generating income in a low-yield environment - j.p. morgan · corporate debt, according to barclays...

Generating Income in a Low-Yield EnvironmentOctober 2011

FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY | NOT FOR RETAIL USE OR DISTRIBUTION

The coming years present an extraordinary challenge for policymakers and investors. Governments across many developed markets are trying to rein in multi-decade high budget deficits and debt-to-GDP ratios, their hands forced to a degree by credit-rating agencies (indeed, debt-related concerns pushed Standard & Poor’s to downgrade the U.S. long-term sovereign rating for the first time in history in August).

IN BRIEFIn this “low for long” rate environment, generating income remains a challenge for investors who need to maintain portfolio yields. However, certain market dynamics are creating opportunities to pick up yields across a range of asset classes.

• A recovering economy and low default rates make the risk/reward trade-offs for high yield debt and leveraged loans potentially attractive.

• Strong corporate balance sheets are creating equity income opportunities as companies look to increase dividends.

• As market volatility makes it more expensive and difficult to access traditional financing, investors can find higher yields in other fixed income sectors, such as mezzanine debt.

• Given the current recovery in property values, fundamentals and cash flow, real assets and REITs are generating attractive and stable yields with the potential for equity-like upside through measured growth in payouts.

Generating Income in a Low-Yield Environment

2 | Generating Income in a Low-Yield Environment

Subsequent prospects for slower growth are pushing central banks to keep monetary policies easier for longer. In August, for example, the Federal Reserve suggested that the Fed funds rate would remain at near-zero levels at least until mid-2013, serving as an anchor for yields along the curve. At its two-day policy meeting in September, the Fed also announced “Operation Twist”—which includes plans to buy about $400 billion of Treasuries and sell shorter-dated bonds by June 2012—in an effort to push down longer-term yields (primarily as a way to help support the housing market).

Meanwhile, the Bank of England announced a new round of quantitative easing this fall in an attempt to stimulate the economy. The European Central Bank, while raising policy rates twice this year to 1.5%, now has turned a corner and seems inclined to maintain easy policy as peripheral Economic and Monetary Union (EMU) pressures build. Finally, Japan is expected to keep policy rates low for an extended period. Despite the faster-than-expected recovery from the tragic March earthquake and tsunami, broader growth trends remain lackluster, in part because government stimulus efforts are limited by the G-7’s largest debt-to-GDP ratios.

For investors, this developed world “new fiscal world order” means it will be increasingly difficult to find income. Consider U.S. and German 10-year yields—both were trading near record lows in early September. As of October 7, the devel-oped world’s average policy interest rate stood at 80 basis points, nearly 260 basis points below the average in 2005–2007. We believe those yields could be biased lower over the coming 12 months, and even in two to three years, the aver-age yields in developed markets are only likely to have recov-ered to current levels.

So what are investors who need income to do? In the following pages, we explore some income-generating strategies for investors.

Corporate Mezzanine DebtThe current market environment creates an attractive opportu-nity for corporate mezzanine debt—primarily subordinated debt used for leveraged acquisitions or refinancing of maturing obli-gations—and is driven by a number of distinct market trends:

• Large supply/demand imbalance for private, dedicated mezza-nine capital: The addressable set of mezzanine opportunities is growing as private equity (PE) firms have significant uninvested capital. The top 25 PE firms, as defined by capital to be invest-ed, have circa ~$130 billion of equity to invest over the next 3 to 4 years; we estimate this capital will require up to $400 bil-lion of senior and subordinated debt financing to effect these leveraged buyouts (LBOs); mezzanine “dry powder” for deals more than $1 billion in size is estimated at $10 to $15 billion or less than ~3% of potential demand.

• Market volatility—driven by ongoing EU concerns, U.S. macro issues, risks to economic growth and unstable equity markets—is increasing the potential cost and reducing the predictability and availability of traditional, underwritten/syndicated financing.

• Large recent outflows from high yield and loan mutual funds are limiting banks’ visibility on the buyer base for syndicated high yield and loans, which is further impacting the cost and availability of traditional financing on commercially reasonable terms.

• Structural shifts in the financial landscape caused by estab-lished and pending regulatory action (Basel III, Volcker, Dodd-Frank) have resulted in a decreased appetite to risk “hung” loan or high yield commitments on bank balance sheets.

As of result of these factors, issuers will have less certainty and access to traditional syndicated credit markets and this, in turn, is driving strong deal flow and a positive pricing environ-ment for mezzanine.

Corporate mezzanine debt offers substantial excess spread (~400–500 basis points)1 versus comparable liquid high yield names (see Exhibit 1 for a comparison of typical terms). This illiquidity premium results from providing certainty and long-term “buy and hold” financing to corporate borrowers. These premiums are highest when traditional sources of debt financ-ing (i.e., banks) become harder and more expensive to access.

