Ii absolute return_fixed_income_outlook

ABSOLUTE RETURN FIXED INCOME OUTLOOK 2013

Scaling the cliffs using beta tailwinds, alpha ladders and hedge safety nets

FOR PROFESSIONAL CLIENTS ONLY | NOT FOR RETAIL USE OR DISTRIBUTION

INVESTMENTINSIGHTS

January 2013

OUTLOOK & OPPORTUNITIES

PLEASE VISIT

www.jpmam.com/insight for access to all of our Insights publications.

AUTHOR

Bill EigenHead of the Absolute Return and Opportunistic Fixed Income Group

The opportunity for traditional bond investors continues to shrink as rate markets run out of steam and the price appreciation portion of core bond returns approaches zero. Going forward, with virtually no price appreciation left, returns from core bonds may start to resemble their sub-2% coupon.

EXHIBIT 1: PRICE APPRECIATION OF CORE BOND RETURNS 1976 - 2012

0%

2%

4%

6%

8%

10%

12%

14%

16%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

Index coupon return (LHS) Index price return (LHS) Ten-year treasury yield (RHS)

1976 1980 1984 1988 1992 1996 2000 2004 2008 2012

Retu

rn Yield

Source: Barclays, as at 31 December 2012

• Hedging portfolios against continued market volatility, driven largely by policymakers’ rhetoric, will sustain itself as one of the main areas of focus for prudent, flexible investors.

• While staying defensive is important, one should not rule out the possibility of a risk to the upside, as 2012 proved an inflection point for some important economic indicators.

IN BRIEF• 2012 was kind to fixed income investors who benefited from declining rates and

tightening spreads.

• As rate and credit betas become increasingly exhausted, investors will have to mute their expectations for future fixed income returns.

• As broad market-wide beta opportunities recede, fixed income investing success will hinge more on managers’ ability to rotate out of systematic, beta-oriented positions into more idiosyncratic, alpha-oriented opportunities.

2 | Absolute return fixed income outlook 2013

INVESTMENTINSIGHTS Scaling the cliffs using beta tailwinds, alpha ladders and hedge safety nets

Recap of 2012: Policymaker experimentation breeds complacency

When the world faced a financial crisis of multigenerational proportions several years ago, most investors supported the deposit guarantees, bank bailouts and the many other extraordinary measures undertaken to try to contain it. Those investors, however, probably would have been incredulous at the time had a forecaster insisted that, not only would these policies still be in place four years later, but that the pace (and cost) of policymaker experimentation would have hardly slackened since the crisis (Exhibit 2).

Securities markets have reacted positively to these unconventional measures during the past year, even though many questions remain as to how the programmes will be unwound, and even though they largely sidestep the underlying structural reforms necessary to ensure long-term stability and growth. Continuous policymaker tinkering gives rise to investor complacency. Investors believe, for instance, that a risk market sell-off will be met with monetary easing designed to re-inflate asset prices. Likewise, they believe that central banks, particularly the US Federal Reserve (the Fed), want rates to remain low for a long time. That is an incomplete understanding of their intentions, however. In the case of the US, what the Fed really wants is employment growth; and progress toward that goal implies higher rates eventually (Exhibit 3).

EXHIBIT 3: BOTH THE SUCCESS AND THE FAILURE OF FED POLICY IMPLY HIGHER RATES

Fed Growth Rates . . .Successful Accelerates . . . rise to offset inflation risk

Unsuccessful Stagnates . . . rise as the yield curve steepens in response to the longer-term fiscal implications of an economy with slower than expected growth potential

In fact, starting this year, the Fed board members and regional bank presidents are publishing their own projections, which not only show that they expect rates to rise, but that they expect them to rise faster than the futures market is currently forecasting (Exhibit 4).

EXHIBIT 4: FED BOARD MEMBERS’ PUBLISHED RATE FORECASTS (SIMPLE AVERAGE OF 19 PARTICIPANTS SURVEYED)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Dec-08 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

Historical Fed Funds market forecast Forward-looking Fed Funds market forecast

xx

x

x

Fed governors projections(as at September 2012)

The Fed expects rates to rise faster than the futures market is predicting

(Per

cent

age,

%)

Source: Bloomberg, Federal Reserve, as at 31 December 2012

EXHIBIT 2: NOTABLE POST-CRISIS POLICY EXPERIMENTS

2010 2011 2012

J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D

QE2: USD 600 billion of monetary stimulus announced by the Fed in November 2010

Twist: Fed program initiated in September 2011 to sell short-term

Treasuries and buy longer-term Treasuries in order to flatten the

yield curve.

