Inflation acclimation: Building inflation-resistant portfolios
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1 J.P. Morgan Asset Management Research Summit 2011 Passport to opportunity Inflation acclimation: Building -resistant portfolios Deepa Majmudar Portfolio Manager and Quantitative Analyst, Tax Aware Fixed Income Group Connie Plaehn Head of Fixed Income Wealth Advisory Team Paul Swoboda Client Portfolio Manager, U.S. Fixed Income Group Although core has recently shown upward momentum, it remains at a relatively low level, well below its historical average, but history has shown that typically bounces back after protracted periods of exceptionally low or deflation. The low level of core in the current environment is due, in part, to the dynamic of the current economic recovery. While the U.S. Federal Reserve s unprecedented monetary response to the recent crisis stoked economic growth, unemployment remains stubbornly high and excess capacity is keeping muted. Accordingly, interest rates remain close to historically low levels. FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY NOT FOR PUBLIC DISTRIBUTION
2 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 02 Key presentation takeaways While does not appear to be an immediate threat, it is certainly a legitimate concern looking farther out into the future. Traditional responses to face challenges in the current market environment. A growing number of investors are turning to -linked derivatives as protection against. Given the current backdrop, however, it is not hard to imagine an environment in which surging commodity prices and a lower U.S. dollar begin to be passed through to the consumer in the form of higher retail prices. Indeed, sharp increases in energy prices, along with other components of CPI, have already led to recent upticks in. (See Exhibit 1.) Shifts in breakeven (calculated as the difference in yield between nominal and -indexed securities of the same maturity) reflect investors growing concerns about near-term. Although longer-term breakeven rates remain near historical averages, short-term breakevens have spiked, implying that investors are more concerned about near-term rising driven by higher commodity prices than they are about longer-term systemic as a result of rising labor costs. As a result, short-term fixed income securities such as cash and short-term bonds are providing investors with a negative real yield, since their nominal yields are far below current levels of CPI. EXHIBIT 1 Soaring energy prices contribute to rising 6-month change [annualized] of CPI components 36.0% 27.6% 19.4% Commodity related Dollar related Domestically driven Offshore produced 4.7% Headline CPI Energy All Transportation 7.0% 4.7% 4.5% 2.6% 1.8% 1.5% 1.5% 1.4% 1.3% 1.2% Nonpetroleum Nonfood Fed comfort zone -0.9% Food Medical Services Wages Housing Excl. Vehicles Shelter Apparel care food & energy ] Components of CPI Owners Equivalent Rent is the largest component of Headline CPI at 24.9% Housing: ex-owners equivalent rent Food and beverage Transportation: ex-fuel Medical care Recreation Motor fuel Other Apparel Education Telephone services IT Source: Bureau of Labor Statistics, J.P. Morgan Asset Management. Data as of March 2011.
3 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 03 EXHIBIT 2 TIPS prices are sensitive to changes in real yields Components of TIPS return Coupon return Inflation adjustment Real price return 2.08% 2.9% 2.1% -3.0% 3.95% 3.6% 1.5% -1.2% 2.40% 3.8% 2.6% -4.0% 13.17% 3.9% 3.4% 5.9% 7.89% 3.6% 2.1% 2.2% 16.57% 3.5% 11.1% 8.40% 3.1% 3.3% 8.46% 2.9% 3.2% 2.4% 2.84% 2.6% 4.3% -4.1% 0.41% 2.5% 1.3% -3.4% 11.63% 2.5% 3.5% 5.7% -2.35% 2.3% 3.7% 11.41% 2.2% 9.4% -0.2% 6.31% 1.2% 3.1% -8.3% Barclays Capital U.S. TIPS Index Duration [Macaulay to worst, years] Source: Barclays Capital, J.P. Morgan Asset Management. Data as of December 31, Returns shown are for the Barclays U.S. TIPS Index. Limitations of traditional responses to risk Investors interested in -protected strategies have historically turned to TIPS or gold, oil and other types of commodities. However, these traditional -protection investments each present investors with challenges. Commodities are notoriously volatile, cyclically sensitive and vulnerable to shocks in supply and demand. In addition, commodities are susceptible to technical pressure and speculation. TIPS, on the other hand, are widely accessible through actively managed investment strategies and ETFs and their solid performance since inception has given investors little reason to reevaluate allocations to these government securities. Upon closer examination, TIPS may be providing investors with unwanted exposure to interest rates. Fueled by a steady decline in nominal and real interest rates, government bonds, including TIPS since their inception in 1997, have enjoyed a prolonged bull market. This strong performance and investors expected compensation in a rising ary environment have led many to describe TIPS as the ultimate riskfree investment. A closer look at their structure, however, reveals embedded risks as a result of their exposure to real interest rates, (real interest rates are defined as nominal rates minus forward looking breakeven expectations). TIPS pay a semi-annual coupon based on their principal value. The principal value is self-adjusted for changes in actual as measured by the CPI Index. However, these adjustments for only serve to protect the purchasing power of TIPS cashflows and principal payments from. They do not protect against increases in real interest rates and can perform poorly in environments when interest rates and do not increase together. Like nominal bonds, TIPS are exposed to movements in real interest rates, a part of their structure that, as shown in Exhibit 2 by the real price return, has been beneficial for much of the last decade. Of course, in a rising interest rate environment, the total return from TIPS indices would be expected to decrease, just as it increased when real yields declined. This has prompted investors to consider breakeven strategies, such as CPI swaps, to provide a purer hedge.