1 Source: J.P. Morgan Asset Management market research, J.P. Morgan Single B High Yield Index as of September 30, 2011.

J.P. Morgan Asset Management | 3

EXHIBIT 1: COMPARISON OF TYPICAL MEZZANINE AND HIGH YIELD BOND TERMS

Source: J.P. Morgan Asset Management, September 30, 2011

* High Yield has higher fees and potentially higher “make-whole” costs.

Global Infrastructure Loans Institutional investors have an opportunity to invest in mature infrastructure loans with low risk profiles and attractive yields. Infrastructure loans—which are loans originated primarily by project finance banks—are high quality, long-term, floating-rate assets that are senior secured by monopolies or assets with monopolistic characteristics.

While pension plans and insurance companies are increasingly seeking out long-term assets to match their liabilities, tradi-tional banks are seeking to mitigate the capital requirements from Basel II and III on holding long-term loans. As a result, in today’s environment, undercapitalized bank balance sheets and increasingly stringent capital requirements for long-dated infrastructure loans have created an opportunity for fixed-income investors to purchase these loans at substantial dis-counts and attractive yields.

As shown in Exhibit 2, because of their historically low default rates and high recovery rates, the average five-year cumula-tive credit loss rate for infrastructure loans is 56 basis points, according to Moody’s and J.P. Morgan Asset Management (data as of February 28, 2011). By comparison, the average five-year cumulative credit loss rates for global corporate A-rated bonds and Baa securities are 49 and 119 basis points, respectively.

In addition, infrastructure credit generally improves over time as the asset performs and the associated debt declines.

Historically, infrastructure loans with 20- to 30-year terms have generally been priced at 100 to 150 basis points over LIBOR with quarterly or semi-annual interest and principal amortization payments. Recent capital rules for banks have widened credit spreads, which stabilized in 2010 closer to 300 basis points. As shown in Exhibit 3, current spreads for infrastructure debt are approximately equivalent to BB corporate debt, according to Barclays Capital, Dealogic and J.P. Morgan Asset Management estimates (data as of 1Q, 2011). In our view, credit spreads, ranging from 200 to 300 basis points are sustainable over the medium term. Depending on the rate environment, swapping a 25-year loan priced at LIBOR plus 300 basis points may generate fixed interest rates

Typical Mezzanine

Typical High Yield Bond

Coupon Range 11–14% 8–11%

Fees 2–4% 3–6%*

Non-Call/ Prepayment Provisions

Flexible (2–3 years) Non-call for 4 years*

Optimal Tranche Size Flexible >$300 million; $500 million–$1 billion desired

Need for Tradeable Liquidity?

No Yes

Ability to Co-Invest in Equity Yes No

Covenants Highly customized/ Negotiated

Market standard; “Take It or Leave It”

Time Frame for Diligence/ Documentation

2–4 months 1–2 weeks

Typical Number of Holders 1–5 20–100

Ability to Control Tranche Often Seldom

Board Observer Rights? Yes Never

Typical Financial Reporting Monthly Quarterly

49 56119

0

100

200

Basi

s po

ints

300

A Infrastructure Baa Ba

690

0

200

400

600

Basi

s po

ints

800

1,000

1,200

1,400

Jan-

00

A BBB BB Infrastructure

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Sources: Moody’s and J.P. Morgan Asset Management. Based on average cumula-tive default rates and recovery rates between 1982 and 2010 as reported by Moody’s in Special Report, Corporate Default and Recovery Rates, 1920-2010, February 28, 2011.

Source: Barclays Capital; Dealogic; J.P. Morgan Asset Management estimate, 1Q 2011.

EXHIBIT 2: AVERAGE 5-YEAR CUMULATIVE CREDIT LOSS RATES FOR GLOBAL CORPORATE BONDS AND NEW ISSUE INFRASTRUCTURE PROJECT FINANCE DEBT

EXHIBIT 3: MARGINS OVER LIBOR FOR LONG-TERM (7+ YEARS) GLOBAL CORPORATE BONDS AND NEW ISSUE INFRASTRUCTURE PROJECT FINANCE DEBT



between 5.70% and 5.90% on a senior secured loan with a duration of about 15 years, according to estimates from a leading third-party market maker (as of end of September).

In recent months, there have been a number of sales of infra-structure loan portfolios, primarily by undercapitalized European banks, at attractive discounts and spreads. Our dis-cussions with banks suggest that while they wish to continue to service their clients by underwriting new infrastructure projects, they are also likely to divest portions of their loan portfolios—providing investors with continued opportunities to invest in mature loans in this sector.

Emerging Market Debt Emerging market debt offers more attractive yields relative to U.S. and other developed market bonds. Issuing emerging market countries—which have stronger growth and fiscal

dynamics—are showing signs of stability due to more estab-lished democracies, thriving commodity-based economies and stronger currency reserves.