QEternity: Fed program to purhase Agency MBS securities without

specifying an end date.

Twist halts; Fed continues to buy long-term Treasuries but without

selling short-term Treasuries.

Securities Market Program (SMP): the ECB’s first attempt

to provide liquidity to dysfunctional markets by

purchasing bonds of troubled European sovereigns.

European Financial Stability Fund (EFSF): lending

and guarantee facility established with EUR 440 billion in funding capacity

EFSF increased to EUR 780European Stability Mechanism (ESM):

policies established as a successor to the EFSF

Outright Monetary Transaction (OMT”): ECB purchases of Eurozone

member bonds

Source: J.P. Morgan Asset Management

J.P. Morgan Asset Management | 3

Policymakers believe their intervention will work. Although the market reflects some scepticism, risk assets generally rally in response to policy action, and this positive feedback provides a basis for policymakers to justify continued activity. The chart in Exhibit 5 shows that pattern. Policymakers take steps to relieve short-term market stress until investor confidence returns. An unforeseen event reminds investors of the rationale for their prior fears, which triggers further policy action, and the cycle repeats. The cumulative result of this behaviour has been an explosion in the size of the Fed’s balance sheet (Exhibit 6).

Policymakers reliably rescue investors, resulting in complacency

EXHIBIT 5: CITIGROUP ECONOMIC SURPRISE INDEX

-200

-150

-100

-50

0

50

100

150

Dec-09 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

Euphoria

Shock, despair Reflate (QE2)

Euphoria

Shock, despair Reflate (Twist)

Euphoria

Shock, despair Reflate (Twist2)

Euphoria

Source: Bloomberg, J.P. Morgan Asset Management as at 31 December 2012

EXHIBIT 6: TOTAL FED BALANCE SHEET

0

1

2

3

2007 2008 2009 2010 2011 2012

Trill

ions

of d

olla

rs

Source: Bloomberg as at 31 December 2012

This unfailing pattern of bailouts by policy action inevitably creates investor complacency. Investor conviction that rate risk and spread risk have departed the market has created an unrelenting rush into rate and ‘safe spread’ investment products, such as investment grade bonds and the upper tiers of high yield and emerging market debt.

As a result of this complacency, yield-hungry investors have bid up the price of fixed income instruments, in many cases substantially above par. For example, the average price of the Barclays Corporate Index stood at around USD 113 at the end of 2012 (Exhibit 7). Investors should be realistic about the prospects for further price appreciation from here.

Investor complacency has pushed up the price of risk assets, pushing yields towards all time lows. EXHIBIT 7: BARCLAYS US CORPORATE CREDIT INDEX

2

4

6

8

10

80

88

96

104

112

120

2009 2010 2011 2012

Barclays US Corporate - YTMBarclays US Corporate - Price

Aver

age

pric

e (U

SD) Yield to m

aturity (%)

Source: Barclays, as at 31 December 2012

While the book has yet to be written on the unprecedented monetary policy, investors are running out of options for acceptable returns in fixed income. When we look back at the most lucrative opportunities of 2012 they emanated from not fighting the Fed and riding out the rate and credit rallies, as well as capitalising on a housing bottom. Now that these beta calls have largely run their course, investors must come to terms with future returns that are both more muted and more challenging to find than they have been in a generation (please refer to Exhibit 1 again).

Having laid out some of the characteristics of the current economic environment, allow us to take a quick detour to look at the merits and relevancy of absolute return investing, before proceeding to our market views for 2013. We see those two topics as closely linked for reasons outlined below.

The relevance of absolute return investing in 2013

As simply allowing rate and credit markets to carry a strategy is becoming less and less reliable, an absolute-return-oriented investment process can transition to more alpha-oriented sources, as well as beta opportunities outside of traditional markets – in alternatives and even private markets.



