A Brave New World for Bonds

Transcription

1 A Brave New World for Bonds Insights into Fixed Income Risks & Market Opportunities during Rising Rate Environments Fixed Income White Paper_r2.indd 1 1/10/ :00:19 AM

2 2 A BRAVE NEW WORLD FOR BONDS IN BRIEF We have just come off a 30-year bull market run for fixed income. Today, real rates interest rates adjusted for inflation expectations stand at or close to 0%. Many investors view bonds as safe investments and reliable sources of income. However, fixed income portfolios today should be evaluated within the context of an exceptionally low yield and coupon environment. As economic stimulus is removed from the system, rates are expected to rise, and long-term traditional core bonds may no longer be a low risk investment. We recommend limiting exposure to core fixed income, shortening duration and diversifying into other fixed incomeoriented investments. As markets transition back to normal growth, inflation and interest rate levels, we believe fixed income traditionally the safe harbor investment and anchor of an investor s portfolio is becoming a riskier asset. This is a very different reality than that of the past 30 years, when higher coupons provided strong returns with low volatility; today s low coupon environment leaves bonds little room to absorb losses when rates rise. As a result, investors need to rethink how they have traditionally allocated their bond portfolios. Here, we take a look at fixed income risks and opportunities as we navigate what appear to be uncharted waters. Transitioning back to growth, but with growing pains Years of mediocre global growth, coupled with aggressive, unorthodox monetary policy, have pushed interest rates and credit bond yields to historical lows (Figure 1). As recently as January 2013, real yields interest rates adjusted for inflation expectations stood at about 0%. However, recent signs of economic improvement and the expected tapering of central bank monetary stimulus now point to a protracted period of rising interest rates. Because the market tends to be forward-looking reacting to events in anticipation of them these factors will likely be reflected in rates far before they become a reality. This will in turn translate into higher yield and price volatility. It s not a matter of if yields will continue to rise; it s a matter of how fast and far and this scenario poses a substantial risk to many investors who continue to hold fixed-rate long maturity bonds. Figure 1: Following a 30-year bond bull market, rates are poised to rise % Sep. 30, % Average Nominal Yields 6.39% Real Yields 2.54% 10 Nominal 10-Year Treasury Yield Aug. 30, % 5 0 Real 10-Year Treasury Yield Aug. 30, % Economic threats in 1981 resulted in unconventional Federal Reserve intervention. Real yields rose to their highest level on record, and investors in 10-year Treasury bonds were paid an interest rate significantly above expected levels of inflation about 6.5% in real terms. Thus began a 30-year bull market in bonds. In the past few years, the Federal Reserve has again taken nontraditional steps to jump-start anemic economic growth. These actions have pushed yields to their unprecedented and historically low current levels, and the bond market is once again at an inflection point. Source: Federal Reserve, Bureau of Labor Statistics. Note: Real yield equals nominal less year-on-year CPI. Data as of August 30, Fixed Income White Paper_r2.indd 2 1/10/ :00:23 AM