4 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 04 As an alternative to TIPS, investors have also turned to linked structured notes, which pay a CPI-linked coupon. However, these securities lack liquidity and pricing transparency, and can be expensive due to structuring costs. Advantages of CPI swaps CPI swaps can be used to provide a hedge against risk. They are structured to capture the difference between expected and actual without exposing investors to changes in real interest rates. The swap buyer is liable upon maturity for paying the swap seller a fixed amount based on forward looking break even rates at the time of purchase. In exchange, the swap seller is liable upon maturity for paying the swap buyer an amount determined by the realized appreciation of the CPI index over the life of the swap. This structure offers the swap buyer protection from a level of higher than is expected at the time of purchase. The CPI swap market includes many maturities ranging from 1- to 30-years. With this structure, CPI swaps provide protection without exposing investors to changes in real interest rates and offer a higher correlation to actual changes in CPI than TIPS. Shorter-term CPI swaps are represented in Exhibit 3 by the 1-3 year BEI index, while longer-term CPI swaps are represented by the BEI index. Notice their significantly higher correlation to actual versus TIPS and their lower volatility levels in comparison to commodities. In addition, CPI swaps are far more tax efficient than TIPS because they can be structured as zero coupon instruments where their net payment is treated as a capital gain/loss. Also, given their historically low correlation to equities, they can help lower overall portfolio volatility, providing a practical solution to manage the uncertainty of risk. In addition, because swaps offer a wide range of maturities, they can easily fit into a broad range of views to complement a variety of investment strategies. EXHIBIT 3 CPI swaps offer high correlation to and low volatility Year-over-year return correlations to CPI TIPS year BEI BEI Index Gold Oil CRB Index Correlations are calculated from monthly returns since January 1998 through December Breakeven index available since Annualized Volatility is calculated by taking the standard deviation of 12-month rolling returns from January 1998 through December Source: Barclays Capital. The market for -linked derivatives has grown substantially since their U.S. debut in the early 2000s, with current annual trading volume around USD 25 billion. Increased liquidity and transparency have lowered transaction costs and bolstered usage among mutual fund, pension and assetliability investors as a viable option in the derivatives space for managing. New products, such as caps, floors and options on CPI, are also becoming available, and the outlook remains positive for continued development. CPI swaps enable portfolio managers to hedge out the risk of without having to buy -indexed bonds, which require far greater capital and may generate unfavorable tax consequences. Combining CPI swaps with nominal bonds creates an -linked portfolio structure and offers investors with a compelling solution to protection. (See Exhibit 4.) GSCI S&P 500 BC Aggregate 5.70% 3.05% 5.77% 15.11% 38.94% 21.84% 32.57% 19.68% 2.92% Annualized volatility 3
5 FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY NOT FOR PUBLIC DISTRIBUTION RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 05 CPI swaps can be combined with traditional core fixed income investments such as U.S. agency securities, mortgage-backed securities and corporate bonds, while the tactical use of commodities can provide additional protection against. Alternatively, investors seeking a more tax efficient investment strategy may prefer a portfolio of underlying municipal fixed income securities with a CPI swap overlay. In both investment strategies, active duration management of the underlying bonds provides flexibility to navigate the portfolios through different interest-rate environments. When to purchase protection Inflation does not appear imminent but it is certainly a legitimate concern looking farther out into the future. While there is no sure or easy way to quantify what amount of protection is appropriate, we believe that it may be prudent to devote a share of assets to such protection, especially considering that once the threat of begins to rise, the price for protection usually increases. Similar to purchasing a hurricane insurance policy for a new house on the Gulf Coast, the ideal time to protect against is when the threat is real but not immediately imminent. EXHIBIT 4 Using CPI swaps to create an -protected bond Nominal bonds CPI [] swap 1.50% 0.50% 3.00% 5.00% Expected [ breakeven] Spread* Real yield Pay expected Receive actual VARIABLE = Inflation-protected bonds Receive actual Spread* Real yield VARIABLE INFLATION ADJUSTED YIELD 2.50% 0.50% 3.00% 6.00% The chart is shown for illustrative purposes only. *Spread represents the credit spread the swap spread. Nominal bonds assume real rate and risk Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. 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, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein employs proprietary projections of expected returns as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital markets theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees or other costs. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Bonds have the same interest rate,, and credit risks. Interest rate risk means that as interest rates rise, the prices of bonds will generally fall, and vice versa. Inflation risk is the risk that the rate of return on an investment may not outpace the rate of. Credit risk is the risk that issuers and counterparties will not make payments on securities and investments. Derivatives may be riskier than other types of investments because they may be more sensitive to changes in economic or market conditions than other types of investments and could result in losses that significantly exceed the original investments. Certain derivatives may give rise to a form of leverage. As a result, the investment may be more volatile. Derivatives are also subject to the risk that changes in the value of a derivative may not correlate perfectly with the underlying asset, rate or index. The use of derivatives for hedging or risk management purposes or to increase income or gain may not be successful, resulting in losses. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited which is regulated by the Financial Services Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l., Issued in Switzerland by J.P. Morgan (Suisse) SA, which is regulated by the Swiss Financial Market Supervisory Authority FINMA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited, all of which are regulated by the Securities and Futures Commission; in Singapore by JPMorgan Asset Management (Singapore) Limited which is regulated by the Monetary Authority of Singapore; in Japan by JPMorgan Securities Japan Limited which is regulated by the Financial Services Agency, in Australia by JPMorgan Asset Management (Australia) Limited which is regulated by the Australian Securities and Investments Commission and in the United States by J.P. Morgan Investment Management Inc. which is regulated by the Securities and Exchange Commission. Accordingly this document should not be circulated or presented to persons other than to professional, institutional or wholesale investors as defined in the relevant local regulations. The value of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. 270 Park Avenue, New York, NY JPMorgan Chase & Co. INST-RS-INFL-GLOBAL Receive the difference between expectations and actual CPI Inflation-protected bonds remove CPI risk
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