Our portfolio construction process involves differentiating between sources of expected return. We categorise returns in terms of beta, alpha and hedges.

• Beta is the return we expect to earn by choosing the sectors within fixed income where we expect to see a broad-based move. Beta returns involve relying on a market to ‘carry’ a strategy. For example relying on the multi-decade rate rally to generate returns in fixed income has been a fortuitous source of beta return for traditional fixed income investors. In our portfolios, the high yield sector over the past year was a powerful driver of beta returns, as spreads tightened. Non-Agency mortgage-backed securities (MBS) is another sector whose beta we saw as attractive coming into 2012 given expectations of a housing bottom.

• Alpha strategies are those that do not rely on the broad-based behaviour of a sector. They are specific, carefully tailored trades, intended to work regardless of market directionality. For instance, we may observe two retailers that are fairly similar and ought to be valued similarly, but that are trading at very different price levels. This can give rise to a pair trade opportunity in which we establish a long position in the undervalued company and a short position in the overvalued company. Because one position is long and the other is short, a dramatic beta move that affects the entire subsector will be effectively canceled. Instead, as the valuations of the positions normalise and the trading patterns converge, we capture the return from the idiosyncratic nature of the trade. This type of long/short opportunity is not limited to the corporate sector, but may also arise in the securitised or rate markets, as well as among different sectors of the fixed income market. For example: US high yield versus euro high yield, sovereigns versus financials, etc.

• Hedging is something that we approach on a systematic basis. As an absolute return focused investor we are not content with positioning portfolios for a base case scenario only. We are in relentless pursuit of hedges against a variety of tail risks to that base case. In general, these positions are liquid and cheap to carry. We expect them to have a modest cost in an unchanged rising market, but produce meaningful gains in a sudden market shock.

As rate and credit beta opportunities continue to decline, we see alpha emerging as the more viable source of return, and therefore a more pronounced area of focus for us as investors heading into 2013. As we stated at the outset, hedging continues to be crucial as policy uncertainty remains.

Analysing the macro backdrop: Beta in the US

The macro environment, while providing plenty of challenges, leads us to be more constructive on the US. Therefore, broadly speaking, the beta part of our portfolio is US credit-based. The next few paragraphs outline some of the main reasons for this.

As we discussed above, 2012 and the prior years since the financial crisis have been consumed by monetary policy manoeuvres. As we enter 2013, the focus is clearly shifting to fiscal policy. Though no ‘grand bargain’ was achieved when Congress opted for a last minute budget deal around the pending fiscal cliff, we see this as symptomatic of the way our policymakers will tackle the long-term deficit – via a number of smaller bills. In spite of the fact that the process could be long and at times quite painful, we believe this transition is healthy. We do, however, advocate for identifying hedges to dampen the market volatility that can result from various stages in the long resolution process. (More on that in the hedging section.)

Fiscal and monetary policy have impacted the housing sector through mortgage refinancing programmes, outright MBS purchases, foreclosure abeyance initiatives and a variety of other activities. Improving home prices have been an important contributor to economic growth in recent quarters. Furthermore, as people exit unemployment and get new jobs, they quickly choose to stop cohabiting with family members and form households of their own. Household formation involves a tremendous number of goods and services, from cable TV subscriptions and landscaping to new furniture and paint. As these service and retail businesses add to staffing to satisfy the new demand, they create even more prospective homeowners. Thus strength in housing and strength in labour markets are interconnected and self-reinforcing.

We are also seeing other evidence of a more confident US consumer, which is crucial to growth prospects in the US. Whereas Japan’s lost decade was triggered by the reversal of a corporate debt bubble, and the current weakness in Europe is rooted in a long-running expansion of government borrowing, the US financial crisis was driven by strained balance sheets at the individual household level. Much of the household leverage has unwound since the crisis, and consumers are thus starting to moderate their tendency to save in favour of spending some of their growing incomes (Exhibit 8).


