FIXED INCOME IN AN INFLATIONARY ENVIRONMENT

Interest rates have stayed low for longer and traditional income sources such as government bonds are yielding far less than inflation¹, prompting some investors to look for more attractive income prospects².

Source: FactSet, J.P. Morgan Asset Management; Bloomberg Finance L.P. Data as of 30.06.2021.  

Inflation remains a key focus, notably in the US, with a growing view that tight supply chains, semiconductor shortages, higher commodity prices and falling jobless rates could push consumer price indices higher. In Australia, the core rate of inflation was 1.1% year-over-year, as of March 2021¹. Inflation has been picking up in the US where the core rate was 2.6% in March 2021, rising to 4.2% in April and stood at 5.0% in May⁴.

The Federal Reserve’s more optimistic view on US economic growth and inflation in 2021⁵ should prompt a reduction in asset purchases in 2022, followed by rate hikes in 2023⁶. The Reserve Bank of Australia has indicated it isn’t in a hurry to raise rates⁷.

Still, investors continue to seek high-grade and high-yield allocation ideas. In today’s environment, it’s crucial to employ an unconstrained and flexible approach to differentiate and invest where opportunities can be found.

1. Source: Consumer Price Index, Australia, Key Statistics, Australian Bureau of Statistics, 28.04.2021.
2. For illustrative purposes only based on current market conditions, subject to change from time to time. Not all investments are suitable for all investors. Exact allocation of portfolio depends on each individual’s circumstance and market conditions.
4. Source: Consumer Price Index Summary, U.S. Bureau of Labor Statistics, 13.04.2021, 12.05.2021 and 10.06.2021.
5. Source: “Summary of Economic Projections”, 16.06.2021.
6. Source: “A hawkish surprise”, J.P. Morgan Asset Management, 16.06.2021.
7, “From Recovery to Expansion”, Reserve Bank of Australia, 17.06.2021.

WHAT CAN INVESTORS DO?

Generally, bonds diversify portfolios as they exhibit low correlation to equities⁸. There are various types of bonds globally and they react differently to market changes, such as interest rate movements and the economic cycle.

An unconstrained approach can help identify the high-conviction investing ideas for a diversified fixed income portfolio.

As market conditions evolve, allocating across the full fixed income spectrum - traditional assets such as government and investment-grade (IG) bonds as well as non-traditional assets such as mortgage-backed securities (MBS) and high-yield (HY) corporate bonds - can help build a resilient and diversified portfolio.

8. Source: Bank of America Merrill Lynch, Bloomberg Finance L.P., FactSet, ICE, J.P. Morgan Economics Research, MSCI, J.P. Morgan Asset Management.

Based on Bloomberg Barclays US Treasury (UST) Bellwether 2y & 10y (2y & 10y UST), Bloomberg Barclays Treasury Inflation-Protected Securities (TIPS), ICE BofAML Country Government (1-10y) (Australia, Germany, Japan & UK (1-10y)), Bloomberg Barclays US Aggregate, Credit – Investment Grade & High Yield (US Aggregate, IG & HY), Bloomberg Barclays US Floating Rate (US Floating Rate), Bloomberg Barclays US Aggregate Securitized – Mortgage-Backed Securities (US MBS), Bloomberg Barclays Pan-European High Yield (Europe HY), J.P. Morgan GBI-EM Global (Local EMD), J.P. Morgan EMBI Global (USD EMD), J.P. Morgan Asia Credit (JACI) (USD Asia Credit), J.P. Morgan Asia Credit (JACI) – High Yield (USD Asia HY), J.P. Morgan CEMBI (USD EM Corporate Credit), J.P. Morgan Asia Diversified (JADE) (Local Asia). *Correlations are based on 10-years of monthly returns. Data as of 30.06.2021.

Diversification does not guarantee investment return and does not eliminate the risk of loss. Yield is not guaranteed. Positive yield does not imply positive return. Past performance is not a reliable indicator of current and future results.

For example, securitised debt such as agency MBS has exhibited uncorrelated returns to risk assets and could act as a hedge to portfolios⁸. Agency securitised debt is issued or guaranteed by US government-related bodies. They demonstrate defensive characteristics and could be considered as an alternative to US Treasuries. US MBS have also demonstrated lower volatility.

HY corporate debt and emerging market (EM) fixed income can also help provide some diversification benefits to a portfolio given their higher correlation with equities and risk assets.

Investors should consider how they allocate to each fixed income market segment as the difference in drivers of return, sensitivity to interest rate movements and corporate fundamentals will affect returns. Having the flexibility to move between sectors may be advantageous.

2. Seek out yield 

Heightened inflation expectations can create risks for holders of core government bonds or longer duration assets. Fixed income investing could become more challenging with the potential price decline from duration risk. Developed market government bonds and IG corporate debt, with their low yields⁹, could face headwinds.

A range of fixed income yields⁹

9. Source: Barclays, Bloomberg Finance L.P., FactSet, ICE BofA, TulletPrebon, J.P. Morgan Asset Management. Euro investment-grade (IG): Bloomberg Barclays Euro-Aggregate –Corporate; Global IG: Bloomberg Barclays Global Aggregate Corporate; AusIG: Bloomberg AusBondCredit (0+Y); U.S. IG: Bloomberg Barclays U.S. Aggregate 0 Corporate. Euro high-yield (HY): ICE BofAEuro Developed Markets Non-Financial High Yield Constrained Index; Global HY: ICE BofAGlobal High Yield; U.S. HY: ICE BofA U.S. High Yield Constrained Index; US dollar emerging market (USD EM) Corporate: CEMBI Broad Diversified; Local EM debt (EMD): GBI-EM Global Diversified; USD EMD EMBI Global; USD Asia Credit: JPM Asia Credit; Local Asia EMD: JPM JADE; USD Asia HY: JPM Asia HY. Past performance is not a reliable indicator of current and future results. Yield is not guaranteed. Positive yield does not imply positive return. Data as of 30.06.2021.

Despite the recent higher-than-expected inflation numbers from the US and Australia, inflation is normal for a recovering and growing global economy, and likely transitory.

That said, a strengthening recovery has bolstered the earnings outlook. Profit margins have been improving and should lead to higher earnings and performance.  

To take advantage of the current return potential, we believe opportunities exist in the higher beta parts of the credit spectrum, where duration is less of a concern. We are seeing improving corporate fundamentals, coupled with a default rate that peaked in late 2020. The overall quality of the market has improved.

Additionally, a strong recovery in the US would also bring along emerging economies levered to US growth, presenting opportunities for local EM debt⁹ and EM currencies.