relative to the 10-year Treasury. In both periods, the Multi-Sector Income Strategy outperformed both the Core Bond Strategy and the Agg. This result can be attributed to the greater yield cushion from the spread sectors and the flexibility to shorten duration and choose the sectors that performed best under these market conditions (for example, high yield and emerging market debt in the August 2012 through January 2013 period). Varied investments, consistent results: Our go anywhere Multi-Sector Income Strategy topped the Barclays Agg and our Core Bond Strategy in both of these rising rate environments EXHIBIT 6: RISING RATE MARKET AND STRATEGY PERFORMANCE COMPARISON AUGUST 2012 JANUARY 2013 MARKET OVERVIEW MAY 2013 AUGUST 2013 MARKET OVERVIEW Yield change Spread change Total return 2-yr UST yr UST yr UST Core bonds* Agency MBS IG corporates HY corporates EMD Yield change Spread change Total return 2-yr UST yr UST yr UST Core bonds* Agency MBS IG corporates HY corporates EMD * Core bonds = Barclays U.S. Aggregate Index * Core bonds = Barclays U.S. Aggregate Index AUGUST 2012 JANUARY 2013 STRATEGY PERFORMANCE Multi-Sector Income Barclays U.S. Agg Core Bond % Index % % /1/2012 8/1/2012 9/1/ /1/ /1/ /1/2012 1/1/2013 MAY 2013 AUGUST 2013 STRATEGY PERFORMANCE Index Multi-Sector Income Barclays U.S. Agg Core Bond 4/1/2013 5/1/2013 6/1/2013 7/1/2013 8/1/ % -3.3% -3.7% Source: Barclays Live, Bloomberg. The information shown for each strategy above is from a representative account that follows that strategy. Past performance is not indicative of future results. Investment returns will fluctuate so that the redemption amount may be worth more or less than the original investment. Performance information is shown net of fees and includes reinvestment of interests when applicable. (Please see additional disclosure on the back page). J.P. Morgan Asset Management 5

6 The great realignment Defying expectations While rates are likely to rise from current levels, it is also possible that they will fall, so let s take a look at performance during periods when rates fell (Exhibit 7). From April 2012 to July 2012, 10- and 30-year Treasuries fell by 73 and 77 bps and from February 2013 to April 2013, by 30 and 28 bps, respectively. In the first period, spreads widened as rates fell. In the second, spreads tightened in line with rates as correlations changed. In the first period, the Agg and the Core Bond Strategy were the top performers, benefitting from the positive effects of long (five-year) duration in a falling rate environment. The spread widening at the time was mild and more than offset by the rate movement. The Multi-Sector Income Strategy, with a shorter duration during that period, lagged the index and the index-oriented strategy. In the second period of falling rates, the Multi-Sector Income Strategy, despite having a shorter duration, actually was the top performer by a small margin. Again, the flexibility to allocate to higher yielding sectors that performed well and avoid those that did not (such as emerging markets debt) led to the better outcome. The devil in the duration: The Multi-Sector Income Strategy did not participate fully in the mid-2012 and early 2013 bond rallies, given a cautious duration stance. Its higher yielding holdings, however, still propelled its outperformance in the 2013 rally EXHIBIT 7: FALLING RATE MARKET AND STRATEGY PERFORMANCE COMPARISON APRIL 2012 JULY 2012 MARKET OVERVIEW FEBRUARY 2013 APRIL 2013 MARKET OVERVIEW Yield change Spread change Total return 2-yr UST yr UST yr UST Core bonds* Agency MBS IG corporates HY corporates EMD Yield change Spread change Total return 2-yr UST yr UST yr UST Core bonds* Agency MBS IG corporates HY corporates EMD * Core bonds = Barclays U.S. Aggregate Index * Core bonds = Barclays U.S. Aggregate Index APRIL 2012 JULY 2012 STRATEGY PERFORMANCE FEBRUARY 2013 APRIL 2013 STRATEGY PERFORMANCE Index Multi-Sector Income Barclays U.S. Agg Core Bond 3.5% 3.2% 1.0% Index Multi-Sector Income Barclays U.S. Agg Core Bond 1.8% 1.6% 1.4% /1/2012 4/1/2012 5/1/2012 6/1/2012 7/1/ /1/2013 2/1/2013 3/1/2013 4/1/2013 Source: Barclays Live, Bloomberg. The information shown for each strategy above is from a representative account that follows that strategy. Past performance is not indicative of future results. Investment returns will fluctuate so that the redemption amount may be worth more or less than the original investment. Performance information is shown net of fees and includes reinvestment of interests when applicable. (Please see additional disclosure on the back page). 6 The great realignment: One approach to unconstrained fixed income investing