A growing willingness to spend among consumers could boost growth in 2013EXHIBIT 8: US CONSUMER SPENDING

0

1

2

3

4

5

6

7

8

9

1.00

1.02

1.04

1.06

1.08

1.10

1.12

1.14

1.16

2008 2009 2010 2011 2012 Savings Rate (%

)

Pers

onal

Inco

me

Inde

x (S

tart

s at

1)

Personal income Savings rate as % of personal income

Source: Bloomberg as at 30 November 2012

A re-leveraging consumer could dramatically boost the velocity of money in the US, an important economic health indicator that has been largely overlooked by investors. Slower and slower money has been a major headwind since the financial crisis (Exhibit 9). We believe this trend may be approaching a bottom. As employment prospects and asset prices show signs of life, growth in consumer willingness to spend should follow. A coinciding acceleration in the velocity of money would create a multiplier effect that even further boosts the consumer’s contribution to a virtuous cycle of economic growth.

An uptick in the velocity of money could be a powerful accelerant to growthEXHIBIT 9: VELOCITY OF MONEY

1.5

1.6

1.7

1.8

1.9

2.0

2.1

2000 2002 2004 2006 2008 2010 2012

Ratio

of q

uart

erly

GDP

to M

2 m

oney

sup

ply

The velocity of money is the number of times a dollar is recycled into new goods and services during a particular period of time. If a farmer fixes his tractor, and the mechanic uses his fee to buy some bread, and the baker buys a watch, the same dollar has been used in three transactions. Any one of the three participants could have instead decided to postpone a transaction and leave the money in the bank, slowing the velocity of money. The index is the ratio of quarterly GDP to M2 money supply, ie, the number of times a dollar is recycled in three months on average.

Source: Bloomberg as at 30 September 2012

The corporate sector continues to have ample cash reserves (Exhibit 10). If consumption rises, it is clear that companies have the resources to increase capacity through business investment and satisfy the new demand. Corporate capital expenditures since the financial crisis have remained depressed longer than many observers expected (Exhibit 11). Capacity utilisation levels (Exhibit 12) indicate these expenditures could materialise soon, and when they do, they may have a sizable impact on growth.

Reported S&P 500 corporate current assets remain at record levels, so corporates have the financial wherewithal to expandEXHIBIT 10: S&P 500 CORPORATE ASSETS

200

250

300

350

400

450

500

2000 2003 2005 2007 2009 2011

(USD

Bill

ions

)


Little growth in non-defence capital goods new orders suggests that corporate fixed capital is aging

EXHIBIT 11: CAPITAL GOODS NEW ORDERS INDEX

30

40

50

60

70

80

90

100

2006 2007 2008 2009 2010 2011 2012

(USD

Bill

ions

)

Source: US Census Bureau via Bloomberg as at 30 November 2012



With capacity utilisation approaching peak levels, the trigger point for a capital refresh / expansion may be sooner rather than laterEXHIBIT 12: US CAPACITY UTILISATION % OF TOTAL CAPACITY SA INDEX

2009 2010 2011 2012

60

65

70

75

80

85

(Per

cent

age,

%)

Source: Federal Reserve via Bloomberg as at 31 December 2012

Credit: Beta ages gracefully

Credit returns, whether investment grade or high yield, have been significant in 2012, and are not likely to remain as robust going forward. The return prospects from here are more on the side of clipping a coupon, and much less on price appreciation. We have reduced our high yield exposure as the market has rallied, but continue to like elements of the high yield sector from a risk-adjusted return standpoint. We do not have much enthusiasm for generic investment grade credit (though there are select exceptions), given the inherent interest rate risk here in the absence of substantial coupon to offset an even very modest move up in rates.

Much of the rationale for our preference for high yield during the last several years still remains well-supported by fundamentals:

• Companies have taken advantage of the low rate environment to refinance debt and extend maturities, reducing the likelihood of a default wave in the near or medium term (Exhibit 13).

• The trailing 12-month high yield par-weighted default rate of 1.14% (as at 31 December 2012) still remains well below the long-term average of 4.1% .

• Default-adjusted spreads remain attractive for most reasonable default scenarios (Exhibit 14).

As a result of refinancing, there is a limited amount of debt maturing in the next few years at risk of default.EXHIBIT 13: HIGH YIELD BONDS DUE TO MATURE AT THE START OF 2009 (LEFT PANEL) AND AS OF THE FOURTH QUARTER OF 2012 (RIGHT PANEL).

