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Mid-year outlook
2012 guide to identifying opportunities across the fixed income markets

in BriEF
Many fixed income investor allocation decisions are guided by benchmarks. As a result, there is a general lack of focus on relative value between sectors and instruments, which creates inefficiencies and price anomalies across fixed income markets. Additional inefficiencies stem from structural changes within both rate and credit markets brought on by government and regulatory intervention as well as the introduction of new investment vehicles such as ETFs. Opportunities exist for patient investors with a relative value approach, liquidity at the ready and command of traditional and alternative investment methods.

Developments since the start of the year

In many respects, 2012 is developing according to our expectations. As we wrote in our 2012 Guide to identifying opportunities across the fixed income markets at the beginning of the year, Investor behaviour has been impulsive, especially in response to unconvincing policymaker action (and inaction). As a result, certain relationships (Spain/Italy, euro/US dollar, etc) are poised to reach levels that diverge from established precedent by multiple standard deviations. These relationships have deteriorated dramatically in the past six months (Exhibit 1, next page). Although global and US output eked out modest gains in the first half of the year, aggressive policy intervention yielded decidedly mixed results. Policy alone cannot account for the dramatic movement in rates. At the beginning of the year, we noted that the illiquidity and risk aversion that characterised 2011 would create exceptional demand for what are commonly considered low-risk instruments. Faced with ongoing uncertainty, investors continue to pour money into US Treasuries and investment grade bonds. Although these sectors may be perceived as safe havens, investors are in fact accumulating an increasing level of interest rate risk while Treasury yields fall from record lows to new record lows (Exhibit 2, next page). We continue to question this behaviour; as we wrote previously, The extraordinary US Federal Reserve (Fed) intervention may ultimately function as a source of rate volatility and idiosyncratic risk rather than a risk offset. To put it another way, when all the passengers run to one side of a boat, the boat becomes unstable. Diversification across fixed income sectors remains the key to navigating what is a difficult investment environment. However, obtaining diversification isnt always as straightforward as some would believe.
All information as of 30 June 2012 unless otherwise stated

AutHor William Eigen

Managing Director Head of Absolute Return and Opportunistic Fixed Income Group

INVESTMENT INSIGHTS

Mid-year outlook

EXHiBit 1: EXTREME DETERIORATION IN MARKET RELATIONSHIPS

1.35 Euro/US dollar

EXHiBit 2: US TREASURY 10-YEAR YIELDS

18

1.25

UST 10-year yield May June Italian 10-year yields

1.30

12

1.20 April 7.00 6.50 6.00 5.50 5.00 4.50 January

0 1970

1980

1990

2000

2010

Source: Bloomberg. Data as of 13 July 2012

The long and short of diversification

An underlying premise of investing in broad-market indices is that they represent a diversified investment pool. The Barclays Capital US Aggregate Index, for instance, contains 7,921 bonds, grouped into four broad categories. Corporate bond valuations are typically analysed in terms of profitability and balance sheet strength. Treasury prices, on the other hand, are driven by fiscal and monetary policy. One might reasonably believe, therefore, that corporate bonds diversify an investors exposure to Treasuries and vice versa. Empirically, however, the two categories behave almost identically. In fact, all of the categories of securities within the Barclays Capital US Aggregate Index are highly correlated with each other (Exhibit 3). EXHiBit 3: US BARCLAYS AGGREGATE CONSTITUENT DAILY RETURN CROSS-CORRELATIONS, FIRST HALF 2012
treasury 1.00 0.96 0.91 0.77 Governmentrelated Corporate securitised 1.00 0.92 0.80 1.00 0.78 1.00

March

May Spanish 10-year yields

7.00 6.50 6.00 5.50 5.00 4.50 January

Treasury Government-related Corporate

March May

Securitised

Source: Bloomberg. Data as of 29 June 2012. The graphs shown above and the graphs, charts and tables found throughout this presentation are for illustrative and discussion purposes only.

Source: Barclays. Data as of 29 June 2012

2 | Absolute Return and Opportunistic Fixed Income Group: Mid-year outlook

EXHiBit 4: INVESTMENT STRATEGIES DAILY RETURN CROSS CORRELATIONS, FIRST HALF 2012
CMBs CMBS Mortage CMOs Credit protection Alternative credit Distressed corporates High yield Macro Cash 1.00 -0.07 -0.11 -0.04 0.04 0.22 -0.09 -0.08 1.00 0.04 -0.14 -0.13 -0.01 0.10 0.06 1.00 -0.43 -0.58 -0.64 -0.10 0.18 1.00 0.53 0.45 0.05 -0.03 1.00 0.87 -0.03 -0.08 1.00 0.04 -0.05 1.00 -0.07 1.00 Mortage CMos Credit protection Alternative credit Distressed corporates High yield Macro Cash