7 Conclusion: Un-constraining the core The final piece of the analysis and arguably the most telling is summarized in Exhibit 8. Here we created a variety of combinations of the Core Bond Strategy and the Multi-Sector Income Strategy, ranging from 100% of one strategy to 100% of the other. We then compared the risk and return characteristics of the different combinations over the entire 17-month analysis period, which included both rising and falling rates and spreads. In all cases, the returns of the combined strategies outperformed the Agg with a higher Sharpe ratio. The curves drive the point home. In the chronically uncertain conditions of low rates and high volatility that have prevailed in the bond market over the past several years and seem likely to persist, there is a reasonable argument for considering the realignment of your fixed income portfolio. By incorporating strategies with more flexibility to change duration and sector exposures, managers are able to more freely seek out the most attractive risk-adjusted return opportunities that the markets have to offer, while still maintaining the characteristics of a bond portfolio. Improving risk/return: Over the full period of our analysis (March 31, 2012 August 31, 2013) a combination of our core and multi-sector strategies outperformed the Agg, with improvement in returns and Sharpe ratios as the unconstrained proportion increased EXHIBIT 8: RISK AND RETURN DYNAMICS OF A COMBINED APPROACH 8A: RISK/RETURN 8B: SHARPE RATIO % MSI, 50% Core 75% MSI, 25% Core 100% MSI, 0% Core % MSI, 0% Core 75% MSI, 25% Core 50% MSI, 50% Core 25% MSI, 75% Core Return % MSI, 75% Core 0% MSI, 100% Core Barclays US Aggregate Index (3.0% risk, 0.7% return) Ratio % MSI, 100% Core Barclays US Aggregate Index (0.2) Risk (annualized volatility) 0.0 0% Core 100% MSI 25% Core 75% MSI 50% Core 50% MSI Source: J.P. Morgan Asset Management, Bloomberg, Barclays Live. Graphs shown using data from March 31, 2012 to August 31, % Core 25% MSI 100% Core 0% MSI J.P. Morgan Asset Management 7

8 The great realignment Strategy performance results EXHIBIT 9A: CORE BOND STRATEGY ANNUALIZED RETURNS 9B: MULTI-SECTOR INCOME STRATEGY ANNUALIZED RETURNS (AS OF MARCH 31, 2014) (AS OF MARCH 31, 2014) Year 1 Source: Morningstar; Results are net of fees. Year 3 Year 5 Year 10 Strategy Barclays U.S. Aggregate Index Year 1 Year 3 Year 5 Inception* Strategy N/A 4.08 Barclays U.S. Aggregate Index N/A 3.16** BofA Merrill Lynch 3-Month U.S. Treasury Bill Index N/A 0.09 Source: Morningstar; Results are net of fees. *Performance inception date: December 1, **Returns are calculated starting from the month end previous to the performance inception date. The information shown for each strategy above is from a representative account that follows that strategy. Past performance is not indicative of future results. Investment returns will fluctuate so that the redemption amount may be worth more or less than the original investment. Performance information is shown net of fees and includes reinvestment of interests when applicable. The opinions, estimates, forecasts, and statements of financial markets expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. Reliance upon information in this material is at the sole discretion of the recipient. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as advice or a recommendation relating to the buying or selling of investments. Furthermore, this material does not contain sufficient information to support an investment decision and the recipient should ensure that all relevant information is obtained before making any investment. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data. Credit Risk: There is a risk that issuers and counterparties will not make payments on securities, repurchase agreements or other investments held by the strategy. Such defaults could result in losses to the strategy. In addition, the credit quality of securities held by the strategy may be lowered if an issuer s financial condition changes. Lower credit quality may lead to greater volatility in the price of a security and in shares of the strategy. Lower credit quality also may affect liquidity and make it difficult for the strategy to sell the security. The strategy may invest in securities that are rated in the lowest investment grade category. Such securities are considered to have speculative characteristics similar to high yield securities, and issuers of such securities are more vulnerable to changes in economic conditions than issuers of higher grade securities. Interest Rate Risk: Bonds and other debt securities will increase or decrease in value based on changes in interest rates. If rates increase, the investment generally declines. On the other hand, if rates fall, the value of the investments generally increases. Your investment will decline in value if the value of the investment decreases. Securities with greater interest rate sensitivity and longer maturities tend to produce higher yields, but also are subject to greater fluctuations in value. Usually, the changes in the value of fixed income securities will not affect cash income generated, but may affect the value of your investment. Securities rated below investment grade are called high-yield bonds, non-investment grade bonds, below investment-grade bonds, or junk bonds. They generally are rated in the fifth or lower rating categories of Standard & Poor s and Moody s Investors Service. Although these securities tend to provide higher yields than higher rated securities, they tend to carry greater risk. International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations. The risks associated with foreign securities are magnified in countries in emerging markets. These countries may have relatively unstable governments and less-established market economies than developed countries. Emerging markets may face greater social, economic, regulatory and political uncertainties. These risks make emerging market securities more volatile and less liquid than securities issued in more developed countries. The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, JPMorgan Chase Bank N.A., J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated, J.P. Morgan Alternative Asset Management, Inc. and JPMorgan Asset Management (Canada) Inc. 270 Park Avenue, New York, NY JPMorgan Chase & Co. IS_Unconstrained fixed income FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY NOT FOR RETAIL DISTRIBUTION