0

100

200

300

400

500

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

or

late

r

USD

billi

ons

0

100

200

300

400

500

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

or

late

r

USD

billi

ons

Source: J.P. Morgan Investment Bank, Markit as at 12 October 2012


EXHIBIT 16: AS ASSETS HAVE COME INTO HIGH YIELD FUNDS, THEY HAVE SHIFTED OUT OF LOWER QUALITY INTO HIGHER QUALITY ISSUANCE

28

30

32

34

30.6

2011 2012

29.6

32.4

33.4

35.0

34.2 34.0

BB and above rated

Cred

it qu

ality

bre

akdo

wn

(%)

36

62

64

66

67.2

2011 2012

67.9

65.0

63.9

62.3

63.3 63.1

B and below rated

68

Source: Morningstar as at 30 September 2012

EXHIBIT 14: DEFAULT ADJUSTED EXCESS SPREAD OF THE HIGH YIELD SECTOR UNDER VARIOUS DEFAULT RATE/RECOVERY ASSUMPTIONS (LONG-TERM ASSUMED RANGE SHADED)

Recovery rates

25% 30% 35% 40%

Annu

al d

efau

lt ra

te

2% 150 140 130 120

3% 225 210 195 180

4% 300 280 260 240

5% 375 350 325 300

6% 450 420 390 360

7% 525 490 455 420

8% 600 560 520 480

9% 675 630 585 540

Source: J.P. Morgan Asset Management; JPMorgan Global High Yield Index as at 31 December 2012

• Corporate behaviour continues to be fairly conservative. We have seen very few of the merger and acquisition (M&A) deals or leveraged buyouts (LBOs) that signal a more aggressive stance among company managers.

• Although there has been much talk lately of the debt issuances being used to fund shareholder dividends, leverage remains moderate on the whole (Exhibit 15).

EXHIBIT 15: LEVERAGE REMAINS AT MODERATE LEVELS

3.0x

3.2x

3.4x

3.6x

3.8x

4.0x

4.2x

4.4x

4.6x

4.8x

5.0x

1Q0

8

2Q0

8

3Q0

8

4Q

08

1Q0

9

2Q0

9

3Q0

9

4Q

09

1Q10

2Q10

3Q10

4Q

10

1Q11

2Q11

3Q11

4Q

11

1Q12

2Q12

3Q12

E

Leve

rage

(tra

iling

12-

mon

th d

ebt/

EBIT

DA)

Source: JPMorgan, Capital IQ as at 12 November 2012. Note: includes debt-weighted metrics for 291 high yield companies – financials and utilities excluded

• Technicals have also been supportive of this market, as investors have sought out yield, and we expect this trend to continue. We note that our high yield allocation has a down in quality bias, which we believe has not yet reaped all the benefits of flows that higher quality high yield has seen.



Tighter valuations and a fragile global economy certainly pose risks. We note, however, that cycles of corporate default are generally not triggered by panics in the financial sector. Rather, they coincide more frequently with traditional recessions. A typical inventory correction-driven recession in the US is unlikely in the near-to-medium term.

Securitised beta: Favours from a friendly Fed

Mortgage refinancing is a popular policy measure because, by reducing the mortgage rate and thus the homeowner’s monthly payment, it puts more dollars in the homeowner’s pocket every month, which can then be spent on higher rates of consumption.

The Fed’s extension of quantitative easing activities into the MBS market already represents a dramatic step to boost refinancing, but the pace of such activity has disappointed policymakers. One reason is that the Fed’s MBS purchases act to reduce secondary mortgage rates, meaning the rate at which banks can sell mortgages into the MBS market and finance subsequent lending. Although this has impacted the rate banks charge to the actual homeowner (the primary rate), the spread between these two rates has widened, and is now near its widest levels in recent history (Exhibit 17).

