Back to the future: A guide to finding fixed income returns

FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY NOT FOR RETAIL USE OR DISTRIBUTION Back to the future: A guide to finding fixed income returns Fixed income strategy May 216 AUTHORS Nick Gartside International Chief Investment Officer, Global Fixed Income, Currency and Commodities Group Marika Dysenchuk Client Portfolio Manager, Global Fixed Income, Currency and Commodities Group IN BRIEF Low bond yields are casting a long shadow over fixed income investing. The combination of ultra-low money market rates and aggressive quantitative easing has caused the cost of bond investments to soar. Consequently, investors face difficult choices when making fixed income allocations in today s environment as they try to balance risk and return. In this paper we set out the macroeconomic and market context for today s low yield world. We also look in detail at Japan s long battle with low growth and low inflation to see if any lessons can be identified to help fixed income investors navigate today s markets. We believe that the current fixed income environment contains a range of interesting opportunities as well as challenges. The most important issue is to take an active approach to fixed income allocations. Today s markets will no longer reward investors who passively follow a fixed income benchmark and rely solely on yield compression for attractive returns. To capitalise on the current bond opportunities and avoid the pitfalls of a low yield world, the key is to focus on solutions-based investing, choosing the most appropriate strategies to match individual investment objectives, whether they are for capital preservation, liability matching, income distribution, or total return generation. Global economic backdrop: An absence of both growth and inflation Easy global monetary conditions, lack of inflation and financial repression will exercise downward pressure on long-term equilibrium yields and returns globally. J.P. Morgan Asset Management Long-Term Capital Markets Assumptions, 216 Viren Patel Client Portfolio Manager, Global Fixed Income, Currency and Commodities Group The current economic backdrop is one that is absent of both growth and inflation. Global growth has yet to recover since the 28 financial crisis, as debt levels have remained high and previous drivers of growth have waned. The significant debt overhang is still evident in both the public and private sectors, where meaningful deleveraging has yet to occur. Meanwhile, the emerging markets, which have seen their share of the world s GDP grow from just 2% in 23 to 4% in 21, have more recently exhibited a declining contribution to world trade growth as they shift from their traditional manufacturingfocused operations to services-oriented economies (see Exhibit 1A and Exhibit 1B). The structural decline across emerging markets has led to a decrease in global demand. When coupled with the significant excess supply in the commodities space, it is likely that inflation will remain at subdued levels. It is also worth noting that while there has certainly been an improvement in the labour market over the past five years, there continues to be some slack that has kept wage growth in check.

Although emerging markets continue to take a bigger share of global GDP, their contribution to global trade growth is declining EXHIBIT 1A: CONTRIBUTION TO GLOBAL GDP FROM DEVELOPED AND EMERGING MARKETS, % EXHIBIT 1B: EMERGING MARKET CONTRIBUTION TO GLOBAL TRADE GROWTH, PERCENTAGE POINTS 1 9 8 7 6 4 3 2 1 Advanced economies Emerging market and developing economies '8 '84 '88 '92 '96 ' '4 '8 '12 '16 '2 1. 8. 6. 4. 2.. -2. -4. '92 '94 '96 '98 ' '2 '4 '6 '8 '1 '12 '14 Source: IMF DataMapper, IMF World Economic Outlook October 21, CPB World Trade Monitor, J.P. Morgan Asset Management; data as of December 21. In the face of this current and expected low growth environment, central banks have resorted to unprecedented monetary policies in an attempt to stimulate their economies. Previously unheard of measures ranging from large scale quantitative easing (QE) to long-term refinancing operations have led to abundant liquidity being injected into the system. In Europe, the European Central Bank (ECB) remains on an extremely accommodative path as it tries to achieve an inflation target of close to, but below 2%. Most recently, the ECB announced an aggressive extension of its existing QE programme. While some of the measures were broadly expected, such as a further deposit rate cut and an increase in the size of monthly financial asset purchases to EUR 8 billion, the ECB surprised markets with two new drastic measures: expansion of the list of eligible purchases to include corporate bonds, and a new series of targeted long term refinancing operations (TLTRO 2), which essentially allows banks to be paid for borrowing money. This significant package suggests that the ECB is both willing and able to come up with innovative easing policies, and we expect this trend to continue going forward. In the US, even following the much anticipated first rate increase from the Federal Reserve (the Fed), the market is questioning whether the US central bank will be able to raise rates again in 216, or whether it will be forced to pause