Fixed income: The future is flexible

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1 FOR PROFESSIONAL CLIENTS ONLY NOT FOR RETAIL USE OR DISTRIBUTION INVESTMENT JUNE 2014 OUTLOOK & OPPORTUNITIES Please visit for access to all of our Insights publications. AUTHORS Nick Gartside Portfolio Manager J.P. Morgan Asset Management IN BRIEF Over the past few decades, fixed income investors have enjoyed strong capital gains, an attractive income and the benefits of diversification. However, with interest rates now at record lows, uncertainty about the timing and extent of future rate increases is posing three key challenges to traditional benchmark-oriented bond strategies: Duration Many widely used fixed income benchmarks carry significant sensitivity to changes in interest rates Concentration The largest benchmark allocations are to the most indebted borrowers Constraints Benchmark strategies have limited flexibility to capture returns outside the confines of the index As a result of these challenges, we are currently seeing a great realignment of fixed income portfolios away from traditional benchmark-oriented strategies towards more benchmark-agnostic, flexible approaches. Unconstrained strategies can take advantage of the full fixed income opportunity set. They give managers the ability to invest in securities with a better risk-reward profile, while allowing them to shift sector and duration exposures on a timely basis to respond to changing market conditions. The ability to invest flexibly across sectors therefore offers diversification benefits and the opportunity to create portfolios with more favourable yield and duration characteristics. In this paper, we assess flexible fixed income management in more detail and look at the importance of selecting the right strategy and the right manager when choosing an unconstrained bond fund. We also examine the performance of one approach to unconstrained fixed income in a rising rate environment, to show how investing in benchmark-agnostic strategies with more flexibility to change duration and sector exposures can have a positive impact on a portfolio s overall risk and return profile. A tiring bull: Traditional fixed income returns are running out of steam For three decades, investors in traditional fixed income strategies linked to traditional benchmarks have enjoyed strong positive returns as bond yields have steadily fallen. In this paper, we have based our analysis on the Barclays regate Bond Index () as this is a widely used traditional fixed income benchmark. Investors in the (hedged to USD) have achieved a positive return in all but two of the last 20 years: 1994 and In 1994, the Federal Reserve (the Fed) raised the overnight fed funds rate by 250 basis points (bps) from 3.00% to 5.50%, which pushed the yield on the 10-year Treasury up by roughly 200 bps. The returned -3.58% that year. From the beginning of May to the end of June 2013, the Fed kept the overnight rate unchanged, but talk of tapering the pace of its asset purchases and it was just talk at the time drove the 10-year yield up nearly 100 bps. Over these two months, all fixed income sectors suffered negative performance and the returned -2.78%.

2 The episode in 2013 reminded investors of what could happen to their fixed income portfolios when rates start rising. Today, the has a significantly higher duration and lower yield than in 1994, leaving investors less protected against rising rates. Exhibit 1 highlights how the yield on major benchmark bonds has fallen steadily over the last three decades, providing a much smaller yield cushion to offset the effect of a rise in interest rates. As we will see, this change in the benchmark presents several challenges to fixed income investors. A more vulnerable benchmark: Less yield cushion and a greater sensitivity to rising rates. EXHIBIT 1: BARCLAYS GLOBAL AGGREGATE BOND INDEX DURATION AND YIELD Yield to worst (%) Yield to worst (LHS) Duration (RHS) Eroded yield cushion Traditional fixed income funds face three key challenges The summer of 2013, a period when rates rose and spreads widened, brought unaccustomed volatility to the entire fixed income asset class. All sectors underperformed, and the only safe place to hide was in cash. This experience, on top of the unconventional monetary policies implemented by central banks around the globe, historically low yields, and the prospect of rising rates, has highlighted three key challenges associated with traditional benchmark-oriented products. 1. Duration Traditional benchmarks tie the portfolio manager to the index s duration, which could expose the portfolio to unwanted interest rate risk, especially in the current low rate environment. A typical benchmark-oriented portfolio tends to hold duration within a narrow band calibrated to the benchmark itself. This gives the portfolio manager little flexibility to shorten duration to hedge the risk of rising rates or to pick up return by extending duration. Exhibit 1 and Exhibit 2 illustrate how much the has changed over time. In the past, this index had less sensitivity to changes in interest rates (duration) and a much higher yield to offset the effect of rising rates. Today, the has a much lower yield and a much higher sensitivity to changes in rates. Source: J.P. Morgan, Bloomberg. Data as at 30 June Duration is modified duration. Diversified benchmarks can be highly concentrated. EXHIBIT 2: BARCLAYS GLOBAL AGGREGATE BOND INDEX IS CONCENTRATED IN GOVERNMENT-RELATED SECURITIES. Government Bonds Government -Related Bonds Agency MBS Credit 100% 90% 80% 70% 60% Credit 21.43% 50% 40% 30% Governmentrelated Securities 78.55% 20% 10% 0% Duration (Years) Source: J.P. Morgan Asset Management, Barclays Capital. Data as of 30 June MBS: Mortgage-backed security. 2