EXHIBIT 17: SPREAD BETWEEN PRIMARY AND SECONDARY MORTGAGE RATES NEAR AN ALL-TIME HIGH

-50

0

50

100

150

200

1998 2000 2002 2004 2006 2008 2010 2012

bps


Banks face higher costs when originating new loans than they did pre-crisis, and these costs clearly contribute to wider primary/secondary spreads. Higher government guarantee fees are being imposed on mortgage bonds, and these fees are paid by the banks and passed along to borrowers. Mortgages that are packaged by banks into government guaranteed bonds can also be put back to the banks under certain circumstances; the government has been more active in exercising this option since

the crisis, and this so-called put-back risk is also being priced-in by the banks and paid indirectly by borrowers.

The above may eventually provide for some interesting relative value trades in the sector. In the meantime, it has continued to be largely dominated by rate risk. Therefore, from a systematic risk standpoint, our preference has been for non-agency residential MBS. This space continues to benefit from improving credit fundamentals. Increasing home prices will continue to support the market, while shadow inventory has steadily decreased. However, we expect to further reduce this position in 2013, as increasing demand for a finite pool of assets has made valuations less attractive in our view.

Commercial mortgage-backed securities (CMBS) is another sector where we see select opportunities, though not unlike other spread sectors, much of the spread compression has occurred here and investors will have to accept far less returns in the future. The asset class has benefited from a number of strong supportive technicals, including negative net supply as 2012 was the fifth consecutive year of declining market share. 2013 is expected to be more robust with issuance estimated at USD 45 - 60 billion (+50%). We expect spreads to tighten modestly at the top of the capital stack, as investors continue to grab for yield and invest further down in credit.

Overall the opportunity in CMBS for 2013 is predicated on careful security selection as the pace of commercial real estate improvements is very much dependent on property types and location. For example, multi-family is by far the strongest of the sectors and has evidenced a continued decline in vacancy rates and modest rent growth. On contrast, retail continues to be weak, except for dominant regional malls, driven by lukewarm consumer spending, weakened retailer balance sheets and an abundance of retail store spaces. Between the two ends of the spectrum are office, industrial and hotel sectors, which have seen very modest improvement and are likely to stay that way with the possibility of slight weakening in 2013.

Overall, we see value in mezzanine bonds and mezzanine investments on single asset or crossed pool portfolios where we can employ our whole loan underwriting process to fully analyse the underlying real estate and the legal structure of the security. (More on that in the Alpha section below.)

Alpha: Methodically ascending the ladder

As we stated at the onset, this is an area of much focus as we move into 2013. The opportunities here are not limited to credit, though it certainly provides quite an expansive playing field given


the depth of that market. These trades are intended to work even if the beta momentum reverses and the credit market weakens. We have seen more volatility in the credit markets since the crisis (Exhibit 18). More volatile markets tend to be more susceptible to mispricings and thus tend to offer tactical trading opportunities more frequently.

EXHIBIT 18: STANDARD DEVIATION OF MONTHLY RETURNS IN THE HIGH YIELD CASH AND SYNTHETIC MARKETS

Barclays high yield(cash market benchmark)

High yield CDX(synthetic market

benchmark)

Pre-crisis, Sept 2005 to Dec 2007

1.32% 2.03%

Post-crisis, Jan 2009 to Nov 2012

2.87% 3.63%

Source: Barclays as at 31 December 2012

Volatility allows patient investors with liquidity at the ready to be compensated for providing that liquidity to an irrational market. The synthetic market allows us to carefully tailor exposure. For instance, credit default swaps allow us to isolate a particular company’s default risk from the rate and spread risk present in the same company’s bonds. Credit default swaps (CDS) also allow us to specify the timeline of the exposure. Whereas a company may only have ten-year bonds outstanding, a variety of credit swap tenures will trade actively, and it is thus possible to shorten a credit exposure to the company from ten years to five years or even just a few months.

EXHIBIT 19: VOLATILITY IN CREDIT MARKETS CREATES ALPHA TRADING OPPORTUNITIES

50

300

550

2010 2011 2012

Safeway 5 year CDS

Kroger 5 year CDS

Trades designed tobenefit as this spreadcompresses

CDS

spre

ad (b

ps)


The above example illustrates a credit relative value trade in the portfolio (Exhibit 19). A long position in five-year Safeway CDS is paired with a short position in Kroger five-year CDS. Because

they are both in the grocery industry, any shift in market risk appetite should be neutralised, and because they are matched-maturity credit default swaps, they should move independently from the rates market or changes in credit curves. The trade is designed to benefit from a return to the relationship between Kroger and Safeway that persisted for more than two years before rumours of a Safeway LBO created a panic among Safeway creditors. These fears have abated somewhat already since we entered the position, and should continue to decline, as an LBO is unlikely given current Safeway valuations. As these fears subside, the relationship between the two credit default swap spreads should compress and generate alpha returns for the strategy. We can scale out of the position as the relationship returns to normal.