given a strong US dollar coupled with global economic weakness and financial market instability. This phenomenon of addressing low growth with ultra accommodative central bank policy is not unique to the developed markets. Even the People s Bank of China has embarked on a variety of easing measures in an attempt to manoeuvre a soft landing for the Chinese economy, including cutting rates five times in 21 and enacting various policy measures to support infrastructure spending. ASSESSING THE IMPACT ON GLOBAL BOND MARKETS In the absence of the two bond investor enemies (growth and inflation), we expect government bond yields to remain low. In Europe, markets have defied expectations that already extremely low government bond yields could not go lower by breaking through the zero rate barrier. As the ECB s QE programme buys more debt than countries are issuing (Exhibit 2A), the resulting negative net supply pipeline has led to an environment in which nearly 4% of eurozone government bonds trade with a negative yield (Exhibit 2B). As a result of the pervasiveness of negative yielding government bonds in Europe, US Treasuries actually look attractive on a relative basis with the 1-year Treasury yielding 1.77% as of 31 March 216. The relative attractiveness of Treasury yields is likely to keep a cap on US government bonds as high quality fixed income investors search for yield. 2 FIXED INCOME

With the ECB soaking up new issuance, more than one third of the European government bond index now offers negative yields EXHIBIT 2A: 216 EUROPEAN BOND ISSUANCE, EUR BILLIONS 216 Issuance, EUR bn 2 1 1 - -1-1 -2-2 -3 Germany France Italy Spain Netherlands Belgium ECB QE* Redemptions Gross Conventional Issuance Net issuance after ECB purchases Austria Finland Ireland Greece Portugal EXHIBIT 2B: EUROPE AND GLOBAL BOND INDEX EXPOSURE TO DIFFERENT YIELD BRACKETS, % 3 2 2 1 1-1 to -. -. to -.2 -.2 to to.. to 1 1 to 2 Global Broad Market Index Euro Government Index 2 to 3 3 to 4 >4 Source: ECB, JP Morgan Chase & Co. *ECB quantitative easing on a cash basis. Data as of 24 March 216. Source: Bloomberg, BoAML, J.P, Morgan Asset Management; data as of 31 March 216. Additionally, there is historical evidence that the 1-year Treasury yield will remain anchored based on its relationship with the Fed Funds rate (Exhibit 3). Typically, when a terminal rate is reached at the end of a Fed tightening cycle, the yield curve is inverted (that is, the 1-year Treasury yield is lower than the base rate). Given the challenges we expect the Fed to have in reaching a terminal rate of 2% in the current tightening cycle, we believe that the 1-year Treasury will not go much higher than its current level. So, if government bond yields in the US and Europe aren t going up, can they continue to fall? The US Treasury yield curve has historically inverted as the Fed Funds rate has risen EXHIBIT 3: US INTEREST RATES AND 1-YEAR TREASURY YIELDS 7 % 6 4 3 2 1-1 Fed Funds Rate US 1 year - Fed Funds Rate -2 '92 '93 '94 '9 '96 '97 '98 '99 ''1 '2 '3 '4' '6 '7 '8 '9 '1 '11 '12 '13 '14 '1 Source: Bloomberg, J.P. Morgan Asset Management; data as of 29 February 216. JAPAN AS A ROADMAP: WE VE BEEN HERE BEFORE While bond market participants have, for the last several years, been applying the widely held assumption that what goes down must surely go up, the direction of bond yields is anything but guaranteed. The Japanese situation proves this uncertainty: Japanese Government Bond (JGB) yields have remained at ultra low levels for over 2 years with little to no sign of rising. As global central banks continue to deploy tools to stimulate their respective economies to increasingly diminishing effects, we look to the well trodden path of Japan as an indication of what could play out in global fixed income markets. Let s look back at what led the Bank of Japan to adopt a zero interest rate policy, and the impact that doing so had on the JGB market. Following the bursting of the asset price bubble in Japan in the early 199s (which stemmed from excessive bank lending and the central bank s attempt to curb inflation by quickly hiking rates), real estate and equity prices declined significantly and stress pervaded the country s financial institutions. In an attempt to encourage commercial bank lending and revive demand, the central bank slashed interest rates from 6% in 1991 to less than 1% in 199, and eventually to % in 1999. Much of the Japanese scenario sounds akin to the current situation in the US, Europe and the UK, with aggregate debt levels high and the authorities struggling to ignite economic growth against a backdrop of high debt levels. The cause of the low interest rate environment is similar to Japan as well: J.P. MORGAN ASSET MANAGEMENT 3