3 INSIGHTS INTO FIXED INCOME RISKS & MARKET OPPORTUNITIES DURING RISING RATE ENVIRONMENTS 3 Rising rates pose risks for fixed income investors Why duration matters Against this backdrop of rising rates, investors in traditional long maturity, fixed-rate core government bonds are expected to lose money, which may take some investors by surprise. If coupons were higher as they were in 1983 and 1999 time could help smooth out some of those losses with the accumulation of income. However, given how low coupons are, traditional long maturity government bonds may not be able to compensate for expected price declines as interest rates rise (Figure 2). This means that long maturity, fixed-rate bonds are at risk for generating negative total returns when rates rise. Rising Rates Falling Bond Prices Figure 2: Low coupons lead to heightened risk from duration Period beginning: May 1983 May 1999 Hypothetical rate moves 10-Year Treasury Bond: one-year Interest Rate Moves (basis points) Capital Loss/Depreciation -15.5% -12.2% -4.4% -8.7% -13.1% -17.5% Coupon 10.1% 4.8% 2.5% 2.5% 2.5% 2.5% One-Year Total Return -5.4% -7.4% -1.9% -6.2% -10.7% -15.0% The two leftmost columns shown are two one-year periods during which interest rates significantly increased. (Note: 100 basis points = 1%.) In both cases, coupons were significantly higher than they are today. However, with coupons currently far lower, bonds have a smaller coupon buffer to offset price losses. As yields have fallen, bonds have seen duration increase; this means that similar historical rate moves will result in larger losses (both before and after coupon payments). This is illustrated in the columns labeled Hypothetical Rate Moves. Source: J.P. Morgan Securities LLC. Hypothetical losses calculated using duration and convexity and yield as of September 25, Bond prices and their yields are inversely related; as yields increase, bond prices decrease. However, the severity of a bond s price movement is determined by the amount of time the bond has until maturity and the size of its coupon (the rate of interest paid by the bond). Longer maturity bonds have more exposure to rate moves, while shorter maturity bonds have less. The degree of a bond s sensitivity to yield changes can be approximated by its duration. Duration is effectively the average maturity of the bond s payments. The higher the duration number, the greater sensitivity a bond has to interest rate moves. For example, a bond with a duration of two years would lose approximately 2% in price in the event of a 1% parallel increase in the yield curve. Conversely, a bond with a duration of nine years would lose approximately 9% in the event of a 1% increase in yields Fixed Income White Paper_r2.indd 3 1/10/ :00:23 AM

4 4 A BRAVE NEW WORLD FOR BONDS Investing in fixed income today: Opportunities exist, but think defensively While a rising rate environment presents substantial risks to fixed income, bonds play an important role in every well-balanced portfolio. In fact, core bonds are one of the only investments that, over time, have helped to protect portfolios against negative market shocks (Figure 3). However, given where we are in the interest rate cycle, investors would do well to consider these basic tenets when investing in bonds today: Limit a portfolio s allocation to core bonds. Keep duration short don t over-reach for yield. Invest in a vehicle you are comfortable with; for example, separately managed portfolios are more likely to hold a bond to maturity; however, you will be giving up daily liquidity and some measure of diversification. Broaden the use of alternative fixed income investments. We also advocate that investors consider a more defensive and diversified approach to investing in fixed income that includes moving into strategies that have limited interest rate risk exposure, employ active credit selection and have fewer benchmark constraints. Some key alternatives follow. Figure 3: Fixed income can diversify risk and reduce portfolio volatility Average Quarter Return 4% 2% 0% -2% -4% -6% -8% S&P 500 Index 2.7% -0.8% -0.9% Increasing Unemployment Barclays Intermediate Treasury Index 3.2% 2.9% Worsening Consumer Confidence -6.9% Slowing GDP Growth Core bonds are one of the only investments that, over time, have protected portfolios against negative market shocks. Bonds provide important diversification benefits that generally have a volatility-reducing effect on portfolios. They will continue to play an important role in our asset allocation. Source: J.P. Morgan Private Bank. Average returns are calculated by using quarterly returns when the macro factor deteriorated, unemployment increased, consumer confidence decreased and GDP growth slowed. Data from june 30, 1992 to June 30, Fixed Income White Paper_r2.indd 4 1/10/ :00:24 AM

