Solving for Fixed Income

MARKET INSIGHTS Solving for Fixed Income Using Market Insights to achieve better outcomes Q4 2016

SINCE 2004, J.P. MORGAN HAS PRODUCED MARKET INSIGHTS TO HELP INDIVIDUAL INVESTORS UNDERSTAND AND MAKE THEIR WAY THROUGH RAPIDLY SHIFTING MARKETS. TODAY, EVEN WITH YIELDS TOUCHING HISTORIC LOWS, WE BELIEVE FIXED INCOME HAS A VITAL ROLE TO PLAY IN DIVERSIFYING PORTFOLIO RETURNS, HELPING TO PRESERVE PORTFOLIO VALUE AGAINST VOLATILITY AND PROVIDING A RELIABLE SOURCE OF INCOME. SOLVING FOR FIXED INCOME TAKES A LOOK AT HOW THE CURRENT ENVIRONMENT HAS AFFECTED FIXED INCOME S TRADITIONAL ROLE AND AT THE MANY OTHER OPPORTUNITIES THAT CAN ACCOMPLISH ITS TRADITIONAL OBJECTIVES. 2

SOLVING FOR FIXED INCOME 1 LOW RETURNS FROM CASH 2 THE IMPORTANCE OF INCOME 3 MOVING BEYOND GOVERNMENT BONDS 4 GLOBAL FIXED INCOME OPPORTUNITIES 5 GLOBAL INVESTMENT GRADE BONDS 6 HIGH YIELD BONDS 7 DIVERSIFICATION AND FLEXIBILITY 3

1 LOW RETURNS FROM CASH Cash can be a real drag In the short term having a little extra cash can be beneficial if you need to allocate quickly to new opportunities. However, cash is definitely no longer king with respect to long-term investment returns. Deposit rates since the Global Financial Crisis in 2008 have been in decline and could come down further if the central bank continues to cut the official cash rate. Despite yields on government bonds being at record low levels, fixed income continues to play an essential role in diversifying investment portfolios. 4

2 THE IMPORTANCE OF INCOME Maximize investment growth with bonds The total return on fixed income investments consists of two components: price, or capital, appreciation and the coupon return. The steady stream of income earned from the coupon can increase the total return from fixed income and act to partially offset any capital loss should it occur. This serves as a critical buffer for portfolios. When thinking of returns from fixed income, investors should focus on the total return, and the importance of that flow of income, in adding to that return. 5

3 MOVING BEYOND GOVERNMENT BONDS Declining cash rates Faced with mediocre momentum in economic growth, lower levels of inflation and inflation expectations, as well as an uncertain political situation, major central banks are moving ever further into the domain of unconventional monetary stimulus. When policy rates do start to rise, however, markets anticipate that this will happen at a very gradual pace. Searching for higher yields Unorthodox monetary policies and the purchase of both government and corporate bonds by central banks have pushed yields on a significant portion of developed market government bonds to ultra low or even negative levels. As a result, investors are moving beyond government bonds in search of higher yields. 6

4 GLOBAL FIXED INCOME OPPORTUNITIES Think global for the best opportunities The fixed income market is diverse, spanning a range of securities that perform differently as markets evolve. Their varying characteristics can play an important role in portfolio diversification. No one type of fixed income security has consistently outperformed or underperformed over the past few years. The different types of fixed income securities are characterized by their varying sensitivities to interest rates (i.e., duration) and their correlation to benchmark government bonds, as well as their yield levels, which result in differing performance. Investors have a wide variety of fixed income choices when considering how to allocate across fixed income markets in their portfolios based on market conditions. 7

5 GLOBAL INVESTMENT GRADE BONDS The safety of investment grade bonds Investment grade bonds are corporate bonds associated with companies with a relatively low chance of defaulting their obligations. The default risk is reflected through a higher yield as compared to what is offered by a government bond, and the yield difference is known as the spread. This spread presents another source of income and a return that will beat cash in the current environment. A selective approach to investment grade bonds can add to the consistency of returns in a fixed income portfolio as economies continue to recover, earnings growth stabilizes and credit fundamentals of the overall corporate bond market (ex-commodities) improve. 8

6 HIGH YIELD BONDS Taking advantage of higher yields High yield bonds have a rating below investment grade and offer more yield to compensate for the additional credit risk. These bonds continue to help investors achieve higher yield amidst the current low yield environment. The largest market for high yield bonds is the U.S; however, this market also has the greatest exposure to energy companies that have been impacted by falling oil prices. The yields for energy companies rose much more than the rest of the high yield market, and outside of the energy sector, the default rate for bonds remains low compared to the compensation that investors can receive. 9

6 HIGH YIELD BONDS Taking advantage of higher yields The European high yield market is growing in size and in quality. While it offers a lower yield than its U.S. counterpart, its exposure to the energy sector is limited and can remove some of the uncertainty around commodity price moves. The European Central Bank s purchase of investment grade corporate debt as part of its bond buying programme will push investors along the risk spectrum as they hunt for yield, creating additional demand for, higher yield segment of the market. 10

7 DIVERSIFICATION AND FLEXIBILITY Why diversification works Fixed income investments diversify portfolios because they generally exhibit low correlation to other asset classes. This principle applies within an asset class as well, and investors should consider how to diversify within the fixed income market. Since 2012, a portfolio that included a wider array of fixed income assets has outperformed Australian government bonds. Investors should also consider how they allocate to each fixed income market segment as the drivers of return, sensitivity to interest rates and corporate fundamentals will affect returns. Having the flexibility to move between sectors may be advantageous. 11

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