Recent net inflows into emerging market debt reflect structural and cyclical shifts in emerging markets that have resulted in much stronger macroeconomic backdrops, both in absolute terms and also relative to their developed-market peers. Emerging markets are expected to outpace growth in developed markets. As shown in Exhibit 4A, emerging markets are expect-ed to post average GDP growth of 5.5% in 2011, according to the International Monetary Fund’s World Economic Outlook, April 2011. This growth is increasingly being driven by domestic demand as emerging markets consumption now exceeds U.S. consumption. Emerging markets are also in a stronger fiscal position with an average 35% debt-to-GDP ratio versus 98% for developed markets (Exhibit 4B, IMF, April 2011).

Advanced economies Emerging economies

-2

0

2

4

6

Perc

ent

8

10

12

’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16

Deb

t/G

DP

Fisc

al d

efic

it/G

DP

Public Debt Advanced (lhs)

Public Debt EM (lhs)

Fiscal Balance Advanced (rhs)

Fiscal Balance EM (rhs)

-11

-9

-7

-5

-3

-1

10

20

40

60

80

100

120

’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16

Source: International Monetary Fund’s World Economic Outlook, April 2011. Data for 2011–2016 are forecasts. Forecasts are based on market conditions and subject to change without notice.

EXHIBIT 4A: CONTRIBUTION TO GLOBAL GDP GROWTH, 2000–2016

EXHIBIT 4B: FISCAL POSITION, 1995–2016


Dollar-denominated emerging market sovereign and corporate debt—which generally have investment-grade ratings—offer attractive yields of just over 6%, at durations of five to seven years (J.P. Morgan Asset Management, September 2011). We expect yields and spreads will gradually tighten over the medium to long term as investors reappraise the asset class (Exhibit 5). This combination of factors makes emerging market debt (EMD) an attractive investment alternative for fixed income investors looking for additional yield and diversification away from developed-market allocations and the dollar.

Global Equity Income In a world where the “income” part of fixed income is reduced, investors looking for sources of yield should consider equities for this purpose. Currently, equity income—which also offers potential capital appreciation—offers a more compelling yield than the 10-year Treasury.

Recently, the projected 12-month forward-looking yield for the MSCI World Index was 3.22%, as of September 30, up from 2.9% at the end of July, and higher than the 10-year Treasury yield. Companies’ ability to support their dividends from earn-ings is also strong. As shown in Exhibit 6, dividend payout ratios—the percentage of earnings paid to shareholders in divi-dends—is low (29.11%, MSCI World Index as of September 30, 2011), and consequently, the dividend cover—the earnings per share divided by the dividends per share—is high (3.44, MSCI World Index as of September 30, 2011).

Although equities involve more risk and near-term volatility, dividend payers tend to be larger, more stable companies with undervalued stock prices and solid financials. Dividend pay-outs have been historically stable, even in periods of earnings volatility (Exhibit 7).

Simply identifying high current dividends is not enough. Investors should focus on companies with attractive yields that also have the financial strength—sustainable cash flows, a strong product range, resilient margins and good balance sheets—to support their operations and maintain a solid dividend stream for shareholders in difficult times. Also, with

EMBI Global spread to Treasuries (left hand side)

Ratings (right hand side)

Mexico crisis Russia default/LTCM

Argentina default

Brazil fears

Asia crisis

FED tightening fearsTurkey crisis

Lehman bankruptcy/Global credit crisis

Sub-prime fears

Developed Market CrisesEmerging Market Crises

Spre

ad (b

asis

poi

nts)

Cred

it r

atin

g (in

vert

ed s

cale

)

0

200

400

600

800

1,000

1,200

1,400

1,600

Aug

-93

Feb-

94

Aug

-94

Feb-

95

Aug

-95

Feb-

96

Aug

-96

Feb-

97

Aug

-97

Feb-

98

Aug

-98

Feb-

99

Aug

-99

Feb-

00

Aug

-00

Feb-

01

Aug

-01

Feb-

02

Aug

-02

Feb-

03

Aug

-03

Feb-

04

Aug

-04

Feb-

05

Aug

-05

Feb-

06

Aug

-06

Feb-

07

Aug

-07

Feb-

08

Aug

-08

Feb-

09

Aug

-09

Feb-

10

Aug

-10

Feb-

11

Aug

-11

B-

BB-

B+

B

BB+

BB

CCC+

BBB-

Source: Moody’s, J.P. Morgan Emerging Markets Bond Index (EMBI Global), as of September 2011.

EXHIBIT 5: EMERGING MARKET SPREADS AND CREDIT RATINGS

2005 2006 2007 2008 2009 2010 9/30/2011

28.3%

40.9%

32.8%29.9%33.1%

Dividend cover

Payout ratio

26.4%29.1%

0

1

2

3

4

Sources: J.P. Morgan Asset Management, FactSet. As of September 30, 2011.

