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Fixed IncomeOpportunities in challenging times: A compendium of our summer webcast series

INVESTMENTINSIGHTS

ABOUT

J.P. MORGAN GLOBAL INSTITUTIONAL

ASSET MANAGEMENT

J.P. Morgan Global Institutional Asset Management is a global leader in investment

management, dedicated to creating a strategic advantage for institutions by connecting clients

with J.P. Morgan professionals. With roughly 800 investors on the ground in more than 30

countries, the firm seeks to deliver first-class investment results to some of the world’s most

sophisticated organizations, including corporate pension plans, endowments, foundations,

insurance companies, sovereign wealth funds and government-affiliated institutions.

J.P. Morgan Global Institutional is distinguished by its capital markets knowledge, global

investment expertise and the long-term, proactive partnerships it establishes with clients.

Our innovative strategies span equity, fixed income, real estate, private equity, hedge funds,

infrastructure and asset allocation. J.P. Morgan Global Institutional is part of J.P. Morgan Asset

Management, which has assets under supervision of $2.3 trillion and assets under management

of $1.6 trillion (as of December 31, 2013).

1Introduction

3A closer look: Finding opportunities in challenging times

5A new breed of absolute return

7 Exercising the freedom to invest: An approach to unconstrained investing

9Liability-driven investing (LDI)

11Maximizing total return

13Opportunistic exposure: Alternative sources of yield

15Opportunistic inflation hedging

17 Steady income streams in shifting global markets

19Unconstrained investing: Diversification across markets and sectors

T A B L E O F C O N T E N T S

I N T R O D U C T I O N

J.P. MORGAN ASSET MANAGEMENT 1

S t a r t i n g f r o m t h e s h a r e d v i e w p o i n t that risk-free

interest rates will very likely rise over time, bringing an end to a decades-

long period of strongly positive returns on standard bond indices, expert

speakers during our summer fixed-income series explored a wide range

of topics related to this asset class. Three broad themes emerged from

these conversations.

First, even in an environment where the base-case expectation is for limited or negative returns, fixed income retains an important role in portfolio construction. It serves as a hedge against poor economic outcomes, given forecasters’ limited success in the past at predicting shocks and recessions. It provides a steady income stream, allowing investors to avoid distressed liquidation of other, more cyclically sensitive assets. It represents a crucial part of plan sponsors’ efforts to deal with funded status surplus volatility. And it offers a variety of ways to guard against the possibility of increased inflation.

Second, although credit spreads have tightened significantly and government bond yields likely have reached their lows for the current cycle, significant opportunities remain in less explored parts of the fixed income universe. Some corners of the emerging markets debt universe, for example, offer still high yields to investors with the ability to perform fundamental credit analysis. Capital structures of smaller issuers, whose size does not qualify them for index inclusion, can also reward bottom-up investors. Subprime asset-backed securities and sections of the MBS market also offer more than government bonds, as does debt issued by European banks.

Third, a one-size-fits-all approach makes less sense today than it did during the bull market in bonds over the past 30 years. Depending on their specific objectives, investors will likely need to exploit a broad and shifting opportunity set within fixed income, and in particular may benefit from unconstrained and absolute return strate-gies. Unconstrained strategies allow managers to take advantage of sometimes fleet-ing relative value opportunities while closely monitoring rapidly changing correla-tions across fixed income asset classes. The absolute return model, which looks for uncorrelated sources of return, facilitates the use of cash as a source of strategic liquidity and emphasizes tail risk hedges via systematic and efficient short positions.

I N T R O D U C T I O N

2 FIXED INCOME—OPPORTUNITIES IN CHALLENGING TIMES: A COMPENDIUM OF OUR SUMMER WEBCAST SERIES

For institutional investors, fixed income represents a large and in many cases growing part of portfolios. Whether this expo-sure is intended to match pension liabilities, hedge against risks such as recession or inflation, or provide alpha through security selection, it requires greater attention and short-term management than before. Our series brought together some of our best current thinking in this area, and we hope it will serve as a springboard for many future conversations.

For more information on these themes, please explore the articles in this paper, or visit our website at:

UNCONSTRAINED INVESTING TRADITIONAL APPROACHES ALTERNATIVE STRATEGIES

• Unconstrainedinvesting:Diversificationacrossmarketsandsectors

• Unconstrainedinvesting:Diversificationacrossmarketsandsectors

• OpportunisticExposure:Alternativesourcesofyield

• OpportunisticExposure:Alternativesourcesofyield

• Exercisingthefreedomtoinvest:Anapproachtounconstrainedinvesting

• Anewbreedofabsolutereturn

• Anewbreedofabsolutereturn • Maximizingtotalreturn

• Exercisingthefreedomtoinvest:Anapproachtounconstrainedinvesting

• Steadyincomestreamsinshiftingglobalmarkets

• Opportunisticinflationhedging

• Liability-driveninvesting(LDI)

Michael HoodManaging Director Global Market Strategist


A closer look: Finding opportunities in challenging timesby Michael Hood, M a n a g i n g D i re c t o r, G l o b a l M a r ke t s S t rat e g i st ,

a n d Megan McClel lan, G l o b a l H e a d o f M a r ke t S t rat e g i e s Fi xe d I n co m e & L i q u i d i t y

fluctuate around the economy’s nominal rate of growth: its real underlying growth, plus inflation. Not only is inflation likely to run below historical norms—fluctuating around 2% in the U.S., as in Europe—but the economy’s real growth potential has slowed to the 2%–2.25% range.