following the bursting of the US real estate bubble and the ensuing global financial crisis, central banks have attempted to encourage business and consumer lending and rekindle demand by adopting very low interest rate policies. The US Fed was the first to begin reducing rates when it lowered the Fed Funds rate from.2% in 27 to.2% in 28, with the Bank of England and ECB both following suit. Even though the Fed finally raised interest rates off this lower bound for the first time in seven years in December 21, it is widely accepted that it will maintain an ultra accommodative stance for an extended period of time. In the UK, the Bank of England is expected to keep rates on hold at a record low of.% for longer than originally expected given a challenging global backdrop, while the ECB continues to implement monetary easing measures to support the fragile eurozone recovery. JAPAN S WARNING FOR CENTRAL BANKS While the scenario in Japan shares a common cause with the current situation in the US, UK and Europe (the bursting of an asset price bubble) and a common outcome (central banks exercising very low interest rate policies for an extended period of time), it is important to highlight several key differences. First, there are important structural distinctions between the Japanese economy and the US, UK and European economies, including stronger underlying economic growth, more robust demographic profiles, and a history of recent innovation in the US, UK and Europe. Perhaps even more importantly, the Bank of Japan s path to negative interest rates has not been one directional. After lowering rates to 2.% in 1987, the Bank of Japan changed course and proceeded to raise rates to 6% between 1989 and 1991, thereby thwarting any positive impact of the low rate environment. Furthermore, as equity markets began to rally at the turn of the millennium, the Bank of Japan once again reversed its accommodative stance and began raising rates, a cycle that was short lived as the policy rate again returned to % in early 21. Meanwhile, the Fed, ECB and Bank of England are being extremely cautious likely looking to Japan as a warning sign in not raising rates too soon, as they recognise that doing so could be detrimental to their economic recoveries much like it was to Japan s. The ECB learned this lesson from its own experience: after lowering rates to record low levels following the financial crisis, it raised rates in 211, citing higher headline inflation as the rationale. However, this move had a large negative impact on the already vulnerable eurozone economy, and the ECB was forced to reverse course and even became the first major central bank to cut rates into negative territory. While we do not see the Fed getting into a similar hike/cut scenario, it s not something that we can categorically rule out given the impact of global growth dynamics and financial market stress that we ve seen thus far in 216. THE IMPLICATIONS FOR FIXED INCOME RETURNS While there are noteworthy distinctions, it is still important to recognise that monetary policy in the US, UK and Europe is broadly following the same path as it has in Japan (at least since the Bank of Japan finally adopted and maintained its ultra low interest rate policy in 199). In fact, while we often think of QE as a more recent phenomenon, the Bank of Japan was the pioneer of this concept in 21 when it initiated current account balance targeting as a way to increase liquidity in the financial system. As such, it may be that the recent experience of the JGB market provides a good roadmap for the US, UK and European government bond markets over the next few years (Exhibit 4). Low government bond yields are often assumed to have a negative impact on fixed income returns, given the assumption that the next move in rates will be up and the lack of yield reduces the ability to generate return and cushion against rate rises. Nevertheless, Japanese fixed income has continued to provide investors with decent returns: the Bloomberg Japanese Sovereign Bond Index has provided annualised returns of 2.2% over the last five years to the end of 21. If Japan is the guide to the future, US, UK and German yields can fall further EXHIBIT 4: JAPAN VS. US, UK, GERMANY 1-YEAR GOVERNMENT BOND YIELDS 28 21 212 214 216 218 22 222 224 226. % US, UK, Germany 1 year yields equally 4. weighted starting June 28 3. 2. 1.. Japan 1 year yields - starting 199 -. 199 1997 1999 21 23 2 27 29 211 213 21 Source: Bloomberg, J.P. Morgan Asset Management; data as of 31 March 216. 4 FIXED INCOME

These returns have been generated as JGB yields have defied market assumptions and continued to move lower: looking back five years, 1-year JGBs yielded.88%; at the end of 21, the yield was.27%. The recent move by the Bank of Japan to cut deposit rates into negative territory in January 216 suggests that government bond yields could move even lower. While in absolute terms a return of a little more than 2% may not strike investors as impressive, against low levels of interest rates and low levels of inflation these returns are ahead of inflation and powerfully demonstrate the ability of government bonds to deliver returns in a low yield environment. It s clear there are lessons to be learnt from the Japanese economy, the key is how to apply these lessons in practice to the rest of the world. THE IMPLICATIONS FOR THE INVESTMENT LANDSCAPE How has Japan s economic position and monetary policy response affected the country s investment landscape? Overall, the result of low government bond yields in Japan has caused investors to adopt more innovative strategies and investment managers to design new product offerings. In the early 2s we saw the start of this innovation with the emergence of Uridashi bonds, which are Japanese bonds denominated in higher