EXHIBIT 6: MSCI WORLD—HISTORICAL CHARACTERISTICS



well-managed, dividend-paying companies in high demand, investors should widen their investment scope to take advan-tage of dividend opportunities around the world and across a wide range of sectors to avoid concentrating their investments too narrowly.

Commercial Mortgage Loans Commercial mortgage loans (CMLs)—high-quality loans that are secured by stable income-producing commercial properties that are well diversified by use, geography and borrower—offer com-pelling risk-adjusted returns of approximately 4% to 5%, according to estimates from J.P. Morgan Asset Management (as of the end of September, 2011). The relatively high yields are stable, paid current and call protected. CMLs also exhibit low correlations with other asset classes—offering investors portfo-lio diversification benefits.

Current valuations look attractive as property fundamentals and values—which experienced significant corrections—show signs of stabilization and recovery. Although commercial mortgage loan spreads have compressed, they remain at attractive levels (Exhibit 8). Moreover, the credit turmoil of 2008 and 2009 has resulted in lending standards that are more stringent today than historic norms. Finally, the recent market dislocation provides portfolio lenders such as J.P. Morgan Asset Management with significant opportunities over commercial mortgage-backed securities (CMBS) lenders that have largely constrained lending because of the market uncertainty.

Non-Agency Residential Mortgage-Backed Securities The non-agency residential mortgage-backed securities (RMBS) market—bonds backed by pools of home loans that are not issued or guaranteed by government agencies—is extraor-dinarily diverse in its range of potential investments. Investors can find securities ranging from well-performing credit-enhanced bonds to bonds with extreme leverage. Meanwhile, since the majority of securities have been downgraded to below investment grade by at least one of the credit-rating agencies, these investments may be more appropriate for long-term investors willing to provide liquidity and ignore the variability in the rating agencies views.

Focusing on the more senior portion of the market—which reflects what used to be investment-grade debt at the time of issue but may have been subsequently downgraded—the expected average internal rate of return (IRR) can range from 5.75% to 9.00%, based on factors such as liquidity, underlying collateral, average life and structure of the securities, according to J.P. Morgan Asset Management (September 2011). In general, we favor fixed- over floating-rate securities, except for some option adjustable-rate mortgages (ARMs) and subprime secu-rities. In the subprime and option ARM sectors, we focus on more seasoned pools with limited modifications and consistent servicer liquidation behavior.

EXHIBIT 8: ALTHOUGH COMMERCIAL MORTGAGE LOAN SPREADS HAVE COMPRESSED, THEY REMAIN AT ATTRACTIVE LEVELS

Source: J.P. Morgan Asset Management, Barclays Capital; data as of September 30, 2011.

* Spreads currently ranging between 200–300 basis points based on variables such as leverage, cash flow coverage, term, property type, location, loan structure and asset-specific characteristics.

Basi

s po

int s

prea

d (b

ps) o

ver

Trea

sury 10 Yr Commercial Mortgage

10 Yr A Corporate Industrial

050

100150200250300350400450500550600

Sep-

95

Sep-

96

Sep-

97

Sep-

98

Sep-

99

Sep-

00

Sep-

01

Sep-

02

Sep-

03

Sep-

04

Sep-

05

Sep-

06

Sep-

07

Sep-

08

Sep-

09

Sep-

10

Sep-

11

15.5

10.6

22.6

6.24.3

5.9

22.4

33.730.7

13.4

22.8

38.6

0

5

10

15

20

25

30

35

40

45

1871–1900

Stan

dard

dev

iati

on (%

)

1901–1929 1930–1945 1946–1978 1979–2000 2001–2011

Dividends standard deviation Earnings standard deviation

Source: IBES, Datastream, European Equities, Credit Suisse.

EXHIBIT 7: DIVIDENDS ARE MUCH LESS VOLATILE THAN EARNINGS


Leveraged Loans Leveraged loans (also known as bank loans) are loans made to businesses with generally below investment-grade credit ratings. The loans are typically senior instruments, secured by the debtor’s assets, and rank first in priority of payment in the capital structure, ahead of unsecured debt. As a result of their senior secured status, bank loans have historically had higher recovery rates and lower volatility relative to corporate high-yield bonds.

Leveraged loans typically offer higher yields than the Barclays Aggregate or Treasury yields and can also act as a hedge against longer-term inflation risks. Investors can gain protection from rising interest rates since the loans’ floating-rate coupons reset every three months or so—enabling yields to rise if short-term rates rise. In other words, investors may be able to avoid likely capital losses in a rising rate and inflationary environment.