How should fixed income investors position portfolios for today’s exceptional market environment? As Meg McClellan and Michael Hood examine apparent investor “complacency” and the now-chronic lack of yield in the fixed income markets, they consider unconstrained approaches that look to take advantage of an expanding opportunity set that may hedge risk, enhance income and boost returns.

Michael Hood regards investor complacency, reflected in very low market volatility, as justifiable realism in the macro-economic context. The last recession cleansed the market of its excesses, which have not had time to build back up in the early stages of what is proving an unusually gradual recovery. The markets, in his view, are merely discounting the low eco-nomic volatility that has accompanied this slow recovery.

TowardanewneutralAlthough a maturing business cycle should persuade the Fed to tighten rates that have hovered near the zero bound for an unprecedented five years, Hood expects a fundamental structural shift to temper the cyclical inevitability of a higher yield curve. He anticipates rates will trend toward the new lower equilibrium diagrammed in Exhibit1.Over the long run, the “neutral” 10-year U.S. Treasury yield has tended to

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Equilibrium bond yields: Lower than before, but higher than today EXHIBIT 1: U.S. POTENTIAL GDP GROWTH AND 10-YEAR U.S. TREASURY YIELD

Source: J.P. Morgan, Congressional Budget Office; data and forecasts as of May 30, 2014.


DisAggregatingIn Exhibits2Aand2B, Meg McClellan shows how the macro-economic climate has affected the fixed income markets. Yields on high-quality bond indices, which were driven lower by central bank intervention and “safe haven” demand for fixed income in the aftermath of the financial crisis, have yet to meaningfully reverse course. Despite the low yields, retail and institutional clients have added to fixed income alloca-tions. Both government and corporate issuers have taken advantage of this persistently high corporate bond demand and the Fed’s accommodative stance by issuing record amounts of lower-coupon debt at longer maturities, extending investment grade index durations.

Institutional investors are addressing this challenge, she notes, by turning to unconstrained approaches that identify and evaluate opportunities beyond the confines of traditional benchmarks, in markets that have grown exponentially larger and more diverse in the past 25 years.

EXHIBIT 2B: U.S. INVESTMENT GRADE CORPORATE INDEX

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Source: Barclays Capital; data as of May 30, 2014.

Declining yield and rising duration across the fixed income universe are eroding the yield cushion

EXHIBIT 2A: GLOBAL AGGREGATE INDEX

Eroded yieldcushion

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A C L O S E R L O O K : F I N D I N G O P P O R T U N I T I E S I N C H A L L E N G I N G T I M E S


A new breed of absolute returnby Bil l E igen, M a n a g i n g D i re c t o r, C h i ef I nv e st m e nt O f f i ce r, A b s o l u t e Re t u r n & O p p o r t u n i st i c F i xe d I n co m e,

a n d Oksana Aronov, M a n a g i n g D i re c t o r, M a r ke t S t rat e g i st , A b s o l u t e Re t u r n & O p p o r t u n i st i c F i xe d I n co m e

Investing for absolute return can serve as a foundation in a fixed income portfolio in times like these when spreads are tight, correlations are high, the economy is strengthening and the end of Fed accommodation is imminent.

Bill Eigen and Oksana Aronov emphasize the strategy’s critical difference. In contrast to other fixed income strategies that seek to maximize risk-adjusted returns, absolute return focuses exclusively and methodically on delivering uncorrelated sources of return.

Lessonslearnedfrom2013’svolatilityBill Eigen says that fixed income today seems to be near an inflection point with extraordinarily tight spreads across sectors (Exhibit3). The condition resembles those of late spring and early summer 2013, when liquidity evaporated and virtually every fixed income sector sustained losses amid concerns that the Federal Reserve would soon end its quantitative easing. In that volatile climate, Bill and his team diligently managed short positions to hedge against rising rates and used a strategic cash allocation to steer clear of the heavy losses suffered in long-only fixed income portfolios.

Source: J.P. Morgan, Barclays Live and Bloomberg; data as of June 30, 2014.

Margins of safety are thin and volatility is low relative to historical normsEXHIBIT 3: OAS HISTORICAL RANGE (SINCE INDEX INCEPTION) AND RECENT VALUES

-200 0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400 2600 2800

Historical range (since index inception) and current values (6/30/2014)

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EM Aggregate (USD)

U.S. Corporate IG

U.S. MBS


Source: J.P. Morgan. Shown for illustrative purposes only. The manager seeks to achieve the stated objectives. There can be no guarantee they can be met.