As policymakers continue to use the housing market as a lever of economic stimulus, the securitised market will present a number of alpha opportunities. On the one hand, investors are fearful that policymaker focus on residential mortgage refinancing means that mortgage securities bear a heightened risk of cashflow curtailment. On the other hand, they are desperate for yield in a low interest rate environment. Derivatives offer a means to benefit from a close analysis of these competing forces.

EXHIBIT 20: COMPARISON OF LOW-LOAN BALANCE SECURITIES TO THE BROADER COHORT OF MBS, AND TO A PARTICULAR INVERSE INTEREST-ONLY MORTGAGE DERIVATIVE BOND IN OUR PORTFOLIO.

0

5

10

15

20

25

30

35

40

45

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Mortgage cohort LLB cohort Portfolio bond

Source: J.P. Morgan Asset Management as at 18 January 2013

The top line in the chart shown in Exhibit 20 represents the pace of refinancing for a broad cohort of mortgages originated in 2006 and 2007 with 6% or 7% coupons. As these mortgages refinance, the cashflow of the associated mortgage securities is curtailed. We have focused on finding securities that are protected from this curtailment. So-called ‘low loan balance’ (LLB) mortgages, for instance, offer such protection. Because these mortgages have already nearly been repaid, the homeowners have very little incentive to pay the up-front costs



required to refinance into a lower-rate mortgage. Careful security selection can identify LLBs that pay even slower than the average LLB – we have depicted in the chart above such a security from our portfolio.

As investors have become more and more desperate for yield during the past year, prices on LLB bonds have rallied strongly. Because our portfolio bond has been prepaying slowly, we have benefited both from the slow curtailment of our interest cash flows as well as from the rally in prices. Investors are aware that the Fed is buying MBS, and thus will continue to trade in this market actively. Given this favourable technical backdrop and the market’s breadth and depth of the market, we believe mortgages and mortgage derivatives will continue to offer attractive alpha opportunities.

Hedges: Finding shelter in the brightest stars

As fixed income markets become scarcer in opportunities and more plentiful in risks, we see hedging as an indispensable part of investing in 2013. There are plenty of macro risks to hedge against, catalysts that may spark a dramatic risk-off shock to the market. Prominent among them is the remote likelihood of Washington’s ability to arrive at any sort of grand bargain. Instead, as we mentioned earlier, the tackling of the US long-term deficit will likely be turbulent and punctuated by a series of smaller deals.

The worst case scenario of a fiscal shock leading to a recession was avoided, but a significant source of downside risk remains. Budget sequestration was postponed for two months, which coincides with the US Treasury reaching its limit under the current debt ceiling. The deal that was recently agreed upon focuses heavily on revenue generation, so expect the Republican party to focus the debt ceiling negotiations on substantial spending cuts.

Most of the other downside risks we are mindful of, whether in the US or abroad, are also related to politics and policymakers’ rhetoric. While it is difficult to ‘trade’ politics, the reigning euphoria/complacency provides attractive hedging opportunities. We are approaching tights in credit indices, which we feel offer asymmetric risk/reward to be long protection in the event of debt ceiling or other macro-driven volatility.

An example of such a hedge, and one that inevitably raises eyebrows, is shorting a basket of emerging debt sovereigns. An important trend in recent years has been the economic progress of emerging market countries. In line with this trend, the emerging market debt (EMD) indices trade at very tight levels to developed market debt relative to their past history (Exhibit 21).