While the events of the past several months have reduced con-cerns over inflation, with interest rates near historic lows, the potential capital loss from rising interest rates could be severe. A move in the 10-year U.S. Treasury from 1.9% to 5%, for example, will result in a 23.7% capital loss (Bloomberg, as of September 30, 2011). And today’s extraordinary monetary accommodation raises the risk of greater inflation tomorrow. Staying short, on the other hand, is not an attractive option for many investors either. Investing in short-duration two- or five-year U.S. Treasury notes, for example, will only yield 25 or 95 basis points, respec-tively (Bloomberg, as of September 30, 2011).

Meanwhile, the opportunity to earn higher yields in leveraged loans is even greater today, given the loans’ LIBOR “floors” (the income generated by leveraged loans has long been based on a spread over LIBOR, or the London Interbank Offered Rate). Given the historically low levels of LIBOR today, new loans often have LIBOR floors that pay the investor the spread plus the higher of the “floor” or LIBOR. LIBOR floors, for example, have recently ranged from 100 to 200 basis points, versus current 3-month LIBOR of 38 basis points, according to Bloomberg, as of September 30, 2011.

As shown in the Exhibit 9, loans are trading at a spread of LIBOR plus 702 basis points2—a level that tends to occur only near the bottom of a deep recession, such as 2001–2002 or 2008. Meanwhile, in another sign of how attractively priced leveraged loans have become, the spread between loans and

high yield debt is now only about 109 basis points; typically that spread has been 150 to 200 basis points.

At these levels, current spreads are implying an annual default rate of more than 12.4%3 over the next few years, a level we believe is highly unlikely. Default rates spiked to almost 11% in 20094 following the sudden and sharp recession and credit crisis, but declined to less than 1% today; most strategists and market participants expect default rates to remain low even with a slowing economy. In addition to high current yields, the decline in loan prices5 to an average of 90.35 provides capital appreciation opportunities to further enhance returns. As Exhibit 10 shows, we believe the potential returns on loans are even more attractive relative to the Barclays Aggregate’s lower yields than they were prior to the August Fed meeting.

EXHIBIT 9: SENIOR SECURED LOAN SPREADS REMAIN NEAR THE PEAK OF PRIOR CREDIT CYCLES

EXHIBIT 10: LEVERAGED LOANS YIELDS ARE STILL OUTPACING YIELDS ON THE BARCLAYS AGGREGATE

Source: Credit Suisse. As of September 30, 2011. Discount margin to maturity. Current average maturity for Credit Suisse Leveraged Loan Index is 4.37 years. Duration of Credit Suisse High Yield Index is 4.29 years.

Source: Barclays and Credit Suisse. As of September 30, 2011.

2 Credit Suisse Leveraged Loan Index, discount margin to maturity at September 30, 2011.

3 Using 420 basis points historical average spread of the Credit Suisse Leveraged Loan Index and assuming normal 3% average default rate and 70% recovery rate.

4 S&P LCD5 Credit Suisse Leveraged Loan Index, average price at September 30, 2011.

High Yield Spread to Worst

Leveraged Loan DMM

Spre

ad In

bas

is p

oint

s

Average420 bps

Average589 bps

811 bps

702 bps

200

400

600

800

1,000

1,200

1,400

1,600

1,800

Jan-

86Ja

n-87

Jan-

88Ja

n-89

Jan-

90Ja

n-91

Jan-

92Ja

n-93

Jan-

94Ja

n-95

Jan-

96Ja

n-97

Jan-

98Ja

n-99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10Ja

n-11

Credit Suisse Leveraged Loan Index DMM

Barclays Aggregate YTW

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

702 bp

235 bp

200 bp

400 bp

600 bp

800 bp

1,000 bp

1,200 bp

1,400 bp



High Yield Bonds The high yield market provided strong returns in 2009 and again in 2010. As a result of the recent market correction, the high yield debt market again offers an attractive and compel-ling risk/reward trade-off. Risk premiums have retraced beyond the long-term average, providing investors with attrac-tive yields if they are willing to take on additional risk.

Currently, high yield bond spreads over similar duration Treasuries are averaging around 834 basis points, bringing total yields to more than 943 basis points, according to the J.P. Morgan Global High Yield Index (as of September 30, 2011). Such spread levels are implying default rates of 8% to 9%, com-pared with current default rates of about 1.2% (Exhibit 11).

At these levels, the market is pricing in a recession caused by declining corporate profits and deteriorating credit fundamentals. In particular, BB rated high yield investments offer attractive valuations versus investment-grade BBB debt. As Exhibit 12 shows, the spread difference between BBB and BB is currently about 340 basis points.

Unlike higher-quality issues, high yield bonds tend to be more sensitive to economic cycles than interest-rate movements. They generally perform well in an expanding economy marked by improving corporate finances and a declining default

outlook. To date, for example, corporate balance sheets are strong, reported earnings are ahead of consensus estimates and firms are maintaining record levels of cash on their balance sheets.