Absolute return process emphasizes positioning for a variety of scenariosEXHIBIT 4: ABSOLUTE RETURN PROCESS DIAGRAM

Attributes

Beta strategies Tactical rotation of sector exposure

For example: Duration/rates Credit (IG, HY, Loans) Securitized (MBS, CMBS, ABS)

Non-U.S./EMD

Alpha strategies Uncorrelated total return opportunities

For example: Credit long/short Yield curve trading CRE lending Index arbitrage Structured long/short Currency long/short Insurance-linked securities

Portfolio hedges Based on perceived tail risks

For example: Cash Credit protection Options strategies Interest-rate protection

When systematic risk is attractiveWhen systematic risk is not attractive—focus on idiosyncratic trades

Goal: maximize risk-adjusted returns

Longer investment horizon given trading costs

Goal: uncorrelated sources of return

Profit from relative prices across markets

Goal: create option-like payo�s for portfolio

Address short term and tail risks

Attributes Attributes

Always present to address prevailing portfolio risk exposures and tail scenarios

hedges against tail risks. Absolute return managers buy credit and rate protection when circumstances warrant and look to cash as a source of strategic liquidity, not simply as a parking place for uninvested funds. This three-pronged approach of beta, alpha and tactical hedges help provide a base for consis-tent returns, a barrier for capital preservation and a foundation for balanced portfolio construction.

FlexibilityforthesakeofconsistencyOksana Aronov says the two capabilities, systematic and efficient shorting, as well as maintaining “dry powder” cash reserves, distinguish absolute return from the unconstrained fixed income approaches that have proliferated during the post-crisis era of near-zero yield. Many unconstrained managers often resort to long-only strategies, pursuing “best ideas” with no benchmark constraints. These approaches can perform well in stable or falling rate environments, as well as stable or falling risk premia. But if we have reached the limits of that scenario, which is likely with the Fed signaling it will raise rates next year, the same factors that drove their exceptional returns could expose them to extraordinary risk. Their past performance, in other words, is no guarantee of future results.

The absolute return process, as shown in Exhibit4, draws on three different sources of return rather than only one. Like unconstrained strategies, absolute return can take advantage of shifting opportunities in traditional fixed income sectors. In addition, it exploits idiosyncratic alpha opportunities in relative value trades and across markets, such as alternative credit and currencies. A third source of returns comes from the strategy’s

A N E W B R E E D O F A B S O L U T E R E T U R N


Exercising the freedom to invest: An approach to unconstrained investingby Lisa Coleman, H e a d o f G l o b a l I nv e st m e nt G ra d e Co r p o rat e C re d i t— G l o b a l F i xe d I n co m e,

Cu r re n c y & Co m m o d i t i e s (G F I CC )

In the current low volatility, low yield environment, determining where to invest fixed income allocations is a dilemma for investors.

Lisa Coleman, head of Global Investment Grade Corporate Credit for J.P. Morgan, believes this investment challenge will continue for as long as financial repression—a climate in which governments and other borrowers benefit from lower interest payments while investors face low to negative real interest rate returns—persists. Coleman discusses the potential for unconstrained fixed income strategies to help address this challenge.

FocusingthefreedomtoinvestUnconstrained fixed income mandates generally have the flexibility to invest across an expansive opportunity set that can extend from investment grade to high yield credits, devel-oped to emerging markets debt and corporate bonds and loans to preferred stocks and convertible securities. Navigating the broad universe in which these “go anywhere” strategies operate has its own challenges. Coleman explores what a multi-dimensional approach to generating attractive risk-adjusted returns under these flexible mandates might look like (Exhibit5).

Source: J.P. Morgan. For illustrative purposes only.

• Fundamental research • Quantitative risk monitoring and signals

Hedging and risk management

Portfolio construction Asset allocation model

Fundamental and quantitative output determine portfolio asset allocation

• Developed & emerging market• High yield & investment grade • Bonds & loans• Preferreds & convertibles• Cash & derivatives

• Downside risk management• Selection of appropriate instruments to hedge

duration and credit risk• State-of-the-art risk metrics

Idiosyncratic credit trades, sector agnostic

Research

Concentrated best ideas portfolio

Designed to capture beta of market as well as alpha from security selection

Sector level portfolios

Navigating the broad universe in which these “go anywhere” strategies operate has its own challenges

EXHIBIT 5: A MULTI-DIMENSIONAL APPROACH TO GENERATING ATTRACTIVE RISK-ADJUSTED RETURNS


In Coleman’s view, critical components of such an unconstrained approach should include the following:

Top-down asset allocationSector allocation decisions determine a strategy’s beta expo-sure and diversification. Generally, allocations are based on top-down fundamental macro research, but can also benefit from forward-looking quantitative signals pointing to potential market risks as they bubble up.

Bottom-up security selectionAlthough asset allocation decisions can be a major contributor to an effective unconstrained multi-sector strategy, fundamental credit research, specialized at the regional and sector level, provide the insight on local economic conditions and individu-al issuer strengths and weaknesses that can help identify attractive alpha opportunities.

Concentrated best ideasAt times, opportunities to enhance returns may arise in sec-tors outside those emphasized by asset allocation decisions. On-the-ground regional and sector specialists—and the flexibil-ity to “go anywhere” can help ensure that these opportunistic, return-enhancing and potentially diversifying ideas find their way into the portfolio.

Hedging and risk managementWith so many moving parts, risk management has to be built into any unconstrained process. Quantitative scorecards and alerts can help monitor evolving risks while a deep under-standing of hedging opportunities can help dampen downside volatility in the most cost-effective fashion.

Coleman believes that turning the theoretical value of unconstrained strategies into the reality of attractive risk-adjusted returns, even in a climate of financial repression and low yields, requires the careful integration of diverse, specialized skill sets and multiple, integrated angles of observation.