Source: J.P. Morgan Asset Management. Data as of 29 June 2012

Although corporate profitability and other factors have some influence on corporate bond prices, this influence is overwhelmed by the direction of interest rates. The same high correlations also hold true for the other categories in the index because their prices are similarly dominated by rates. It is, however, possible to build fixed income portfolios that are well-diversified. To do so, we categorise our holdings according to the investment themes and strategies we see in the market (Exhibit 4). In practice, they have little connection with, and therefore low correlation to, each other or the Barclays Capital US Aggregate Index constituents. In contrast to the index, note that only two of these correlations are above 0.5, and three times as many are meaningfully negative at below -0.1. Although positively correlated assets do provide some diversification benefit to each other, the positive correlations in the strategy are balanced with investments that are negatively correlated, which provide even more diversification and return stability. For example, when prices fell in distressed corporates during the first half of the year, prices rose in collateralised mortgage obligations (CMOs), offsetting the loss. These results manifest two important characteristics of the strategy. First, in contrast to the index, we avoid large rate risk exposures. EXHiBit 5: SYSTEMATIC APPROACH TO SHORTING
opportunity identification Extreme technicals: Data that indicates investors are rushing into an investment on a momentum basis rather than due to an objectively sound value proposition Evolution over time: Evidence that investors are ignoring historical patterns and venturing into unprecedented territory Emotion: Explicit or implied exuberance or complacency; an unwillingness to consider that a contrary investment view has any merit

Second, our portfolio contains both long and short positions. When examining an investment, active index-based managers have two choices: they can love it a little or they can love it a lot. Our strategy, on the other hand, fully reflects our assessment of an investments valuationwhether we think it is too low, and represents a good value, or too high and is poised to fall.

Short exposures
In an emotion-driven market where momentum pushes valuations to extremes that fundamentals cant support, shorting can generate attractive risk-adjusted returns. When our analysis indicates that the opportunity can compensate transaction and carrying costs, we will take a position. We believe shorting like going long must be done systematically, in terms of both the opportunity identification and the implementation (Exhibit 5). When shorting is approached systematically, it permits the portfolio to seek profit in a risk-controlled manner when an irrationally exuberant market returns to reality. It also provides a source of return that is inherently uncorrelated to long exposure and thus contributes to a diversified portfolio.

implementation Convexity/downside beta: The position must produce the return behaviour being sought in an efficient manner. If helping to protect a long position, for instance, the short position must produce solid returns when the long position is suffering. Carry cost/cheapness: Short positions should be cheap to carry and ideally supported by heightened interest among long-side investors and thus richer long valuations. liquidity: Short positions should be liquid and trade in reasonable lot sizes so that transaction costs do not disproportionately offset the positions value

J.P. Morgan Asset Management | 3

INVESTMENT INSIGHTS

Mid-year outlook

Diversification benefits and tail-hedging

Exhibit 6 illustrates one type of short that we favour: a cheap tail-hedge. It represents protection we purchased on the iTraxx Europe Main series 9 tranche 22-100 index. By buying protection on this index, we were expressing a view that several of the constituent bond issuers could encounter financial difficulty. Most investors believe that widespread financial turmoil among investment-grade companies is unlikely. We generally agree; however, the index sometimes reaches levels suggesting turmoil is not just unlikely, but nearly impossible. Such optimism means that it becomes fairly inexpensive to short the index. Other closely related instruments also can help signal when technicals have created a trading dislocation in an instruments price. The iTraxx Europe Main series 9 tranche 22-100 usually mirrors the behavior of the iTraxx Europe main series 9. In the second quarter, trading levels began to deviate between the two indices. EXHiBit 6: ITRAXX EUROPE SERIES 9 TRANCHE 22-100 DISLOCATION IN THE SECOND QUARTER
300 250 200 150 100 50 0 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 iTraxx Europe Main Series 9 (bps spread, LHS) iTraxx Europe Main Series 9 tranche 22-100 (bps spread, RHS) 100 90 80 70 60 50 40 30 20 10 0

that gains from the position were designed to offset losses that might have materialised elsewhere in the portfolio in an extreme market environment. The dislocation reversed in the second quarter as investors became increasingly concerned about global growth. As we unwound the position, the pattern of realised gains offset market weakness that impacted other components of the portfolio, smoothing out the performance of the portfolio as a whole. Although we have reduced much of the exposure, we continue to hold a variety of other hedges with similar risk characteristics.