But government austerity programs and weak consumer spending are still weighing on the economy—a factor that will likely keep a lid on Treasury yields for some time. Compared to government debt and investment-grade alternatives, the level of yield now available is much more attractive relative to the risk taken.

Global Real AssetsGlobal real assets are a natural next stopping point for investors in the current market environment. First, the various sub-sec-tors of the real assets world—such as private equity real estate, infrastructure and real estate investment trusts (REITs)—offer yields that are not only currently very competi-tive with other fixed-income alternatives (Exhibit 13), but also exhibit a long-term stability that should offer comfort to inves-tors that these yields are sustainable contributors to both income generation and total returns. Secondly, while bonds pay out a fixed coupon over the duration of the bond itself, real assets offer a bond-like yield that can also grow in line with cash flow growth. Therefore, as a complement to bond holdings, real assets offer investors both a stable, competitive yield AND the potential for equity-like upside. In the context of a diversified portfolio, this optionality can benefit investors across various economic scenarios.

EXHIBIT 11: DEFAULT RATES REMAIN EXCEPTIONALLY LOW

EXHIBIT 12: SPREAD BETWEEN BONDS RATED BBB AND BB

Source: J.P. Morgan. Data as of September 30, 2011.

Excludes CIT Group’s default in November 2009 as it was arguably an outlier due to the company’s rapid decline from investment grade to high yield to default.

The above information is shown for illustrative purposes only. Opinions, estimates and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice.

Source: Barclays. Data as of October 17, 2011.

Par-

wei

ghte

d de

faul

t rat

e (%

)

10.911.5

4.4

2.31.4

2.81.61.41.7

4.04.9

8.67.5

3.1

1.12.7

0.90.4

2.23.8

16.9

13.9

2.01.70.81.2

0

2

4

6

8

10

12

14

16

18

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

4Q08

1Q09

2Q09

3Q09

4Q09

2010

YTD

Annualized default rate

Trailing 12-month default rate

Sep-111.20

Spre

ad in

bas

is p

oint

s

0

100

200

300

400

500

600

700

Aug-01

Aug-00

Aug-02

Aug-03

Aug-04

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11


Private Equity Real EstateAs shown in Exhibit 14, direct investments in commercial real estate have historically demonstrated a consistent ability to generate attractive and stable yields for their investors. Many aspects of the property business lend themselves to yield gen-eration. Tenants lease space with often multi-year contracts that lock in rates and may even allow for periodic increases in the rent over the life of the contract. While there is idiosyncratic risk associated with a single property investment—e.g., a large tenant suddenly goes bankrupt or a persistent decline in the attractiveness of a property’s neighborhood results in secular declines in market rental rates—a multi-property portfolio can largely diversify away such risk by owning multiple property types in different geographies, staggering lease renewals (i.e., thousands of leases across a portfolio will come up for renewal at different times ensuring that at no time is an exceedingly

large percentage of the portfolio space at risk of going vacant), and renting to tenants in diverse industry sectors. The result is a portfolio that can be relied on to generate a relatively defen-sive stream of income across multiple economic backdrops.

Additionally, that yield can serve as a reliable base for mid- to long-term total returns by contributing solidly to price appreci-ation in up markets and offsetting price declines. Exhibit 15 demonstrates that, on average, over periods when annualized five-year price returns are negative, the income returns for both private real estate and REITs have been high enough over the same periods to offset those losses and generate positive total returns. Investors in the S&P 500 Index would have, how-ever, experienced net losses. While the amounts do not seem large, note that $100 invested in direct real estate or REITs over the down periods would have increased, on average, to

between $118 and $125 over a five-year period, while S&P 500 investors would have ended up with $94, according to J.P. Morgan Asset Management analysis. In a low-return world, that difference is significant. Finally, since the first quarter of 1978, private real estate has experienced unlevered cash flow growth of 2.7% (as of 2Q2011 as measured by National Council of Real Estate Investment Fiduciaries, or NCREIF). Theoretically, with a steady state payout ratio (i.e., the percentage of the cash flow that property managers pay out to investors as a dividend), these increases can be passed on to investors, serving both as a natural measure of appropriate price appreciation and a defense against rising inflation and interest rates.

EXHIBIT 13: REAL ESTATE YIELDS LOOK ATTRACTIVE VERSUS ALTERNATIVES

EXHIBIT 14: PRIVATE REAL ESTATE IS A PROVEN YIELD GENERATOR

EXHIBIT 15: EVEN WHEN PRICE RETURNS ARE NEGATIVE, REAL ESTATE YIELDS CAN OFFSET LOSSES TO UNDERPIN STABLE POSITIVE RETURNS

Source: Barclays-Lehman, NAREIT, FTSE EPRA NAREIT (International REITs), NCREIF.