E X E R C I S I N G T H E F R E E D O M T O I N V E S T : A N A P P R O A C H T O U N C O N S T R A I N E D I N V E S T I N G


Liability-driven investing (LDI)by Owais Rana, G l o b a l H e a d o f L D I S o l u t i o n s ,

a n d Sean Kurian, Le a d S t r u c t u r i n g S p e c i a l i s t

For more than a decade, corporate plan sponsors have been riding a funded status roller coaster. This experience has forced plan sponsors to focus more than ever on managing funded status volatility, contribution surprises and their potential impact on the corporation, its shareholders and plan participants.

Well aware that a mismatch in interest rate exposure between plan assets and liabilities represents a significant but “hedge-able” risk, many sponsors are reassessing traditional asset-only investment practices and shifting toward asset/liability-aware strategies.

Owais Rana and Sean Kurian of J.P. Morgan’s Global Liability-Driven Investment Solutions Group offer insights and a frame-work to help plan sponsors evaluate derisking alternatives and chart a steadier course toward their final pension plan destinations.

DefiningtheendgameOwais Rana explains that deciding on the final outcome, or endgame, is the first step sponsors should take when structur-ing an LDI solution. Solutions can vary from hedging some of the interest rate risk by simply extending duration to design-ing a more complete hedge using a customized hedging approach. The latter requires that the asset-liability match be more closely managed across the term structure, which

usually results in a need for increased governance. Ultimately, sponsors can terminate plans and transfer liabilities via an insurance company buyout, but this is generally the highest cost option.

Source: J.P. Morgan. For illustrative purposes only.

A typical LDI glide path maps a gradual shift from growth assets to hedging assets, with increasing customizationEXHIBIT 6: POTENTIAL LDI SOLUTION

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Long credit

Custom blend of Treasuries and credit

Hedge assets

Phase 1 Phase 2 Phase 3 Endgame

Funded status trigger 95% 100% 105% 110%

Hedge ratio 33% 85% 95% to 100%

95% to 100%

Funded status value at risk $159 mn $91 mn $56 mn $27 mn

Expected return on assets 6.4% 6.0% 5.5% 5.1%


The next step is to clearly assess where the plan is today and where it will need to be (in terms of funded status and risk and return on assets vs. liabilities) to reach the endgame objective. Getting from “here” to “there” will require balancing the often-competing goals of generating sufficient returns to keep up with liability growth (or to plug a pension deficit) while managing funded status risk.1

AdynamicderiskingstrategySean Kurian explains why he believes plan sponsors need a dynamic derisking process aligned with their objectives and risk tolerance to accomplish these goals. Exhibit6(previous page) shows a potential “glide path solution” for an under-

L I A B I L I T Y - D R I V E N I N V E S T I N G ( L D I )

LDI strategies come in many shapes and sizesEXHIBIT 7: FINDING THE APPROPRIATE STRATEGY FOR YOUR PLAN

Plan sponsor profile Strategy

Plan statusEndgame goal

Amount in hedging assets

Funded status Objective Possible hedging strategies

Degree of hedge customization

Initial LDI stage Various• Lower interest rate risk

by adding interest rate sensitive instruments

• Long government/credit• Long credit• Treasuries/STRIPS*

Middle LDI stages Various• Lower credit spread risk

with more credit-oriented hedging assets

• Long credit• Intermediate credit• Treasuries/STRIPS*

Later LDI stages On-balance sheet

• Lower term structure risk by focusing on matching the term structure of the liability

• Custom credit• Treasuries/STRIPS*

Later LDI stages Termination• Lower variability to insurance

company pricing basis• Reduce term structure risk

• Assets that are acceptable for in-kind transfer

Source: J.P. Morgan. For illustrative purposes only. *STRIPS is the acronym for Separate Trading of Registered Interest and Principal of Securities.

High Low Medium

funded plan with the goal of reaching 110% funded status and reducing funded status risk by roughly 80%. The solution involves a gradual shift from growth to hedging assets, with progressively greater customization of the hedge. Initially, the focus is on hedging interest rate risk by extending dura-tion through long government (and credit) bonds. As funded status improves, the focus shifts to hedging credit spread exposure with a greater allocation to long credit bonds. In the later stages, when preserving funded status improvement is paramount, the hedge becomes even more customized and precise.

Exhibit7 presents a loose overview that can help guide plan sponsors to an appropriate strategy for their plans, given their starting point and endgame objectives. Interest rate risk will need to be managed while assets and liabilities remain on the balance sheet. This is true—with additional nuances—even if the endgame is plan termination.

1 Risk measures can vary. J.P. Morgan’s Global LDI Solutions Group focuses on funded status value at risk (VaR) as a key risk measure, defined as the smallest percentage by which funded status outcomes could deteriorate, with a probability not exceeding 5% (assuming a 95% confidence level), over a one-year time horizon.


For decades, fixed income strategies have delivered steady positive total returns. Steve Lear and Doug Swanson consider whether the strategies can continue to do so in an environ-ment of low and rising rates—and where investors might find value in traditional sectors.

