Managing Risk/Reward in Fixed Income

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1 INSIGHTS Managing Risk/Reward in Fixed Income Using Global Currency-Hedged Indices as Benchmarks In the pursuit of alpha, is it better to use a global hedged or unhedged index as a benchmark for measuring returns? Here is what our analysis has uncovered: Global currency-hedged indices provide diversification Unhedged currency indices produce more volatile returns Global currency-hedged indices reduce risk Our analysis is based on government bond indices, but it also suggests that our recommendations would apply to aggregate indices. The conclusion: Global currencyhedged indices provide attractive risk-adjusted returns. Michael Wilson Managing Director Global Applied Risk and Research, Fixed Income April 2008 For more information, please contact your JPMorgan representative. Overview and Recommendation In the search for a better risk-adjusted level of returns, investors are seeking ways to increase absolute fixed income return on their investments while reducing volatility. As a fixed income index is typically the benchmark chosen by investors to measure fixed income return, many clients have asked for our thoughts on the suitability of different benchmarks, particularly when their requirements are changing. Well-diversified benchmark indices achieve the highest, risk-adjusted returns. There are two main sources of diversification: credit sector diversification and global diversification. Credit sector diversification gives investors exposure to broad market sectors, including Treasuries, Mortgage Backed Securities (MBS), Asset Backed Securities (ABS), corporate bonds, emerging market debt and high yield bonds Globally diversified indices cover global bond markets, giving investors exposure to either government bonds or a mixture of broad market securities Given that globally diversified portfolios provide the highest level of interest rate diversification, the main question investors ask is whether to hedge their currency exposure. To find an answer, we have looked at the risk/reward characteristics of global indices compared to U.S. dollar indices as measured over 10- and 20-year periods. Diversification is key to increasing risk-adjusted returns. The results of our research revealed that unhedged indices produce more volatile returns due to their open currency positions. In contrast, currency hedged indices provide interest rate diversification while removing currency volatility. These conclusions, also applicable for individual portfolios, were the same for both global government bond indices and global broad market indices. We therefore recommend that investors seeking global diversification should use a global currency-hedged index as their benchmark. When examining risk-adjusted total portfolio returns, some currency exposure improves diversification, as currency movements generally have a low correlation with interest rate returns. The optimal mix will vary for different clients, but it is likely to be approximately 70% to 90% hedged into U.S. dollars. We additionally recommend that asset managers add value to portfolios by using a foreign exchange (FX) overlay strategy relative to their chosen benchmark. Any historical analysis to determine the appropriate level of FX hedging tends to be very dependent on the historical period chosen. From a U.S. dollar perspective, if the period measured represents a time of dollar strength (over and above that captured in the interest-rate differential), then 100% hedging tends to be the optimum position. However, if the period measured represents significant dollar weakening, then the hedge ratio is very low. For that reason we recommend the 70% to 90% hedge with FX overlay to take advantage of currency movements in the short term. Better insight + Better process = Better results

2 The case for using global hedged indices as benchmarks U.S. dollar risk and performance Our analysis is based on government bond markets as measured by the Citigroup World Government Bond Index (hereafter referred to as WGBI) from December 31, 1987 to December 31, We chose these indices since the hedged indices data has been measured longer than other equivalent indices from JPMorgan, Lehman Brothers or Merrill Lynch. Exhibit 1 illustrates the historical risk and returns for the U.S. treasury component of the WGBI. The chart clearly reveals what we would expect from fixed income markets: over extended time periods longer maturity indices produce higher returns and higher risks. On a forward-looking basis, we would differentiate between the levels and the slope of the curve. For levels, we would anticipate lower average returns in the future as we expect interest rates will likely be lower over the next 20 years than they have been over the past 20 years for three reasons: Better inflation management High demand for fixed income securities from sovereign funds and pension funds Moderate issuance We continue to expect higher returns from longer duration assets but probably a gentler slope, as the premium yield for longer-dated assets may be lower in the future. Volatility of returns Another way of examining this data is to look at the volatility of returns using actual historical data. Exhibit 2 uses the same U.S. Treasury Index, but shows the range of annual, calendar year returns over the past 20 years. Exhibit 2 gives rise to a number of points: As expected, the range of returns is most extreme for a full maturity index with the lowest return of -4% in the year to September 1994, the highest return of 18% in the year to December The range of historic returns is much narrower than for many asset classes, such as emerging market debt or equities. For investors requiring the lowest probability of negative absolute returns over a 12 month period, a 1 to 3 year index has often been used, but has produced one period of negative returns in the year to March Exhibit 1: Over time, longer maturity cash indices generate higher returns at greater risk Risk versus Return, US$ assets, from 1987 to 2007 JPM Cash USD Data: Annualized quarterly returns for index changes from December 1987 to December Cash Index: JPMorgan Cash Index is based on 12-month LIBOR in USD. Source: JPMorgan and Citigroup. 2