3 2. Concentration Exhibit 2 shows how the Barclays regate Bond Index is comprised of more than 78% in government-related and only 21% in credit-related securities. This higher allocation to government bonds results in increased issuer concentration risk and relatively lower yields. The exposure to spread sectors, which provide a cushion against the impact of changes in interest rates, is smaller. 3. Constraints Fixed income markets offer opportunities along the risk-return spectrum, from low yielding short-term money market instruments to higher yielding sectors such as emerging market bonds (see Exhibit 3). Investors linked to traditional benchmarks such as the have traditionally invested mainly in the developed market government bond and investment grade credit sectors at the low end of the risk spectrum. The potential reward from investing solely in these two sectors has become less attractive in today s low yield environment. Higher yielding sectors, such as high yield credit and emerging market debt, offer higher returns and can enhance the overall risk-return profile of a typical portfolio. A broader mix of sectors can expand opportunities for yield and price. EXHIBIT 3: BOND SECTORS ALONG THE RISK-RETURN SPECTRUM Return Money market funds Source: J.P. Morgan. Core/traditional sectors Government bonds Investment grade credit Risk* Emerging market bonds High-yield bonds Extended sectors * Historical volatility. Chart shown for illustrative purposes only. Flexible allocations can boost return opportunities Convertible bonds The ability of unconstrained strategies to tap into multiple sources of fixed income returns looks particularly advantageous at a time of historically low rates and unconventional monetary policy. Exhibit 4 shows how selected bond sectors would be expected to react to a fairly modest 1% rise in local central bank policy rates. Government bonds would suffer losses across the curve, with particularly heavy falls in longer-dated maturities as these bonds have a much higher duration. In contrast, on a total return basis, investors could expect to still achieve a positive return from higher yielding fixed income sectors for example high yield bonds and emerging market debt sectors as the coupon return could offset any drop in yields. Rising rates will hit government bonds much more than high yield and emerging market debt. EXHIBIT 4: ESTIMATED PRICE IMPACT OF A 1% RISE OVER ONE YEAR IN LOCAL INTEREST RATES ON SELECTED INDICES % Price return Total return -15 Treasury: 1-3 years 5-7 years 10+ years Floating Investment High yield EMD USD Europe rate grade credit sovereign EMD USD corporate EMD LC sovereign Source: J.P. Morgan, Barclays, FactSet. Fixed income sectors shown are provided by Barclays Capital and are represented by Treasury Europe: Barclays Pan-Euro Aggregate Government - Treasury Index; Floating Rate Barclays US Floating Rate Notes (BBB); IG credit: Barclays regate Corporates Index; High yield: Barclays Global High Yield Index; EMD sovereign ($): Barclays Emerging Markets Sovereigns index; EMD corporate ($): Barclays Emerging Markets Corporates Index; EMD sovereign (LC): Barclays Emerging Market Local Currency Government Index. Change in bond price is calculated using both duration and convexity. Guide to the Markets - Europe. Data as at 30 June J.P. Morgan Asset Management 3