yielding currencies, such as the Australian dollar and New Zealand dollar, so as to provide investors with a higher total return. The development of new investment products followed as commercial banks began launching investment trusts offering Uridashi strategies to retail investors. The next phase of product innovation in Japan was the rise of funds offering monthly distributions, as investors became increasingly interested in income over total return (Exhibit A). Following the financial crisis, Japanese investors became even more adventurous with their investment strategies and expanded their sector universe to incorporate high yield corporate bonds. However, they went one step further and adopted a new trend of double decker funds, which are high yield funds with currency overlays typically in the high yielding Brazilian real in order to further increase their return profile (Exhibit B). Innovation is a two-sided coin. Expanding your investment universe from both a sector and geographic perspective provides diversification and enhanced yield opportunities. Similarly, product innovation can help to solve the dilemmas that investors face in a constantly evolving investment environment. However, it is imperative that investors consider the risks associated with such strategies and that they are appropriately compensated for taking them. Low government bond yields in Japan have caused investors to adopt more innovative strategies and investment managers to design new product offerings EXHIBIT A: FUNDS WITH MONTHLY DISTRIBUTIONS IN JAPAN JPY Trillion 12 1 8 6 4 2 '98 '99 ' '1 '2 '3 '4 ' '6 '7 '8 '9 '1 '11 '12 '13 '14 '1 Source: Ibbotson Associates Japan, J.P. Morgan Asset Management; data as of 31 August 21. EXHIBIT B: FUNDS WITH CURRENCY OVERLAY ( DOUBLE-DECKER FUNDS ) IN JAPAN JPY Trillion 4 4 3 3 2 2 1 1 '96 '97 '98 '99 ' '1 '2 '3 '4 ' '6 '7 '8 '9 '1 '11 '12 '13 '14 '1 Source: Ibbotson Associates Japan, J.P. Morgan Asset Management; data as of 31 August 21. For instance, Uridashi bonds may be suitable for some investors, though they need to understand that these securities inherently have not only the credit risk associated with the issuer of the bond but also currency risk, which can be much more volatile than bonds. Investors should also be wary of strategies that rely on the performance of a single sector or on an individual economic scenario playing out: in the case of double-decker funds, the very specific exposure to both US high yield and the Brazilian real can be dangerous as they both have highly concentrated risk that tends to be correlated with risk-on/risk-off sentiment. Instead, we believe it is important to have an active asset allocation approach in order to take advantage of shifting market conditions the days of fire and forget are over. J.P. MORGAN ASSET MANAGEMENT

AN ACTIVE APPROACH CAN MAXIMISE OPPORTUNITIES FROM TODAY S BOND MARKETS While the current low yield environment creates a challenge for fixed income investors, one positive outcome over the past 2 years is the expansion of the global fixed income markets. With the growth of developed ex-us and emerging market bond markets, investors now have access to a wider array of opportunities. This expanded universe offers the potential for greater diversification, enhanced yield, and a more flexible duration profile. While the benefits of a large and diverse fixed income market may seem obvious, it is important to consider the nuances of how to access this growing asset class. Historically, fixed income investors have adhered to the traditional approach of benchmark investing, in which portfolios are positioned in line with market capitalisation weighted indices. The issue with this method of passive investing is that bond benchmarks inherently reward bad behaviour: those countries and companies with the most debt outstanding constitute the largest weight in the index even though they are the ones that may be least able to pay back their debt. Additionally, traditional fixed income benchmarks no longer provide sufficient protection against rising rates. Combining the low yield environment with issuers that have extended the duration of their debt leads to an eroded yield cushion (see Exhibit 6). We can also look to Japan as an example in this instance, where an ongoing low yield environment led to increased debt issuance, resulting in concentrated, rather than diversified, risk in bond benchmarks. Declining yields and rising duration is eroding the yield cushion provided by traditional bond indices, such as the Global Aggregate Index EXHIBIT 6: BARCLAYS GLOBAL AGGREGATE INDEX YIELD AND DURATION % 8 7 6 4 3 2 1 Yield (%, LHS) Duration (year, RHS) Eroded yield cushion '96 '97 '98 '99 ' '1 '2 '3 '4 ' '6 '7 '8 '9 '1 '11 '12 '13 '14 '1 Years 8 Source: Barclays Live, J.P. Morgan Asset Management; data as of 31 March 216. 