OldreliableholdsitsowninthenewnormalCore and core-plus fixed income can steady investment portfo-lios and diversify their sources of return as effectively today as they have historically. In periods of market volatility, their reli-able coupon income has cushioned the blow of falling asset

Maximizing total returnby Doug Swanson, U .S . C h i ef I nv e st m e nt O f f i ce r,

a n d Steve Lear, U .S . C h i ef I nv e st m e nt O f f i ce r

Source: J.P.Morgan; data as of May 31, 2014. The above information is shown for illustrative purposes only.

High yield valuations are still attractiveEXHIBIT 8: DOMESTIC HIGH-YIELD SPREADS VERSUS DOMESTIC DEFAULT RATE

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Average default rate = 2.1%Average spread = 448 bps

Default rate low 1993 thru 1999 = 1.2%

Default rate low2003 thru 2007 = 0.3%

Domestic HY default rate Domestic HY spread to worst

Long-term avg= 577bps

Long-term avg= 4.08%

prices and provided cash flow to help investors avoid distress liquidations. Steve Lear emphasizes that this dual diversifica-tion and cash flow function remains operative even in an extraordinarily low rate environment, while Doug Swanson highlights the opportunities to be found despite the accommo-dative policy rates adopted by the world’s central banks that “subsidizes borrowers at the expense of savers.”

The policy is working, which—paradoxically—is good news for credit lenders. From a top-down, macroeconomic perspective, Steve Lear observes that it has stabilized the global economy and improved credit conditions. So even with rates where they are today, investors can earn a reasonable spread on high yield debt in a low-default environment, as Exhibit8shows.


Hedgingtomorrow’sbeta,harvestingtoday’salphaWhile the market offers opportunities to take advantage of the recovery, it is enabling strategies that can potentially hedge against inflationary excess. Treasury Inflation-Protected Securities (TIPS) breakevens, though they’ve rebounded from their financial crisis lows, still have not fully returned to pre-crisis levels (Exhibit9A). With wages rising (Exhibit9B) estab-lishing a position in TIPS now may provide an economical and relatively robust barrier against rising rates and falling bond prices in the future. Surveying core and core plus from the bottom up, Doug Swanson takes note of several opportunities to enhance returns today. He finds relative value in some lon-ger-dated Treasury STRIPS vs. on-the-run Treasury notes and bonds. And as demand for conventional longer-dated issues has picked up, it has improved short-duration prospects. He has identified a number of trades in non-indexed issues (spe-cifically floating rate agency securities, subprime auto asset-backed securities and senior tranches of non-performing and re-performing short-duration mortgage-backed securitiza-tions), which offer stronger risk-reward profiles than other sectors of the market amid persistently low rates and the prospect that they will rise, the fixed income investor faces sizable challenges. Yet the likely, as well as the unforeseeable, possibilities do not make the diversifying nature and funda-mental liquidity of a fixed income allocation any less essential to a balanced portfolio. And in the vast and varied core and core-plus universe, we believe that exhaustive bottom-up research can enhance dependable coupon returns with above-market alpha.

Source: Bloomberg, Bureau of Labor Statistics; data as of June 10, 2014, for Exhibit 9A and June 6, 2014, for Exhibit 9B.

The value in inflation protection: 10-year TIPS breakevens are attractively priced in a rising wage environment

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EXHIBIT 9A: 10-YEAR BREAKEVEN (NOMINAL—TIPS)

EXHIBIT 9B: AVERAGE HOURLY EARNINGS(PRODUCTION & NONSUPERVISORY WORKERS)

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M A X I M I Z I N G T O T A L R E T U R N


The search for yield persists in the current environment of slow and steady spread compression. Yet, as Purnima Puri and Jonathan Segal of Highbridge Capital Management explain, investors able to access overlooked niche markets within non-investment grade credit can still realize attractive risk-adjusted returns.

YielddroughtbringsforthfloodsofnewissuancePersistently low rates have reduced the burden of interest payments on cash flows at the same time as a moderate eco-nomic recovery has kept defaults near historical lows. The combination has squeezed spreads to Treasury yields through-out the high yield universe so that little room for further com-pression remains (Exhibit10). Even with the easing of credit

Opportunistic exposure: Alternative sources of yieldby Purnima Puri , H i g h b r i d g e C a p i t a l M a n a g e m e nt ,

a n d Jonathan Segal , H i g h b r i d g e C a p i t a l M a n a g e m e nt

Source: J.P.Morgan; data as of May 31, 2014. The above information is shown for illustrative purposes only.

Yields have fallen and spreads compressed since 2011EXHIBIT 10: HISTORICAL INVESTMENT YIELDS AND SPREADS

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14Treasuries (10-year)Treasuries (5-year)High yield (yield-to-worst)Levered loans Yield (3-year)High yield (spread-to-worst)Levered loans discount margin (3-year)

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conditions inevitable at this stage in the cycle, Purnima Puri does not anticipate a rising default rate in the near term, given proactive measures CFOs have taken to refinance exist-ing debt with a lower cost of capital.

NewentrantsDespite the narrowing spreads, a range of factors continues to generate return potential. Jonathan Segal observes that a changing buyer base is creating attractive opportunities across the credit spectrum. He cites the convertible debt market, where long-only investors have replaced hedge funds as dominant players. Currently accounting for 60% of the mar-ket, they tend to focus on the a security’s equity performance rather than on its credit aspect. The shifting market composi-tion has resulted in a supply/demand imbalance, with few investors employing a credit relative value approach.