4 Look for sources of return beyond changes in interest rates. EXHIBIT 5: FIXED INCOME SECTOR RETURNS Q14 Ann. 23.4% 11.9% 13.2% 18.6% 13.7% 57.7% 15.4% 9.8% 19.2% 6.5% 5.8% 9.2% 12.0% 5.6% 12.2% 9.0% 8.1% 25.9% 15.1% 9.2% 18.0% 1.1% 4.7% 8.6% 11.8% 5.5% 10.5% 6.5% 5.6% 21.0% 11.8% 5.4% 15.0% 0.1% 3.1% 8.3% 5.5% 4.3% 3.6% 5.3% -5.1% 16.6% 7.2% 4.8% 10.9% -0.1% 2.5% 4.9% 5.2% 4.1% 3.6% 4.9% -7.9% 5.1% 5.9% 4.2% 5.7% -2.7% 2.5% 4.4% 4.9% 3.5% 3.4% 3.2% -9.7% 2.3% 4.6% 3.6% 5.4% -8.3% 1.9% 4.3% 3.5% 2.8% 3.1% 2.0% -25.2% -3.6% 2.9% -1.9% 2.0% -8.5% 1.4% 4.2% Source: Barclays Capital, FactSet, J.P. Morgan Asset Management. Annualised return covers the period from 2004 to : Barclays Global High Yield; US Treasury: Barclays US Aggregate Government Treasury; : Barclays Global Treasury x US; Debt (USD): JP Morgan EMBI+; Global Corp (IG): Barclays regate Corporates; Debt (LC): JPMorgan GBI-EM Global. Portfolio: 15% US Treasury; 30% Treasury ; 5% EM Debt (USD); 10% ; 10% Debt (LC); 30% Global Corp (IG). Guide to the Markets - Europe. Data as at 30 June Exhibit 5 shows how returns across fixed income asset classes vary over time, with US Treasuries and global high yield acting as opposites when Treasuries perform well, high yield struggles, and vice versa. The best performing asset class in a given year is unlikely to be the best over the next two years. Hence a flexible approach where allocations are tactically managed to own the best assets and omit the worst at any particular moment can potentially deliver stronger returns over time. Unconstrained fixed income: Shaking off the benchmark constraints To avoid the limitations imposed by traditional benchmarks ahead of predicted interest rates increases, bond investors are increasingly expanding their investment universe and directing their fixed income managers to choose from the best opportunities available globally. Investors are looking at traditional bond indices and, seeing the low level of interest rates and high percentage of concentrated issuance, are concerned about the potential for negative returns if rates move significantly higher and/or if the creditworthiness of those heavily indebted borrowers declines. As a result, assets under management in non-traditional fixed income funds have more than tripled in the last six years to reach nearly USD 600 billion a trend that we expect to continue (Exhibit 6). Non-traditional fixed income funds have been gaining in popularity. EXHIBIT 6: ASSETS UNDER MANAGEMENT IN MULTI-SECTOR BOND FUNDS IN THE UK, EUROPE EX UK, AND THE US AUM ($ bln) 700, , , , , , , Q UK Europe US Source: J.P. Morgan, Morningstar Morningstar Direct. US Open-end (OE) ex Money Market (MM) ex Fund of Funds (FoF), Exclude Obsolete Funds. Europe OE & MM ex FoF ex Feeder (domiciled, most compr.) UK OE ex FoF ex Feeder (domiciled). Morningstar Categories: US: World Bond, Multisector Bond, Europe: Alt - Long/Short Debt, Other Bond, UK: IMA Sector: Strategic Bond. Periodicity: calendar year and YTD Data as at 31 March

5 Choosing the right unconstrained approach is key Unlike most conventional fixed income strategies, whose performance is closely linked to changes in interest rates and credit spreads, the performance of flexible/less constrained strategies is driven largely by the manager s view on the future path of rates and spreads and how the manager chooses to position the portfolio in light of these market views. The subsequent risk and return profile of unconstrained strategies is therefore likely to vary to a much greater extent than for strategies tied to a benchmark, resulting in a much greater dispersion of returns (see Exhibit 7). Greater flexibility results in greater dispersion of returns. EXHIBIT 7: ONE-YEAR RETURN DISPERSION ACROSS FIXED INCOME SECTORS 1-Year Returns Top Quartile 2nd Quartile 3rd Quartile Bottom Quartile (USD) 20.0 Unconstrained Fixed Income builds portfolios on the basis of opportunity rather than on benchmark constraints, exploiting high-conviction opportunities that offer enhanced returns. Unconstrained strategies in practice: Evaluating returns during periods of rising rates To see how a representative unconstrained fixed income fund has performed during recent periods of rising rates, we ve taken a look at our JPMorgan Funds Global Strategic Bond Fund. This is a benchmark-agnostic, best ideas fund that has the flexibility to allocate across all fixed income sectors and to actively manage duration within a broad range (from zero to nine years). The performance of the JPMorgan Funds Global Strategic Bond Fund in five recent periods where rates have risen more than 40 bps is shown in Exhibit 8. Also shown is the performance of the Index and the rise in benchmark government bond yields (as represented by 10-year US Treasuries). 1-year return (%) In four out of five periods of rising rates, the JPMorgan Funds Global Strategic Bond Fund produced a positive return, compared to only two by the regate Index. Even when the fund fell in value, during the taper-related market turmoil of April-August 2013, it significantly outperformed the. 0.0 Alt - Long/ Short Debt Other Bond Global Corporate Bond EUR Government Bond Global High Yield Bond The superior results from the unconstrained strategy during these periods of rising rates can be attributed to the manager s ability to navigate the rising rate environment by dynamically shifting portfolio sector allocations and adjusting interest rate sensitivity. Source: J.P. Morgan Asset Management, Morningstar Direct. Data as at 30 June Morningstar categories: EAA OE Alt - Long/Short Debt, EAA OE Other Bond, EAA OE Global Corporate Bond, EAA OE EUR Government Bond, EAA OE Global High Yield Bond. Currency USD. Total Monthly Return We believe strategies that adopt a top-down/bottom-up approach, rather than a focus on single macro bets, are best placed to consistently add value through dynamic interest rate management, sector allocation and security selection. However, as an unconstrained approach requires the portfolio manager to exercise greater discretion over investment decisions, it is important to find an experienced manager with demonstrated capabilities in a broad range of sectors and backed by a global specialist research team. At J.P. Morgan Asset Management, our experienced international fixed income team, supported by a globally integrated, researchdriven team of over 200 investment professionals, manages globally diversified best ideas portfolios with flexibility to invest across the universe of fixed income sectors and issuers. The team J.P. Morgan Asset Management 5