Sector and portfolio positioning

Global rates
This most recent batch of easing measures continues what is becoming a consistent tug-of-war between policymakers and economic indicators. The Citigroup Economic Surprise Index (Exhibit 7) uses currency market trading to measure the extent to which investors have been caught off guard by newly published economic reports. It shows a clear sawtooth pattern between euphoria and despair that has in turn triggered complacency and aggression on the part of policymakers. Carrying this pattern forward could lead one to believe that the most recent coordinated easing will boost sentiment and support risk asset prices. In some cases, however, the easing was more tentative than in the past (for example, the halfhearted extension of Operation Twist announced in late June). Nevertheless, we believe the turmoil in Europe will continue to support global investment flows toward US dollar-based assets. EXHiBit 7: CITIGROUP ECONOMIC SURPRISE INDICATORRISK TOLERANCE VERSUS POLICY ACTION
150 100 50 0
Reflate Reflate Reflate Stimulate: QE2 Stimulate: Twist 2 Euphoria Shock > Despair

Apr 12

Source: Morgan Markets. Data as of 29 June 2012

CESIUSD Index
Euphoria Euphoria

As the situation developed, it began to move towards our criteria for a short: trading volume was significant, indicating that the technical was strong; the relationship was deviating from a well-established historical pattern; and emotion was outweighing the rationally justified relationship between price and intrinsic value. We initiated a position late in the first quarter of 2012, and gradually unwound the position as the relationship reverted to its historical pattern. The difference between trading level and intrinsic value represented a dislocation, but the overall level of the index suggested irrational exuberance regarding the global economic outlook as a whole. We sized the trade as a tailhedge, meaning

Shock > Despair

Shock > Despair

-50 -100
Stimulate: Twist

-150 Jan 10

Jul 10

Jan 11

Jul 11

Jan 12

Source: Bloomberg. Data as of 29 June 2012

4 | Absolute Return and Opportunistic Fixed Income Group: Mid-year outlook

Corporate credit: Benefiting from muddle-through economic growth High yield corporate bonds
The muddling-through US economy has, paradoxically perhaps, been highly supportive of corporate credit. It has generated just enough growth to ensure that companies can avoid default, but not so much as to induce risky behaviour. Companies have stayed focused on balance sheet strength and seemingly uninterested in acquisitions. Accordingly, we are maintaining significant positions in US corporate bonds, including lowerrated high yield bonds.

We also hold non-agency mortgages complementing our agency positions. Now that housing has shown signs of bottoming out, we believe the non-agency sector stands to benefit as the market starts to price in improving price stability (Exhibit 8). We have invested our allocation to the sector in relatively conservative structures and collateral types, including, for example, senior securities on Prime and true Alt-A borrowers. EXHiBit 8: S&P/CASE-SHILLER COMPOSITE20 HOME PRICE INDEX (NOT SEASONALLY ADJUSTED)
220

Synthetic credit
Our synthetic credit strategy remains an important part of the portfolio, and it has been one of the largest contributors to returns year to date. We have sold short-dated (well within two years) credit default swap protection against certain corporations, as the market continues to compensate investors handsomely for default risk insurance. The strategy offsets some of its long exposure with short positions that express other investment themes, such as the view that retail spending is likely to remain sluggish.
195

Index

170

145

120 2006

2007

2008

2009

2010

2011

2012

structured securities: Positioning for a housing rebound

Two critical factors point to an increase in the pace of mortgage refinancing in the US. First, mortgage interest rates have fallen to record lows. Second, the thinking in Washington and on the campaign trail holds that if the government can induce people to refinance, the overall reduction in interest payments will feed into consumption and small business investment, boosting economic growth. The low rate policy is especially appealing since the government already owns many of the mortgages as a result of the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) takeovers, so it does not require the political consensus called for by such measures as tax reform. In our portfolio, we have emphasised agency positions that we believe are less likely to be impacted by increased refinancing activity, such as mortgages that are nearly paid off or have been recently refinanced. Should prepayments spike, we believe opportunities in the sector could appear as investors rush to sell securities to avoid prepayment risks they do not fully understand. Our allocation to this strategy could rise from its current level of 2% in such a scenario.

Source: Bloomberg. Data as of 30 April 2012

Commercial real estate: One property at a time

The commercial mortgage-backed securities (CMBS) sector continues to be heavily influenced by investors search for yield in a world where it has become scarce. The strength of this technical does not change the fact that the sectors fundamentals are mediocre. Foreclosures and losses are still working through the system, and overleveraged loan maturities from 2005 and 2007 continue to weigh on delinquency rates.

J.P. Morgan Asset Management | 5

Mid-year outlook

summary: Trading not trending

On the whole, financial markets so far this year have behaved as we expected. We wrote at the beginning of the year that we anticipated the environment in 2012 would be a trading one rather than a trending one and we continue to hold that view. We hope to benefit from ongoing volatility, which places a premium on the ample liquidity we possess in our portfolio. Investors generally possess equity portfolios that are far more diversified than their fixed income holdings. An appropriate allocation to an absolute return fixed income strategy such as ours can reduce exposure to rate risk and contribute to an appropriately risk-managed stream of returns.

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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 Managements 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) Socit responsabilit limite, European Bank & Business Centre, 6 route de Trves, 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 JPM5273 | 08/12