5 INSIGHTS INTO FIXED INCOME RISKS & MARKET OPPORTUNITIES DURING RISING RATE ENVIRONMENTS 5 Extended credit Individually, there is no single asset that can be utilized in a fixed income allocation and which doesn t come with unique risks. However, there are a number of fixed income asset classes distinctly different from traditional long maturity, fixed-rate core bonds that can be used as part of a well-balanced fixed income allocation. One example is extended credit, which includes high yield corporate credit, 1 leveraged loans, floating rate bank loans and corporate sovereign debt in European emerging markets. These bonds possess characteristics, such as higher yields, that make them less sensitive than traditional core bonds to rising interest rates (credit spreads historically have cushioned the effect of rate movements). As a result, they can be good sources of diversification in your fixed income portfolio (Figure 4). Figure 4: Historical performance of fixed income assets with a 1% rise in interest rates 2.3% 3.7% 4.2% -0.9% -2.6% -2.1% -4.5% -4.2% -3.9% -8.2% -15.3% Long Treasuries (20+ years) Intermediate Treasuries (7 to 10 years) TIPS Corporates Agg Bonds Munis EM Sovereign Debt EM Local Debt High Yield Bank Loans Convertibles Source: J.P. Morgan Private Bank. Price impact of a 1% increase in the 10-year Treasury is estimated using monthly regressions from January 1994 to August 2013, based on availability of index data. For information on indexes used as proxies for bond categories and index definitions, see Definitions on page High yield bonds are speculative non-investment grade bonds that have higher risk of default or other adverse credit events, which are appropriate for high-risk investors only Fixed Income White Paper_r2.indd 5 1/10/ :00:24 AM

6 6 A BRAVE NEW WORLD FOR BONDS what is beta? Beta is commonly used in finance as a measurement of how much a portfolio or security will move in relation to the overall market. A beta of 1.0 indicates that a security tends to reflect the full movements of the market, while a security with a beta of less than 1.0 indicates that a security captures less market return. For example, a security with a beta of 0.5 means that the security tends to capture half of the market s return when all other influencing factors are held equal. Benchmark-agnostic strategies Traditionally, bond investors have chosen long-only, benchmark-focused strategies that have delivered moderate coupons with low risk of capital loss. High-quality core fixed income has generated strong performance for investors over the past 30 years; since 2009, core-aware credit strategies have worked well, too, as credit spreads tightened and yields fell both positive for returns. However, with interest rates poised to rise, investments in benchmark-aware strategies come with duration risk exposures that could result in significant losses. We recommend shifting assets out of these more traditional and benchmark-aware strategies into those that are more benchmark-agnostic. Strategies that are benchmarkagnostic have the investment flexibility to target portfolio exposures in different market environments in order to position around various risks (such as duration risk) in effect creating a varying beta investment strategy compared to the benchmark-aware universe (Figure 5). It s important to note that benchmark-agnostic strategies carry their own risks. While they tend to have lower betas compared to the broad market, they can be just as volatile as, and more correlated at points with, traditional risk assets such as equities or commodities. Used properly as a diversifier, however, they can play a key role in portfolios in the current rising rate environment. Figure 5: Beta comparison of benchmark-aware vs. benchmark-agnostic funds Benchmark- Aware Fund Beta Benchmark- Agnostic Fund Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Benchmark-agnostic funds navigate the opportunities in the market, dynamically changing their portfolio exposures as they seek to outperform the benchmark. In recent market cycles, this has translated into varying but consistently lower beta than their benchmark-aware peers. Source: J.P. Morgan Private Bank. Benchmark Aware Fund proxy by JPM High Yield Fund (OHYFX) and Benchmark Agnostic Fund proxy by JPM Multi-Sector Income Fund (JSISX). Fund betas are calculated with respect to the Merrill Lynch U.S. High Yield Index Fixed Income White Paper_r2.indd 6 1/10/ :00:27 AM