SmallercapitalstructuresremainundertheradarLarge long-only investors often ignore smaller capital struc-tures, overlooking their favorable fundamentals. Exhibit11illustrates the predicament of the smaller creditworthy bor-rower. The top portion shows that a $10 billion fixed income mutual fund requires position sizes of $100 million or more to make a meaningful contribution to performance. But because owning 10% or more of an issue would constrain a bondholder in a liquidity event, the hypothetical midsize mutual fund is limited, often by explicit mandate, to issues of $1 billion or more.

The lower portion of the exhibit depicts the practical impact of this phenomenon. Smaller high yield issuers today (those with less than $300 million in outstanding debt) face a 200-basis-point spread disadvantage compared with large issuers (those with more than $2 billion outstanding). The smaller capital structures have an additional advantage for investors with the mandate flexibility to invest in them: Limited large-investor demand can limit an issue’s technically driven volatility.

Source: BAML; data as of June 30, 2014. For illustrative purposes only.

Size of the companies are determined by total value of bond debt outstanding. Large issuers have a minimum of $2 billion and small issuers have a maximum of $300 million.

The case for “midmarket” high yieldEXHIBIT 11: OPPORTUNITIES IN HIGH YIELD AND LEVERED LOANS

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ILLUSTRATIVE EXAMPLE: LARGE FUNDS MUST INVEST IN LARGE CAPITAL STRUCTURES

Fund size $10 billion

Minimum position size 1%

Minimum investment size $100 million

Maximum concentration to be “liquid” 10%

Minimum tranche size to be “liquid” $1 billion

HIGHT YIELD LARGEST VS. SMALLEST ISSUER SPREAD

O P P O R T U N I S T I C E X P O S U R E : A L T E R N A T I V E S O U R C E S O F Y I E L D


Though investors have not been concerned about inflation for the past few years, inflation protection has recently resurfaced as a concern amid the continued strengthening of the U.S. economy. Jon Fraade and Deepa Majmudar explore the advan-tages of owning multiple sources of inflation protection in var-ious market environments.

Investors have grown accustomed to muted inflation of under 3%, and many expect that the trend will continue. Using TIPS as a proxy for inflation expectation, the market is currently pricing in a headline inflation rate for the next 10 years of just

Opportunistic inflation hedgingby Jon Fraade, S e n i o r C l i e nt P o r tf o l i o M a n a g e r,

a n d Deepa Majmudar, S e n i o r P o r tf o l i o M a n a g e r

Source: J.P. Morgan, BLS, FactSet; data as of June 30, 2014.

CPI used is CPI-U and values shown are % change vs. one year ago and reflect May 2014 CPI data. CPI component weights are as of December 2013. Core CPI is defined as CPI excluding food and energy prices.

Exhibit sourced from Guide to the Markets—U.S., p. 27.

‘65 ‘70 ‘75 ‘80 ‘85 ‘90 ‘95 ‘00 ‘05 ‘10-3

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(sa) (%)Food and beverage 14.9 2.4Housing 41.4 2.6Apparel 3.4 0.7Transportation 16.4 1.8Medical care 7.6 2.8Recreation 5.8 0.4Education and commodities 7.1 1.5Other 3.4 1.8

Headline CPI 100.0 2.1Less:

Energy 9.0 3.4Food 13.9 2.5

Core CPI 77.1 1.9

50-yr. avg. May 2014Headline CPI: Core CPI: 4.1% 1.9%

4.2% 2.1%

Ready to riseEXHIBIT 12: CONSUMER PRICE INDEX, 1965–MAY 2011

2.26%. That is lower than actual headline CPI has been for any rolling 10-year period in 55 years, Jon Fraade observes.

CPIappearspoisedforapickupBut CPI appears to have troughed and will likely rise gradually in coming years (Exhibit12). In May 2014, headline CPI was 2.1% vs. its 50-year average of 4.2%, and core CPI (ex-food and energy) was 1.9% vs. its 50-year average of 4.1%. Inflation could emerge from a variety of sources. If


O P P O R T U N I S T I C I N F L A T I O N H E D G I N G

unemployment continues to fall, wage pressures could lead to general and sustained inflation across many sectors of the economy. Unrest in the Middle East could jolt the global energy sector, which constitutes 10% of the U.S. economy.

Constructinganinflation-sensitiveportfolioHow can an investor best prepare for a potential outbreak of inflation? A portfolio should contain an array of inflation-pro-tection solutions, such as TIPS, inflation-linked derivatives, commodities and leveraged loans. One size does not fit all, Deepa Majmudar notes. TIPS provide an explicit inflation hedge (embedded inflation protection), their returns directly tied to the inflation rate. Commodities offer correlated inflation protection and can hedge well against a potential food or energy price shock (Exhibit13).

Real return solutionsEXHIBIT 13: LEVELS OF LIQUIDITY AND CREDIT RISK IN EMBEDDED AND CORRELATED INFLATION-PROTECTION VEHICLES

Source: J.P. Morgan. Shown for illustrative purposes only.