7 6 4 3 2 1 Instead of passive fixed income investing, we believe that today s fixed income markets require active management. As lenders of our clients money, we believe it is imperative to only invest in those countries and companies in which we have strong conviction that we can be repaid, with interest. In order to identify these opportunities, as well as avoid the negative credits, investors need to have a globally integrated, research driven approach to markets. ALLOCATING TO FIXED INCOME: A FLAVOUR FOR EVERY INVESTOR The extent to which investors employ active management varies depending on their risk tolerance and ultimate objective. For certain investors who engage in internal asset allocation, it is important to have access to single sector strategies so that they can use the individual building blocks in order to construct a comprehensive, diversified fixed income portfolio. For instance, distinguishing beyond just high yield and emerging market debt to look at more niche strategies, such as US vs. European high yield, or emerging market corporates vs. emerging market local currency approaches. Investors in single sector strategies must keep in mind the importance of diversifying risk at their overall portfolio level, and not concentrating too much in any particular strategy or theme. Despite the low yields across the government bond sector, strategies focusing on this area of the market remain appropriate for conservative investors who are focused on capital preservation and liquidity over generating yield and total returns. In this instance, aggregate strategies are an attractive way to gain exposure to an array of fixed income markets, including high quality government bonds, corporate bonds, agencies and mortgages. Given some of the challenges mentioned earlier pertaining to fixed income benchmarks, it is important when investing in these strategies to consider your view on the future path of rates and the impact of duration on your overall investment portfolio. Yet another way to access fixed income markets within an active context is to completely remove the concept of a benchmark and only invest in best ideas or what we call going unconstrained. There are several different methods of unconstrained investing, including those strategies that focus within a particular sector for instance, investing in an unconstrained manner across the emerging market debt or credit sectors as well as those that scan the entire global fixed income universe for opportunities and invest across government bonds, high yield and investment grade credit, mortgages and emerging market debt. 6 FIXED INCOME

While we have been in the current environment of low growth and muted inflation for an extended period, economic cycles are not dead and there will be times when you do want duration exposure or you do want an allocation to emerging market local currencies. By employing these flexible, unconstrained strategies, investors can allow experienced investment managers to make and time these allocation decisions, as well as to identify the individual securities that stand to benefit from the prevailing environment. The unconstrained approach brings with it the need for robust risk management. This is due to the fact that the absence of a benchmark places all of the risk onto the decision maker compared to single strategy approaches, which transfer much of the risk on the investor s choice of benchmark. As mentioned earlier, fixed income is a broad and diverse asset class, with close to USD 9 trillion of debt outstanding and over 24 bond categories (as split by Morningstar). As such, there is something for every type of investor. Rather than focusing on the underlying sectoral exposure or benchmark to be managed against, we believe it is key for investors to consider their ultimate objective and the solution they are trying to achieve, whether it is capital preservation, liability matching, income distribution, or total return generation. BRINGING IT ALL TOGETHER BUILDING EFFECTIVE FIXED INCOME PORTFOLIOS The twin enemies of bond investors growth and inflation are absent from today s global markets. As global central banks attempt to stimulate their economies with ultraaccommodative monetary policies, we expect rates to remain low across markets. However, that doesn t mean there are no returns to be had in fixed income; in fact, the JGB market is an example of the capacity for government bond markets with very low yields still to provide attractive returns. However, this environment of persistently low interest rates does require investors to be more attentive than ever to their approach to the fixed income asset class. PRIORITIES FOR BOND INVESTORS IN THIS ENVIRONMENT 99Active over passive. Given the growth of global fixed income markets and the increasing dispersion across sectors, combined with the eroded yield cushion on traditional fixed income benchmarks, it is even more important to employ an active approach that allows managers to shift portfolio positioning in response to changing market conditions. 99Solutions, not benchmarks. Without yield, benchmark returns are no longer guaranteed. Instead, we believe starting with the end result the solution you re looking for is the most productive method for achieving your objective. 9 9 Risk vs. return. While product innovation can help solve the dilemmas that investors face in an extended low yield environment, it does not come without risks. Investors must weigh the potential returns of their investments with the associated risks involved, and be careful not to layer on the same risk in different vehicles. J.P. MORGAN ASSET MANAGEMENT 7

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