7 INSIGHTS INTO FIXED INCOME RISKS & MARKET OPPORTUNITIES DURING RISING RATE ENVIRONMENTS 7 Hedge funds Hedge funds are designed to target market opportunities and nimbly reallocate to capture imbalances in market prices. This allows them to generate asymmetric returns during volatile market periods, including rising rate environments (Figure 6). Hedge funds differ from benchmark-agnostic strategies in that they are not required to provide daily liquidity to investors. Therefore, they have access to a unique and broader set of investment opportunities. Illiquidity also enables hedge funds to limit, to an extent, the impact of market volatility on their portfolios. This has historically produced volatility levels that fall between those of core and high yield bonds (Figure 7). Overall, hedge funds possess characteristics that allow them to efficiently capture upside return and to generate desirable downside protection, making hedge funds an attractive fixed income alternative for those investors who can suitably invest in them. Figure 6: Asymmetric returns profile enables hedge funds to capture returns during rising rate environments 248 bps rate increase 225 bps rate increase 128 bps rate increase 105 bps rate increase Oct 93 Nov 94 Sep 98 Jan 00 May 03 May 04 Aug 05 Jun % 11.7% 8.3% 7.8% 4.9% 2.7% -0.5% 0.1% 2.7% -0.8% -0.4% -3.9% Hedge Funds Barclays Aggregate High Yield Source: J.P. Morgan Private Bank and PerTrac. HFRI Fund of Funds Diversified Index; Merrill Lynch U.S. High Yield Master II Index; Barclays U.S. Aggregate Index. Rate change reflect changes in the 10-year U.S. Treasury bond. Figure 7: Volatility in hedge funds vs. extended credit and core bonds Hedge Funds High Yield U.S. Aggregate 50% Aggregate/ 50% High Yield YTD 3.7% 6.6% 4.0% 5.1% 1 YR 3.2% 4.6% 2.8% 3.4% 3 YR 4.3% 6.7% 2.8% 3.8% 5 YR 6.1% 13.8% 3.7% 7.7% 7 YR 6.0% 12.1% 3.4% 6.7% 10 YR 5.6% 10.4% 3.5% 5.9% Source: J.P. Morgan Private Bank. All volatility numbers are calculated using monthly returns ended in August Fixed Income White Paper_r2.indd 7 1/10/ :00:27 AM

8 8 A BRAVE NEW WORLD FOR BONDS Today, less is more Compared to the last 30 years, investors today need to think differently about how they invest in fixed income. We are entering uncharted waters, where low coupons are offering negative real returns with the risk of substantial losses from rising rates. Going forward, investing in bonds requires a willingness to make the right tactical changes in your portfolio and in this respect, we firmly believe a smart defense is more important than a smart offense. Key to this is a fixed income portfolio diversified across extended credit and short duration core bonds, and which includes benchmarkagnostic strategies and hedge funds where appropriate (Figure 8). Investment opportunities exist, but return expectations and risk taking, for now, need to be lowered. Sometimes, less really is more. Figure 8: Positioning a defensive fixed income allocation Non-USD Strategies Inflation Protection Core-Aware Extended Credit-Agnostic Core-Agnostic Extended Credit-Aware For more information Please contact your J.P. Morgan representative for a current portfolio evaluation and guidance on how to position your fixed income allocation defensively in today s rising interest rate environment Fixed Income White Paper_r2.indd 8 1/10/ :00:28 AM

9 INSIGHTS INTO FIXED INCOME RISKS & MARKET OPPORTUNITIES DURING RISING RATE ENVIRONMENTS Fixed Income White Paper_r2.indd 9 1/10/ :00:28 AM