We agree, of course, that the emerging markets hold great promise over the long term, and we see merit in the argument that many emerging market countries have handled their

Recent CDS levels (left panel) suggest that emerging markets trade in a fairly stable relationship to developed markets. However, the financial crisis revealed that they are much more predisposed to panic (right level).EXHIBIT 21: EMERGING MARKET VERSUS DEVELOPED MARKET CREDIT DEFAULT SWAP LEVELS

0

200

400

600

800

1000

1200

2010 2011 2012

Emerging market CDS Developed market CDS

Emerging market CDS Developed market CDS

0

200

400

600

800

1000

1200

2008 2009

Source: Bloomberg as at 31 December 2012. Note: developed market CDS data series is the simple average of United States, German, and UK CDS


finances better in recent years than some of their developed market counterparts. We have no doubt, however, that a global macroeconomic downturn, or even a short-term macro-related market shock, would impact the emerging markets severely. In the first scenario consumption in developed markets, which drives the export-led economies of the emerging market, would falter. In the second – technicals would turn negative quickly as investors who were in EMD for the sake of chasing yield and had lacked a deep understanding of these countries would flee those markets on risk-aversion and need for liquidity.

Yet when we examine EMD spread levels they seem to imply that such an event is impossible, even though it has happened routinely every few years for the last several decades. The overconfidence of the market in the EM story translates into a cheap hedge.

Finally, cash remains our largest, cheapest and most efficient hedge. We will continue to maintain that buffer in the context of continued macro-dictated market volatility. In addition, with all of the complacency we have seen in fixed income markets, cash allows investors to get long volatility, and become a liquidity provider in times of stress.

A portfolio fit to weather any forecast

The last several years have witnessed numerous reversals of fortune, and we believe 2013 will extend this pattern. As a result, we remain long volatility across our platform. We see significant opportunities to benefit if investors become skittish, either due to the renewed debt ceiling debate, continued tumult in Europe, a slowdown in China or one of a host of other potential, largely political, threats. We are able to remain patient due to our healthy cash reserves which allow us to act as a liquidity provider when heightened risk aversion causes investors to unload assets at cheap prices.

While these trends in market beta evolve, we continue to pursue alpha trades actively. By acquiring investments with attractive price, carry, convexity and risk characteristics, we position the portfolio to continue to generate returns as traditional fixed income managers squeeze the remaining benefits of long-only spread and long-only rate exposure out of the instruments they trade. In addition to our beta and alpha positions, we continue to actively hedge the portfolio, knowing that market shocks are periodic, and the background of unprecedented policymaker experimentation and global financial imbalances could trigger such a shock at any time.

We continue to advocate an approach that is flexible and diversifies an investor’s risk by allocating exposure to a variety of risk factors, rather than wholly relying on policymakers to deliver adequate future risk-adjusted and inflation-adjusted returns.


FOR PROFESSIONAL CLIENTS ONLY | NOT FOR RETAIL USE OR DISTRIBUTION.This document has been produced for information purposes only and as such the views contained herein are not to be taken as an advice or recommendation to buy or sell any investment or interest thereto. Reliance upon information in this material is at the sole discretion of the reader. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily reflect the views of J.P. Morgan Asset Management. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. Both past performance and yield may not be a reliable guide to future performance and you should be aware that the value of securities and any income arising from them may fluctuate in accordance with market conditions. There is no guarantee that any forecast made will come to pass.

J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase & Co and its affiliates worldwide. You should note that if you contact J.P. Morgan Asset Management by telephone those lines may be recorded and monitored for legal, security and training purposes. You should also take note that information and data from communications with you will be collected, stored and processed by J.P. Morgan Asset Management in accordance with the EMEA Privacy Policy which can be accessed through the following website http://www.jpmorgan.com/pages/privacy.

Issued in Continental Europe by JPMorgan Asset Management (Europe) Société à responsabilité limitée, European Bank & Business Centre, 6 route de Trèves, L-2633 Senningerberg, Grand Duchy of Luxembourg, R.C.S. Luxembourg B27900, corporate capital EUR 10.000.000.

Issued in the UK by JPMorgan Asset Management (UK) Limited which is authorised and regulated by the Financial Services Authority. Registered in England No. 01161446. Registered address: 25 Bank St, Canary Wharf, London E14 5JP, United Kingdom.

LV–JPM5676 | 01/13

To learn more about the Investment Insights programme, please visit us at www.jpmam.com/insight

Documents

Ii absolute return_fixed_income_outlook