3 Exhibit 2: Full maturity indices may produce wide-ranging returns as illustrated below when this index rose to a high of 18% in the year to December 1995 and a low of -4% in the year to September 1994 Range of annual returns, US$ assets from 1987 to % Max. rolling annual return 18.30% 10 5 Well-diversified indices achieve the highest, risk-adjusted returns % Min. rolling annual return 4.08% Data: Annualized quarterly returns for index changes from December 1987 to December Source: Citigroup. Global bonds Unhedged indices add risk Many investors believe that adding global bonds to their portfolios increases risk. In the case of unhedged indices, this concern is very much true, as shown in Exhibit 3. Although returns from unhedged indices are not materially different (the small difference in returns is due to interest rate differentials and small currency movements during the period), risk has been increased significantly. This results from a single factor: currency risk is higher than interest rate risk. Approximately 80% of a typical global government bond index is exposed to non-u.s. bonds. Hence, about 80% of the currency position in an unhedged index may be affected by the rise and fall of the U.S. dollar. Based on internal analysis, we assume % FX risk is roughly equivalent to one-year of duration risk, the currency position in an unhedged government bond index is more than 10 years of duration risk. Therefore, currency risk is clearly higher than the interest rate risk of the selected index. Hedged indices reduce risk If we look at currency hedged indices as opposed to unhedged indices, the picture changes dramatically and the risk/return profile becomes much more attractive. Exhibit 3: Adding global unhedged indices almost always increases risk Risk versus Return, Global unhedged versus US$ assets, from 1987 to 2007 JPM Cash USD Unhedged USD Data: Annualized quarterly returns for index levels from December 1987 to December Cash Index: JPMorgan Cash Index is based on 12-month LIBOR in USD. Source: JPMorgan and Citigroup. 3

4 Exhibit 4: Global hedged indices produce superior returns to unhedged indices at less than half the risk Risk versus Return, Global hedged and unhedged versus US$ indices, from 1987 to 2007 Hedged USD Unhedged USD JPM Cash USD Currency risk is higher than interest-rate risk Exhibit 4 shows that hedged indices are more efficient than unhedged or US$ indices. Currency hedging has removed FX risk, while interest rate diversification has produced better risk-adjusted returns. For example, our analysis shows that it has been possible to receive a comparable return to the 1- to 5-year U.S. index, by using the less volatile 1- to 5-year global hedged index. In fact, higher returns than those offered by the 1- to 10-year U.S. index can be achieved for a similar level of risk by using the 1- to 30-year global hedged index. Clearly, currency hedged global indices offer superior risk-adjusted returns compared to single market indices over the long term. On a forward looking basis, we believe that hedged indices will continue to provide better risk-adjusted levels of returns though levels of yields may be lower. Comparison over time Data: Annualized quarterly returns for index levels from December 1987 to December Cash Index: JPMorgan Cash Index is based on 12-month LIBOR in USD. Source: JPMorgan and Citigroup. Given 20 years of history, how has the relationship altered over time? Exhibits 5 and 6 tell a consistent story. During both 10 year time periods, the global hedged indices offered better risk-adjusted returns. Analysis with Euro as the base currency The analysis for currency hedging becomes more complex when the base currency is the Euro due to the changes in Europe over the past 20 years. From 1987 to 1997, there was a strong convergence of interest rates with rates falling in those markets that had historically had higher inflation (such as Spain and Italy) and convergence towards the lower rates historically prevalent in Germany. This produced an era of strong returns from broad European interest rates that are unlikely to be repeated. Over the last 10 years, interest rate levels have Exhibits 5 and 6: Global hedged indices offer investors better risk-adjusted returns over 10 year periods Global hedged and unhedged versus US$ indices, Hedged USD Unhedged USD JPM Cash USD Sources: JPMorgan, LehmanLive Global hedged and unhedged versus US$ indices, JPM Cash USD Hedged USD Unhedged USD