LiquidityLevel of credit risk

EMBEDDED INFLATION PROTECTION

TIPS High Low

Global inflation-linked securities High Low

Inflation-linked derivatives High Low

CORRELATED INFLATION PROTECTION

Commodities High Low

Leveraged loans High Medium

Effective active management of an inflation-sensitive portfolio will pay close attention to correlations among the various components of the portfolio. These correlations are not static and will interact in different ways at different times.

We do not expect that consumer prices will suddenly spike any time in the foreseeable future. But the rate of inflation may well have troughed. To mitigate the effects of future inflation, investors are well advised to own, and carefully monitor, a diversified range of inflation-sensitive assets in their portfolios.


Coupon payments drive total returnEXHIBIT 14: BARCLAYS U.S. AGGREGATE INDEX RETURN COMPONENTS (1980 TO 2013)

Source: Barclays Live, Bloomberg; data as of December 31, 2013.

Barclays U.S. Aggregate price returnBarclays U.S. Aggregate coupon return10-yr yield

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Steady income streams in shifting global marketsby Iain Stealey, H e a d o f G l o b a l Ag g re g at e S t rat e g i e s ,

a n d Matthew Pal lai , U n co n st ra i n e d S t rat e g i e s

Income can still be found in global bond markets—often in unfamiliar places. Matt Pallai and Iain Stealey discuss the pro-cess of constructing a well-diversified global portfolio capable of generating income from both traditional and non-traditional fixed income sectors.

ThecouponiscriticalHistorically, coupon payments have been by far the main source of long-term fixed income returns (Exhibit14). Since 1980, they have accounted for about 90% of the total return of the Barclays U.S. Aggregate Index. But as yields have declined to near- historic lows, coupon payments have been steadily decreasing. In an environment of rising rates, a cou-pon not only provides cash flow but accounts for all of a bond’s total return. A 0.37% average annual increase in the rate on the U.S. 10-year Treasury over a 15-year period, Matt Pallai calculates, would mean that income would account for 214% of the index’s total return over the full period.

Europeanbankcredit:OpportunitybeyondtraditionalbondsBecause traditional fixed income sectors no longer provide adequate yield, investors need to consider opportunities in a wide range of sectors and geographies. They should also look to diversify their risk premia beyond duration risk to include credit and liquidity risks, among others.


Source: J.P. Morgan, Barclays Capital; data as of March 31, 2014.

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Subordinated Fin Corp Senior Fin

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Covered bonds (excluded) 0.8%

Senior unsecured (From Jan 2016 (e)) 1.1%

Tier 2 (From 2015 (e)*) 2.4%

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Higherrisk

Taking select advantage of the bank capital structureEXHIBIT 15: EUROPEAN BANK CAPITAL YIELDS, RISK LEVELS IN CAPITAL STRUCTURE

*Can be written down fully from August 1, 2013, upon receipt of new state aid.

S T E A D Y I N C O M E S T R E A M S I N S H I F T I N G G L O B A L M A R K E T S

Today Iain Stealey finds especially attractive prospects in European bank debt (Exhibit 15). In the wake of the eurozone sovereign debt crisis and facing stricter regulations, such as Basel III, European banks have significantly strengthened their balance sheets.

Moving down the capital structure brings higher yields, but analysis here is critical, Iain Stealey cautions. An investor must thoroughly examine all the key characteristics of a given bond issue, such as credit quality, duration, covenants and place in the capital structure.

By broadening their opportunity set to include extended sectors, investors can find new income streams and diversify their risk premia. But especially if interest rates rise and income becomes an even more critical source of total return, any investment prospect must be carefully examined before it is selected or discarded.


Bond markets today offer a dynamic and global opportunity set. Bob Michele and Scott McKee examine how to construct well-diversified global portfolios to capture investment poten-tial, manage risk and bolster total return.

Investors confront a challenging market environment, as yields remain low, spreads are tight and rates are generally expected to rise. Bob Michele makes the case for expanding the opportunity set beyond traditional core fixed income to include sectors such as high yield, emerging market debt (EMD) and non-investment grade securitized fixed income. Combined with a flexible, unconstrained approach, this broader universe can potentially offer both diversification and enhanced yield (Exhibit16).

Dynamicapproach,deepresourcesA dynamic, unconstrained approach to sector allocation enables a portfolio manager to bring in diverse return streams, finding value across geographies and sectors. In order to identify these opportunities throughout the global fixed income universe, managers need to have dedicated sec-tor expertise. In the EMD sector, Scott McKee points out, there

Unconstrained investing: Diversification across markets and sectorsby Bob Michele, G l o b a l C I O a n d H e a d o f G l o b a l , F i xe d I n co m e, Cu r re n c y & Co m m o d i t i e s G ro u p,

a n d Scott McKee, H e a d o f E m e rg i n g M a r ke t D e b t , Co r p o rat e Te a m

Expanding the opportunity set can boost total returnEXHIBIT 16: DURATION, CORRELATION, YIELD AND RETURN AMONG FIXED INCOME SECTORS

Source: J.P. Morgan, Barclays Capital, Bloomberg, BIS, FactSet; data as of March 31, 2014. Fixed income sectors shown above are provided by Barclays Capital and are represented by the global aggregate for each country except where noted. U.S. HY represented by Barclays U.S. Corporate High Yield. EMD sectors are represented by the J.P. Morgan EMBIG Index (USD) and the J.P. Morgan GBI-EM Global Diversified Index (LCL). European corporates are represented by the Barclays Euro Aggregate Credit—Corporate Index and the Barclays Pan-European High Yield Index. Sector yields reflect yield to worst. Duration is modified duration. Correlations are based on seven years of monthly returns for all the sectors. Past performance is not indicative of future results. Yield to worst shown for U.S. HY, MBS, CMBS and ABS.*Example security used as proxy for the market.

