With equity market volatility recently reaching decade long highs, many investors are reassessing their portfolios to ensure that they are positioned to weather whatever challenges may come next. To many, that may mean diversifying their equity holdings while strengthening their fixed income allocation with core bonds – with longer duration and higher overall issuer quality – to act as a portfolio stabilizer and reliable source of income.

A popular approach to gaining core fixed income exposure is to invest in a passive index strategy designed to track the Bloomberg Barclays US Aggregate Bond Index (more commonly referred to simply as “the Agg”). This index has historically delivered negative correlation to equities, while acting as a ballast within a diversified portfolio at a relatively low cost to investors. The Agg, however, has changed in recent years. One of the most significant changes that has surprised investors is the expansion of debt issued at the lowest end of the credit quality spectrum (BBB-rated bonds). At the same time, corporate debt has grown rapidly, pushing corporate bonds to their highest weighting ever in the Agg (approximately 25% as of 12/31/19), suggesting that this sector may likely drive more risk and return than it has historically.

The Agg's exposure to corporates is at a 35-year high

Chart source: Bloomberg Barclays, J.P. Morgan Asset Management; data as of 12/31/19. Benchmark index is the Bloomberg Barclays US Aggregate Index.

How can investment managers improve upon the Agg?

In the last two years, we have observed a significant increase in the number of BBB-rated securities on the threshold of being downgraded to junk. With the recent uptick in equity market volatility, we have also seen investment grade credit spreads widening. This means that some of those issuers are going to face more and more challenges when it comes to refinancing their debt, so there is more and more opportunity to improve upon a passive index approach of buying the most leveraged and indebted companies.

Consequently, the most straightforward answer is to employ fundamental screening processes. Yet in many instances, fundamental active management comes at a meaningfully higher price point. Another option is a rules-based strategy, which combines fundamental screening with low cost, index-like processes.

While systematically assessing characteristics like issuer solvency, balance sheet quality and overall value compared to other issuers can be challenging for many asset managers, we at J.P. Morgan have developed an extensive proprietary research process that is systematic and repeatable.

We’ve heard a lot about factor investing in the equity world. How does it apply to fixed income?

Investors are becoming increasingly familiar with the concept of factor investing in the equity space – to help enhance return or reduce risk - and, more recently, in the alternatives world via long-short strategies. We believe that the corporate bond space is the next frontier in factor investing.

In essence, the same screening factors applied to equities – such as value, quality and momentum – can be applied to corporate securities. We employ such a proprietary systematic screening process within the corporate sector of the JPMorgan U.S. Aggregate Bond ETF.

What specifically are you looking for within each of the factors and why?

• Value: We look for companies that are undervalued compared to their fundamental quality, as cheap securities tend to outperform more expensive securities.
  
  
• Quality: We seek companies with strong profitability, low leverage and high interest coverage. Higher quality securities tend to deliver stronger risk-adjusted returns than lower quality securities.
  
  
• Momentum: We screen for companies with positive recent performance in both credit and equity markets, as securities that have recently outperformed tend to continue to outperform.
  

Essentially, this factor-based approach replicates many of the strategies used by active managers.

Once this screening process is completed, the sectors, credit spread and portfolio duration are aligned with the Agg, ensuring that the portfolio continues to offer the same long-term risk and return attributes of a core fixed income portfolio. With the risks aligned to the benchmark, the factors provide improved security selection vs. the passive debt-weighted index, enabling the Fund to potentially avoid downgrades and enhance returns during periods of equity market stress.

How does this add value over the Agg from a risk-return perspective?

Many clients look to their core fixed income exposure – along the lines of an Agg index – to provide ballast to their equity allocation and buffer their portfolio during times of equity market volatility. We believe that applying this screening process to the corporate component of the Agg can enhance the outcome that clients seek, providing excess returns during equity market drawdowns through better issuer selection. In recent months, we have seen a meaningful uptick in downgrades of some of the most leveraged investment grade issuers, and our process has avoided of most of these downgraded issuers. Looking forward, we would expect that the performance impact of this process to be even more substantial as strong fundamentals are prioritized by fixed income investors.

Looking to build a ballast in your bond portfolio?

JPMorgan U.S. Aggregate Bond ETF serves as a foundation for investors seeking a well-diversified, high-quality core fixed income portfolio, with a thoughtful, factor-based approach to selecting corporate issuers.

Learn more about JPMorgan U.S. Aggregate Bond ETF (JAGG)   ►

Risk summary

The following risks could cause the funds to lose money or perform more poorly than other investments. For more complete risk information, see the Fund's prospectus.
Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops.
The Fund’s investments are subject to the risk that issuers and/or counterparties will fail to make payments when due or default completely. If an issuer’s or counterparty’s financial condition worsens, the credit quality of the issuer or counterparty may deteriorate, making it difficult for the Fund to sell such investments.
Actively managed funds typically have higher fees than index-linked products.

Indexes

Index returns are for illustrative purposes only. ETFs have fees that reduce their performance; indexes do not. You cannot invest directly in an index.

The Bloomberg Barclays U.S. Aggregate Index (“the Agg”) is an unmanaged index representing SEC-registered taxable and dollar-denominated securities. It covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through, and asset-backed securities.