10 10 A BRAVE NEW WORLD FOR BONDS Definitions Indexes used as proxies for bond categories are as follows: Long Treasuries Barclays Capital U.S. Treasury 20+ Year Index; Intermediate Treasuries Barclays Capital U.S. Treasury 7 10 Year Index; Treasury inflation protection securities Barclays Capital U.S. TIPS Index; Corporate bonds Barclays Capital U.S. Corporate Bond Index; Aggregate bonds Barclays Capital U.S. Aggregate Bond Index; Municipal bonds Barclays Capital Municipal Bond 1 15 Year Bond (1 17 Maturity) Index; Emerging market sovereign debt J.P. Morgan EMBI Global Composite Index; Emerging markets local debt J.P. Morgan GBI-EM Index; High yield bonds Merrill Lynch U.S. High Yield Master II Index; Bank loans S&P/ LSTA Leveraged Loan Index. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The Barclays Capital Intermediate U.S. Treasury Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of greater than or equal to one year and less than 10 years, are rated investment grade, and have $250 million or more of outstanding face value. The Barclays U.S. Aggregate Bond Index represents securities that are U.S. domestic, 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. This index was formerly the Lehman Aggregate Bond Index. The Barclays Capital U.S. Corporate Bond Index consists primarily of publicly issued U.S. corporate securities. The index includes both corporate and non-corporate sectors. The corporate sectors are industrial, utility and financial. To be included in the index, an issuer must have debt with at least one year to final maturity, have at least $250 million par amount of debt outstanding and be rated investment grade by at least two rating agencies. The Barclays Capital U.S. TIPS Index consists of inflation-protection securities issued by the U.S. Treasury. Index Rules include: (1) must have at least one year to final maturity; (2) must have at least $250 million par amount outstanding; (3) must be rated investment grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody s, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment grade; (4) must be fixed rate; (5) must be dollar denominated and non-convertible; (6) must be publicly issued; (7) must be a U.S. Treasury Inflation Note. The Barclays Capital U.S. Treasury 7 10 Year Index consists of securities in the Treasury Index (i.e., public obligations of the U.S. Treasury) with a maturity from seven up to (but not including) 10 years. Index Rules include: (1) must have at least one year to final maturity regardless of call features; (2) must have at least $250 million par amount outstanding; (3) must be rated investment grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody s, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment grade; (4) must be fixed rate, although it can carry a coupon that steps up or changes according to a predetermined schedule; (5) must be dollar denominated and non-convertible; (6) must be publicly issued; (7) must be a U.S. Treasury security. The Barclays Capital U.S. Treasury 20+ Year Index consists of securities in the Treasury Index (i.e., public obligations of the U.S. Treasury) with a maturity of 20 years or more. Index Rules include: (1) must have at least one year to final maturity regardless of call features; (2) must have at least $250 million par amount outstanding; (3) must be rated investment grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody s, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment grade; (4) must be fixed rate, although it can carry a coupon that steps up or changes according to a predetermined schedule; (5) must be dollar denominated and non-convertible; (6) must be publicly issued; (7) must be a U.S. Treasury security. The Barclays Capital Municipal Bond 1 15 Year Bond (1 17 Maturity) Index is a sub-index of the Barclays Capital Municipal Bond Index; it is a rules-based, market value weighted index of bonds with maturities of one year to 16 years and 11 months engineered for the tax-exempt bond market. The HFRI Fund of Funds Diversified Index is an index of Fund of Funds classified as Diversified that exhibit one or more of the following characteristics: invests in a variety of strategies among multiple managers; historical annual return and/or a standard deviation generally similar to the HFRI Fund of Fund Composite Index; demonstrates generally close performance and returns distribution correlation to the HFRI Fund of Fund Composite Index. The J.P. Morgan EMBI Global Composite Index tracks total returns for U.S. dollar-denominated debt instruments issued by emerging market sovereign and quasi sovereign entities. This includes Brady bonds, loans, Eurobonds and external debt instruments (source: J.P. Morgan). The J.P. Morgan GBI-EM Index is the first comprehensive, global local emerging markets index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds to which international investors can gain exposure. The Merrill Lynch All Convertibles All Qualities Index includes convertible securities with a minimum issue size of $50 million; U.S. dollar denominated; sold into the U.S. market and publicly traded in the United States; convertible into U.S. dollar-denominated common stock, ADRs or cash equivalent. The Merrill Lynch U.S. High Yield Master II Index tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. Yankee bonds (debt of foreign issuers issued in the U.S. domestic market) are included in the index provided the issuer is domiciled in a country having an investment grade foreign currency long-term debt rating (based on a composite of Moody s and S&P). The S&P 500 Index (S&P 500) consists of 500 stocks chosen for market size, liquidity and industry group representation. It is a market value weighted index (stock price times number of shares outstanding), with each stock s weight in the index proportionate to its market value. All returns include reinvested dividends except where indicated otherwise. The S&P 500 Total Return Index also includes dividends reinvested. The S&P/LSTA Leveraged Loan Index covers the U.S. loan market. It reflects the market weighted performance of institutional leveraged loans in the United States, based on real-time market weightings, spreads and interest payments Fixed Income White Paper_r2.indd 10 1/10/ :00:28 AM

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