5 Global hedged indices produce less volatile returns whether measured in U.S. dollars or Euro Exhibits 7, 8 and 9: Global hedged indices produce superior returns to unhedged indices at close to half the risk Exhibit 7 Exhibit 8 Global hedged and unhedged versus Germany indices, Hedged EUR WGBI Germany EUR Risk% Data: Annualized quarterly returns for index levels from December 1987 to December Currency used prior to January 1999 is the Ecu (XEU). Source: Citigroup. become more stable but the Euro has fluctuated widely, moving from weakness after its launch in 2002 to considerable strength in These factors can distort the analysis used for U.S. dollar bonds and make the selection of the time period important. However, Exhibits 7 9 suggest that similar conclusions hold true in Europe as in the U.S. namely currency-hedged indices offer better risk-adjusted returns. Investment grade credit Global diversification is also beneficial Unhedged EUR Gaining historical perspectives into the credit markets is somewhat limited. First, data is more recent for credit markets than for government bond markets. Second, non-u.s. credit markets have changed rapidly over time and have only recently started to provide the range of issuers and sectors needed to provide broad diversification benefits. We have analyzed data from December 31, 1997 to December 31, 2007 to illustrate the benefits of diversification in credit markets (see Exhibit 10 next page). Exhibit 10 shows that similar conclusions hold true in credit markets as in government bond markets: 1. Unhedged indices add volatility without producing a material increase in returns Global hedged and unhedged versus Germany indices, Hedged EUR Unhedged EUR WGBI Germany EUR Risk% Data: Annualized quarterly returns for index levels from December 1987 to December Currency used prior to January 1999 is the Ecu (XEU). Source: Citigroup. Exhibit 9 Global hedged and unhedged versus Germany indices, Hedged EUR Unhedged EUR 3.5 WGBI Germany EUR Risk% Data: Annualized quarterly returns for index levels from December 1997 to December Currency used prior to January 1999 is the Ecu (XEU). Source: Citigroup. 2. Global indices hedged to the U.S. dollar reduce risk with a small impact on returns 3. Note that the appearance of higher returns from a U.S. aggregate in this exhibit is primarily due to the greater exposure of the U.S. index to non-government markets. A Global Aggregate Index has a significantly higher percentage weighting of governments: 48% compared to 24% for the U.S. as of September 30, 2004 and 47% compared to 22% for the U.S. as of December 31,

6 Exhibit 10: Risk versus return global, U.S. and aggregate indices, from 1997 to Hedged USD JPM Cash USD 1 2 Lehman Aggregate Hedged USD Lehman Aggregate USD Lehman Aggregate Unhedged USD Unhedged USD Data: Annualized quarterly returns for index levels from December 1997 to December Cash Index: JPMorgan Cash Index is based on 12-month LIBOR in USD. Source: Lehman Brothers, JPMorgan and Citigroup. Global hedged indices consistently offer better riskadjusted returns Summary Our research clearly shows that global unhedged indices produce more volatile returns whether measured in U.S. dollars or Euro. Global currency hedged indices, however, provide interest rate diversification while removing currency volatility. An analysis of the credit markets also supports this conclusion. Therefore, we recommend that investors use global indices as benchmarks rather than single country benchmarks. Global diversification offers greater return opportunities than single country investments. We also recommend that investors use global indices that are hedged into their base currency. Hedged strategies have historically provided superior risk-adjusted returns, a trend that we expect to continue. To ensure that absolute return goals for the portfolio are achieved, consider further diversification options. As currency movements generally have a low correlation with interest rate returns, we recommend that client portfolios have some currency exposure. The optimal mix will depend on portfolio objectives with those asset managers most interested in risk-adjusted returns likely to hedge 70% to 90% of their currency exposure in U.S. dollars. We additionally recommend that asset managers add value to portfolios by using a foreign exchange (FX) overlay strategy relative to their chosen benchmark. We are happy to share further insights and to answer your questions regarding using global hedge indices as benchmarks for fixed income portfolios. For more information, please contact your JPMorgan representative. 6

7 Notes 7

8 Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. 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. These materials have been provided to you for information purposes only and may not be relied upon by you in evaluating the merits of investing in any securities referred to herein. Past performance is not indicative of future results. Indices do not include fees or operating expenses and are not available for actual investment. Indices presented, if any, are representative of various broad base asset classes. They are unmanaged and shown for illustrative purposes only. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regarding such matters. JPMorgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. and its affiliates worldwide which includes but is not limited to J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors, Inc., Security Capital Research & Management Incorporated, J.P. Morgan Alternative Asset Management, Inc. JPMorgan Chase & Co IM_FI_HI

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