6 Flexible fixed income funds have the ability to provide a more defensive stance in rising rate environments. EXHIBIT 8: PERFORMANCE OF JPMF-GLOBAL STRATEGIC BOND FUND IN PERIODS OF RISING RATES JPM Global Strategic Bond Fund (LHS) 10Yr UST Yield (RHS) Barclays (LHS) % Change in 10yr US Treasury Yield basis points Global Strategic Bond Fund (%) Barclays Global Agg Bond Index (%) Aug 10 Mar Jan 12 Mar Jul 12 Jan Apr 13 Aug Oct 13 Dec Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Source: J.P. Morgan, Bloomberg, Barclays. Inception date: 3 June Fund return shown net of all applicable expenses, fees and taxes for JPMorgan Funds Global Strategic Bond Fund Net A Acc USD share-class. Fund rebased to 100 as at fund inception. Barclays regate Total Return hedged to USD. Please note that past performance is not a guarantee of comparable future results. Data as at 28 February Fund performance is shown based on the NAV of the sub-fund including Performance fee but excluding Annual Management Fees, Operating and Administrative Expenses. Conclusion In the chronically uncertain conditions of low rates and tight spreads that have prevailed in the bond market over the past several years, and given that the high levels of uncertainty seem likely to persist, there are good reasons to consider realigning fixed income portfolios. By incorporating strategies with more flexibility to change duration and sector exposures, managers are able to more freely seek out the most attractive risk-adjusted return opportunities that the markets have to offer. J.P. Morgan flexible fixed income To learn more about flexible fixed income and J.P. Morgan Asset Management s unconstrained bond funds, please visit or speak to your local sales representative.

7 JPMorgan Funds - Global Strategic Bond Fund Risk Profile The value of your investment may fall as well as rise and you may get back less than you originally invested. The value of debt securities may change significantly depending on economic and interest rate conditions as well as the credit worthiness of the issuer. Issuers of debt securities may fail to meet payment obligations or the credit rating of debt securities may be downgraded. These risks are typically increased for emerging market and below investment grade debt securities. In addition, emerging markets may be subject to increased political, regulatory and economic instability, less developed custody and settlement practices, poor transparency and greater financial risks. Emerging market currencies may be subject to volatile price movements. Emerging market and below investment grade debt securities may also be subject to higher volatility and lower liquidity than non emerging market and investment grade debt securities respectively. The credit worthiness of unrated debt securities is not measured by reference to an independent credit rating agency. Asset-backed and mortgage-backed securities may be highly illiquid, subject to adverse changes to interest rates and to the risk that the payment obligations relating to the underlying asset are not met. The fund may be concentrated in a limited number of countries, sectors or issuers and as a result, may be more volatile than more broadly diversified funds. The value of financial derivative instruments can be volatile. This is because a small movement in the value of the underlying asset can cause a large movement in the value of the financial derivative instrument and therefore, investment in such instruments may result in losses in excess of the amount invested by the fund. The possible loss from taking a short position on a security may be unlimited as there is no restriction on the price to which a security may rise. The short selling of investments may be subject to changes in regulations, which could adversely impact returns to investors. Movements in currency exchange rates can adversely affect the return of your investment. The currency hedging that may be used to minimise the effect of currency fluctuations may not always be successful. Investment Objective To achieve a return in excess of the benchmark by exploiting investment opportunities in, amongst others, the debt and currency markets, using financial derivative instruments where appropriate. FOR PROFESSIONAL CLIENTS ONLY NOT FOR RETAIL USE OR DISTRIBUTION 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. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication may be issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Switzerland by J.P. Morgan (Suisse) SA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited; in Australia by JPMorgan Asset Management (Australia) Limited; in Brazil by Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by J.P. Morgan Investment Management Inc., JPMorgan Distribution Services Inc., and J.P. Morgan Institutional Investments, Inc. member FINRA/ SIPC. LV JPM /14