Use Yield to Worst (YTW) for all bond vehicles. Use dividend yields (indicated) for REITs, and current value capitalization rate for private real estate. As of 3Q11, except for private real estate, which is latest available data as of 2Q11.

Source: NCREIF, J.P. Morgan Investment Management. As of June 30, 2011.

Source: NCREIF (ODCE), NAREIT, Standard & Poor’s, J.P. Morgan Investment Management.

Period covered is from June 1988 (inception of S&P indices) through to June 2011. Use rolling-year trailing price and income returns, annualized.

Perc

ent

1

2

3

4

5

6

7

LehmanAgg

AAACorp

U.S.REITs

InternationalREITs

BaaCorp

PrivateReal Estate

Perc

ent

-10-8-6-4-202468

1012

Dec

-80

Dec

-82

Dec

-84

Dec

-86

Dec

-88

Dec

-90

Dec

-92

Dec

-94

Dec

-96

Dec

-98

Dec

-00

Dec

-02

Dec

-04

Dec

-06

Dec

-08

Rolling 5-year appreciation (annualized)

Rolling 5-year income (annualized)

Perc

ent

Private Real Estate U.S. REITs S&P 500

Average annualized 5-year income return over periods

when 5-year price return is negative

Average negative 5-year annualized price return over

same periods

Average annualized 5-year total return when 5-year price

returns are negative

-6

-4

-2

0

2

4

6

8



Meanwhile, the current real estate lending environment—with a funding gap between first mortgages and the equity needed to recapitalize over-leveraged properties—is also creating opportu-nities to find higher yields in real estate mezzanine debt.

U.S. and Global REITsREITs are publicly traded companies that own, manage and often develop commercial property. REITs and real estate oper-ating companies are now trading in country markets across the globe offering investors a market capitalization of $784 billion (FTSE EPRA/NAREIT Global Index as of September 30, 2011). Evidence suggests that over time, REITs’ investment perfor-mance more closely tracks that of real estate than the equity market. Exhibit 16 demonstrates that at least in one aspect, REITs are very similar to private real estate funds. Since incep-tion of the NAREIT U.S. Equity REITs index in 1972, and over the last 10 years through September 30, 2011, REIT dividend yields (measured as an income return) made up about 60%–70% of REITs’ annualized total return performance, generating stable income returns of between 5.5% and 8%.

REITs’ cash flows can also, as with private real estate, grow over time as rents and property revenue increase. Currently, REIT investors likely face a period of potentially strong dividend growth. Two things are working for investors on this

front. First, per Exhibit 17, Global REIT dividend coverage ratios (cash flow/dividend payouts) are as high as they have ever been. In fact, if REITs were to raise dividend payouts to pull this ratio back to long-term averages, dividends could grow by just over 15%, without any increase in cash flow. Secondly, after seeing cash flow decreases over 2008–2010, REITs are in a period of recovery. As an example, U.S. REIT dividend yields grew between 4.3% and 5.5% on an annualized basis in the late 1990s and in the mid 2000s, both recovery periods after property bear markets.

InfrastructureInfrastructure assets are natural monopolies that provide essential services. Natural monopolies have limited competi-tion: for example, it does not make economical sense to con-struct two or more power lines, natural gas or water lines to serve a single household. Similarly, it does not make economi-cal sense to construct a second airport or a close and parallel toll road unless the first one has congestion issues. Essential services also create stable demand: Price and income elastici-ties for the services that regulated utilities provide are very low. Water or gas bills are mostly correlated with weather than anything else. Demand for transportation services, though more income elastic, is also relatively stable as long as eco-nomic activity prevails.

EXHIBIT 16: STABLE REIT YIELDS ACCOUNT FOR ~60% TO 70% OF TOTAL RETURNS OVER TIME

EXHIBIT 17: GLOBAL REIT DIVIDEND COVERAGE RATIOS ARE AS HIGH AS THEY HAVE EVER BEEN…YIELDS CAN GROW

Source: NAREIT, J.P. Morgan Investment Management. As of September 30, 2011.

Source: Datastream, UBS Investment Research, J.P. Morgan Investment Management. As of September 30, 2011.

Perc

ent

0

2

4

6

8

10

12

14

Since inception—1972 Last 10 years

Yield

Price

Mul

tipl

e

1.30x

1.35x

1.40x

1.45x

1.50x

1.55x

1.60x

1.65x

1.70x

1.75x

Dec

-89

Dec

-90

Dec

-91

Dec

-92

Dec

-93

Dec

-94

Dec

-95

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

Dec

-08

Dec

-09

Dec

-10

Average1.56x


Mature infrastructure assets exhibit relatively stable cash flow growth trends. Exhibit 18 demonstrates two main points empirically: First, cash flows for mature infrastructure assets grew faster than CPI in the OECD economies over the past 25 years. The rates and tariffs they charge mostly have automatic inflation adjustments (in the case of utilities) or are directly indexed to inflation (in the case of transportation assets). The second point is that infrastructure cash flows exhibited very small income elasticities and mostly continued to grow during recessionary periods. Consequently, the asset class offers a high and growing yield to investors.

