for institutional use only not for public distribution fixed income dynamics: understanding the...

FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION

Fixed Income dynamics: Understanding the world’s debt markets

J.P. Morgan Investment Academy


Understanding the importance of fixed income securities in a portfolio

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Two of every three invested dollars are held in the global fixed income markets

Portfolio

Capital preservation

Income

Diversification

Opportunity


Reviewing the fixed income landscape

U.S. Treasury securities

U.S. Treasury Inflation Protected Securities (TIPs)

Build America bonds

Zero Coupon bonds

Municipal bonds

Corporate bonds – U.S. and foreign

Sovereign bonds– Bonds issued by foreign governments

High Yield bonds – U.S. and foreign

Fixed rate capital securities

Certificates of deposit – U.S. and foreign

Mortgage-Backed Securities (MBS)

Commercial paper

Fixed income derivatives, including:– Collateralized mortgage obligations (CMOs)

– Structured notes

– Forwards

– Futures (e.g., Treasury bond, Treasury bill and Eurodollar futures)

– Options (typically an option on interest rates)

– Swaps

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While fixed income includes many instruments, these are the major categories.


Appreciating the appeal of fixed income

BOND: Represents a loan from a bondholder to the bond issuer. The bond is essentially an “IOU note” from the issuer.

COUPON: The interest rate stated on a bond when it is issued.

PRINCIPAL: Original amount invested; the face value.

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Investors prefer bonds because of the predictability of their value and income stream.

A bond’s price may go up or down in value, but the maturity price is known, i.e. par (100). Most bonds have stated coupon rates and pay fixed payments semi-annually. Floating rate notes have coupons that are tied to an index and pay more frequently (monthly, quarterly), while zeros pay at maturity.

Predictable future value

At issue

120

110

100

90

80

Predictable income stream

At maturity


Premium

Discount

Buying at a premium versus at a discount

BUYING AT A PREMIUM: The investor is paying more than a bond’s face value.

BUYING AT A DISCOUNT: The investor is paying less than a bond’s face value.

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Bond prices fluctuate with market conditions when traded on the secondary market.

Par(face value)

110

100

90

Bond value


Understanding bond yields

YIELD: the percentage of income obtained from an investment (interest or dividend) relative to the value of the investment.

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It is important to remember that when interest rates rise, bond prices fall.

=

Inverse relationship of yield and price.

Interest rates

Bond prices

$

%

Yield annual income current price/


Factoring in maturity and average life

MATURITY DATE: The date on which an investor’s principal amount will be repaid, along with the final interest payment.

YEARS TO MATURITY: The number of years left until maturity.

AVERAGE LIFE: Similar to maturity, but factors in prepayment speed and interest rate resets.

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Bonds with the longest maturities tend to fluctuate the most with interest rate changes.

Interest rates

Bond prices

$

%

Short-term1 – 3 yrs.

Inter-term3 – 10 yrs.

Long-term10+ yrs.


Reading an original bond certificate

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Though obsolete today, these highly decorative certificates included vital investor information.

MaturityCouponPar Value Issuer


Evaluating multiple bonds

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To help simplify your bond comparisons, there are several types of yield for mutual funds.

30-day SEC yield 12-month yield OR dividend/distribution yield

DefinitionYield snapshot based upon the 30-day period ending on the last day of the previous month

12-month yield: Yield based upon the fund’s dividends paid in the most recent 12 months

Dividend/distribution yield: Annualized yield based upon the most recent dividend payment

Bottom line Future interest rate earnedHistorical past payments, distribution yield can be skewed because of large one time payments


Using quality ratings to compare credit risk

Standard & Poor’s, Moody’s and Fitch rate bonds on multiple factors:– Economy

– Finances

– Debt

– Management

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A bond’s quality rating is based on the strength of the issuer’s financial condition and ability to repay the investor.

Standard & Poor’s Moody’s Fitch

Investment grade

Highest quality AAA Aaa AAA

Very high quality AA Aa AA

High quality A A A

Medium quality BBB Baa BBB

Below investment grade

Predominantly speculative BB Ba BB

Speculative, low grade B B B

Poor to default CCC Caa CCC

Highest speculation CC Ca CC

Lowest quality, not paying interest C C C

In default, in arrears (interest payments have not been made), or of questionable value

D DDD

DD

D

Not rated NR


Measuring sensitivity to interest rate change

Calculated in years, duration is a measure of a bond price’s sensitivity to a 1.00% change in interest rates.

When interest rates change, bond prices change (rates increase, price decrease).

Bonds with higher duration have more price volatility and will cause larger swings in portfolio valuation.

Example: A bond with a duration of 4 years means that for a 1% increase in interest rates, the bond price will fall by 4%.

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Duration is an important measurement when assessing a bond’s overall risk.

Bond duration Bond duration volatility

1 – 4 years Short; conservative

4 – 7 years Intermediate; moderate

7+ years Long; aggressive


Assessing the impact of change

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Rising or falling interest rates can significantly affect bond prices.


Anticipating future interest rates

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Currently at historic lows, interest rates are projected to rise over the next two years.


Using the Morningstar style box to view bonds

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Bonds with the highest quality and lowest risk are represented in the upper left quadrant.

Safest

Highest Risk

ShortLimited

IntermediateModerate

LongExtensive

Maturity/interest rate sensitivity

High:AAA - AA

Medium:A - BBB

Low:BB - C

Quality


Looking beyond the U.S. markets

Greater opportunity set

More efficient portfolio diversification

Potential for greater risk-adjusted returns

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Source: Citigroup Non-USD World Government Bond Index, U.S. component of Citigroup World Government Bond Index.; TheCityUK Financial Markets Report, Oct. 2012

The global bond markets are vast and growing, and offer significantly more choices than the stock market.

Internationally issued bonds have grown from 48% to 71% of the total fixed income market.

Foreign

, 71%

United

States;

29%

Foreign, 48%United States; 52%

20121985


Understanding investment risks

Interest rate risk

Credit, or default risk

Reinvestment risk

Currency risk (for foreign bonds)

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Every investment has inherent risks — these are the most important to consider.


Diversifying to minimize risk

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Active, global investing provides a much larger universe of countries, sectors and issuers from which to generate returns and improve diversification.


Summary

A bond is an “IOU Note” from the issuer.

Bonds have an inverse relationship with interest rates. When Interest rates rise, bond prices fall; conversely, when interest rates fall, bond prices go up.

Bonds offer investors a predictable income stream and the potential for appreciation.

Investor considerations:– Who is the issuer? Where is the issuer domiciled?

– What is the quality of the bond and the financial health of the issuer?

– What is the coupon rate? What is the issuer willing to pay me for this loan?

– What does it cost? Are you buying a new issue at par, paying a premium in the secondary market or buying the bond at a discount?

– When does it mature? Is it callable?

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Thank you

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Disclosure

The above commentary is intended solely to report on various investment views held by J.P. Morgan Asset Management. 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. The views and strategies described may not be suitable for all investors. 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. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

© J.P. Morgan Chase & Co., July 2013

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