Since 2004, J.P. Morgan has produced “Market Insights” to help individual investors understand and make their way through rapidly shifting markets.
Today, even with yields not far from historic lows, we believe fixed income has a vital role to play in diversifying portfolio returns, helping to preserve portfolio value against volatility and providing a reliable source of income. “Solving for Fixed Income” takes a look at how the current environment has affected fixed income’s traditional role and at the many other opportunities that can accomplish its traditional objectives.
1. LOW RETURNS FROM CASH
Cash can be a real drag
In the short term, having a little extra cash can be beneficial if you need to allocate quickly to new opportunities. However, cash is definitely no longer the king with respect to long-term investment returns. Deposit rates since the global financial crisis in 2008 have been in decline and could come down further if the central bank continues to cut the official cash rate.
Despite yields on government bonds still being very low, fixed income continues to play an essential role in diversifying investment portfolios.
2. THE IMPORTANCE OF INCOME
Maximize investment growth with bonds
The total return on fixed income investments consists of two components: price, or capital, appreciation and coupon return.
The steady stream of income earned from the coupon can increase the total return from fixed income and act to partially offset any capital loss should it occur. This serves as a critical buffer for portfolios, especially in an environment of rising yields.
When thinking of returns from fixed income, investors should focus on the total return, and the importance of that flow of income, in adding to that return.
3. MOVING BEYOND GOVERNMENT BONDS
Monetary policy remains accommodative around the world but central banks are starting to step back from the world of unconventional monetary stimulus. However, policy rates will only rise at a very gradual pace this cycle, if at all in some regions. The U.S. is already starting to normalize interest rates and other central banks will follow in time.
Searching for higher yields
Unorthodox monetary policies and the purchase of both government and corporate bonds by central banks have pushed yields on a significant portion of developed market government bonds to ultra low or even negative levels. As a result, investors are moving beyond government bonds in search of higher yields.
4. GLOBAL INVESTMENT-GRADE BONDS
The safety of investment-grade bonds
Investment-grade bonds are corporate bonds associated with companies with a relatively low chance of defaulting their obligations. The default risk is reflected through a higher yield as compared to what is offered by a government bond, and the yield difference is known as the spread. This spread presents another source of income and a return that will beat cash in the current environment.
Investment grade bonds can add to the consistency of returns in a fixed income portfolio. However, no market is without risk and years of easy money has seen a rise in leverage in some parts of the investment grade market. Investors need to be selective on which parts of the market they invest in.
5. HIGH YIELD BONDS
Taking advantage of higher yields
High yield bonds have a rating below investment grade and offer more yield to compensate for the additional credit risk. These bonds continue to help investors achieve higher yield amidst the current low yield environment.
The largest market for high yield bonds is the U.S; however, this market also has the greatest exposure to energy companies that have been impacted by falling oil prices. The yields for energy companies rose much more than the rest of the high yield market, and outside of the energy sector, the default rate for bonds remains low compared to the compensation that investors can receive.
6. DIVERSIFICATION AND FLEXIBILITY
Why diversification works
Fixed income investments diversify portfolios because they generally exhibit low correlation to other asset classes. This principle applies within an asset class as well, and investors should consider how to diversify within the fixed income market. Since 2013, a portfolio that included a wider array of fixed income assets has outperformed Australian government bonds.
Investors should also consider how they allocate to each fixed income market segment as the drivers of return, sensitivity to interest rates and corporate fundamentals will affect returns. Having the flexibility to move between sectors may be advantageous.