EXHIBIT 18: INDICES OF ANNUAL EBITDA FOR AN EQUALLY WEIGHTED PORTFOLIO OF 237 U.S. AND EUROPEAN ASSETS, AGAINST U.S. AND EU-15 CPI AVERAGES, 1986–2009 (NOT ADJUSTED FOR CURRENCY EXCHANGE RATES)

Sources: J.P. Morgan, FactSet, FAA, FHWA, MARAD, Eurostat, OECD, IMF, and company websites as of December 31, 2009.

The charts and/or graphs shown above and throughout the presentation are for illustration and discussion purposes only. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Indices do not include fees or operating expenses and are not available for actual investment.

Inde

x

0

50

100

150

200

250

300

1986 201020082006200420022000199819961994199219901988

RecessionInfrastructureaverage

CPI

SummaryAgainst the backdrop of a low growth, low interest rate climate, securing a high and stable income going forward is proving to be a difficult quandary for investors. The good news is that there are ample opportunities and strategies across a rich and developing spectrum of assets from fixed income and equities to real assets and REITs.

For more information about income opportunities in today’s low interest rate environment, contact your J.P. Morgan client advisor or visit www.jpmorgan.com/institutional.

www.jpmorgan.com/institutional


jpmorgan.com/institutional

Past performance is not a guarantee of future results. Not all investment ideas referenced are suitable for all investors. This material is not intended as an offer or solici-tation for the purchase or sale of any financial instrument. 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. The information provided herein 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 or investment advice. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein may employ proprietary projections of expected returns as well as estimates of their future volatil-ity. Forecasts contained herein may be based upon proprietary research and are developed through analysis of historical data and capital markets theory. Any forecast contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. J.P. Morgan accepts no legal responsibility or liability for any matter or opinion expressed in this material.

Selected Risks: International investing involves special risks, including economic, political, and currency instability - especially in emerging markets. Investments in emerging markets could lead to more volatility in the value of a portfolio. The small size of securities markets and the low trading volume may lead to a lack of liquidity, which leads to increased volatility. Emerging markets may not provide adequate legal protection for private or foreign investment or private property. High yield securi-ties are generally rated in the fifth or lower rating categories of Standard & Poor’s and Moody’s Investors Service. Although these securities tend to provide higher yields than higher rated securities, there is a greater risk that the Fund’s share price will decline. Mortgage-related and asset-backed securities may or may not be guaranteed by governments and their agencies, supranational organizations, corporations, or banks. The value of these assets will be influenced by factors affecting the assets underlying such securities. During periods of declining asset values, the asset-backed securities may decline in value.

Real estate and infrastructure investing may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector. Real estate and infrastructure investing may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrower.

Mortgage-related securities are subject to certain other risks. The value of these securities will be influenced by the factors affecting the housing market and the assets underlying such securities. As a result, during periods of declining asset value, difficult or frozen credit markets, swings in interest rates, or deteriorating economic condi-tions, mortgage-related securities may decline in value, face valuation difficulties, become more volatile and/or become illiquid. Additionally, during such periods and also under normal conditions, these securities are also subject to prepayment and call risk.

Although certain Loans are secured by collateral, an investment could experience delays or limitations in realizing on such collateral or have its interest subordinated to other indebtedness of the obligor. Loans are vulnerable to market sentiment such that economic conditions or other events may reduce the demand for Loans and cause their value to decline rapidly and unpredictably. Loans that are deemed to be liquid at the time of purchase may become illiquid. No active trading market may exist for some of the Loans and certain Loans may be subject to restrictions on resale. The inability to dispose of Loans in a timely fashion could result in losses. Typically, Loans are not registered securities and are not listed on any national securities exchange. Consequently, there may be less public information available.

The value of real estate securities in general, and REITs in particular, are subject to the same risks as direct investments in real estate and mortgages, and their value will depend on the value of the underlying properties or the underlying loans or interests.

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 regu-lated by the Securities and Exchange Commission. Accordingly this document should not be circulated or presented to persons other than to institutional, professional 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.

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© 2011 JPMorgan Chase & Co. | WP_Generating Income Low-Yield Environment

FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY | NOT FOR RETAIL USE OR DISTRIBUTION

CONTRIBUTORS

Rebecca Patterson, Chief Markets Strategist, J.P. Morgan Asset Management, Institutional

Michael C. Hudgins, Real Estate Strategist, Global Real Assets

Additional representation from Highbridge Principal Strategies LLC, Global Equities and the Fixed Income and Real Asset teams.

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