Duration (years)

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U.S. Treasury

Current yield

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Q1 2014 return

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2013 return

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AGGREGATE SECTORS

U.S. 5.7 0.8 2.4 1.8 -2.0 Japan 8.0 0.5 0.6 2.8 -15.9 UK 8.6 0.2 2.6 2.7 -0.6

Germany 5.7 0.3 1.1 2.2 2.6

Italy 6.2 0.1 2.4 5.0 11.6

Spain 5.4 0.1 2.1 5.2 15.3

NON-AGGREGATE SECTORS

U.S. HY 4.0 -0.2 5.2 3.0 7.4

Euro HY 3.9 -0.4 4.6 3.3 9.9

EMD (Hard ccy sov) 7.1 0.2 5.9 3.5 -6.6

EMD (Local sov) 4.6 0.1 6.9 1.9 -9.0

Euro corp 4.5 0.1 1.8 2.4 2.4

MBS (below IG)* 0.0 -0.1 4.0 1.2 1.8

CMBS (below IG)* 2.5 0.1 5.5 4.5 4.4

ABS (below IG)* 0.0 -0.2 4.5 0.9 2.9


Bob Michele notes that fixed income managers are employing a wide range of approaches to unconstrained investing. While some are getting it very right, a near-equal number are getting it very wrong. Investors should be certain that their unconstrained fixed income managers have the depth of resources, sector expertise and risk management tools to achieve the strategy’s promise—and avoid its potential pitfalls.

Source: J.P. Morgan, Barclays Live, Bloomberg; data as of May 31, 2014. Correlations calculated using rolling one-year daily data over the past 13 years.

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Shifting relationships: Managers must continually monitor correlations across different markets and environmentsEXHIBIT 17: FIXED INCOME SECTOR CORRELATIONS TO THE 10-YEAR U.S. TREASURY

U N C O N S T R A I N E D I N V E S T I N G : D I V E R S I F I C A T I O N A C R O S S M A R K E T S A N D S E C T O R S

are important distinctions across sectors, as hard currency sovereign, hard currency corporate and local currency sover-eign bonds provide three unique risk and return profiles. In addition to expertise within each of these sectors, it is also important that managers have local, on the ground presence because there is significant differentiation across emerging market countries.

ClosercorrelationsAsExhibit17illustrates, correlations among fixed income sec-tors have increased significantly in the past year, and in some instances correlations with the 10-year U.S. Treasury have gone from negative to positive. It is crucial that managers examine the shifting relationships in unconstrained strategies that have exposure to a variety of fixed income sectors. Only in this way can managers fully understand how positions will interact with one another. Without a benchmark as a reference point, managers should consider an array of measures—corre-lation across markets is one—in order to evaluate a portfolio’s risk exposures in a more holistic fashion.


OUR NETWORK OF INVESTMENT PROFESSIONALS

Megan McClellanManaging DirectorHead of Global Fixed Income Market Strategies

Bill EigenManaging DirectorChief Investment OfficerAbsolute Return & Opportunistic Fixed Income

Oksana AronovManaging Director Market Strategist Absolute Return & Opportunistic Fixed Income

Owais RanaManaging Director Global Head of LDI Solutions

Sean KurianExecutive Director Lead Structuring Specialist

Doug SwansonManaging DirectorU.S. Chief Investment OfficerGlobal Fixed Income

Steve LearManaging DirectorU.S. Chief Investment OfficerGlobal Fixed Income

Purnima PuriPortfolio ManagerHighbridge Capital Management

Jonathan SegalPortfolio ManagerHighbridge Capital Management

Jon FraadeManaging DirectorSenior Client Portfolio ManagerGlobal Fixed Income

Deepa MajmudarManaging DirectorSenior Portfolio Managerand Inflation SpecialistGlobal Fixed Income

Iain StealeyExecutive DirectorPortfolio ManagerHead of Global Aggregate StrategiesGlobal Fixed Income

Matthew PallaiPortfolio ManagerUnconstrained StrategiesGlobal Fixed Income

Bob MicheleManaging DirectorGlobal CIO and Head of Global FixedIncome, Currency & Commodities Group

Scott McKeeExecutive DirectorHead of Emerging MarketDebt Corporate Team

Lisa ColemanManaging Director Head of Global Investment Grade Corporate Credit—Global Fixed Income, Currency & Commodities (GFICC)

Michael HoodManaging Director Global Market Strategist


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The 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.

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.

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.

Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments involve greater risks than traditional investments and should not be deemed a complete investment program. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise and investors may get back less than they invested

There can be no assurance that the professionals currently employed by JPMAM will continue to be employed by JPMAM or that the past performance or success of any such professional serves as an indicator of such professional’s future performance or success.

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.

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