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Searching for Returns in Fixed Income Markets - A Discussion of Asians Bonds Development and Opportunities in Structured Securities Stephen Chang Head.

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Presentation on theme: "Searching for Returns in Fixed Income Markets - A Discussion of Asians Bonds Development and Opportunities in Structured Securities Stephen Chang Head."— Presentation transcript:

1 Searching for Returns in Fixed Income Markets - A Discussion of Asians Bonds Development and Opportunities in Structured Securities Stephen Chang Head of Fixed Income, Pacific Regional Group December 2004

2 Investment Outlook A Case for Asian Bonds –Asian bonds outlook –Alpha potential –Status of Asian bond market development –Benchmark selection –JPMF Asian bond presence Opportunities in Structured Securities –Introduction to Mortgage Backed Securities (MBS) –Introduction to Asset Backed Securities (ABS) –Risk Implication for portfolio management Prepayment and structure risk Pricing and relative value Agenda

3 Investment Outlook

4 Range trading in US Treasuries has persisted with no real trends US economic data has been strong but sustainability is questionable Asia has been experiencing strong economic growth, outpacing those in US and in Europe Asian currencies are arguably undervalued with central bank FX reserves building up rapidly from trade surplus and foreign investment Twin Deficits in the US are a structural problem where a correction should lead to USD declining further Liquidity is aplenty in US and Asian countries with capital inflow, and lack of lending growth Investment Outlook: Key Themes

5 US Treasuries: Range Bound Environment Source:Bloomberg

6 US Economy: Payroll Growth Sustainability Source:Bloomberg

7 US Economy: Borrowing for Consumption Source:Bloomberg

8 US Budget: Deficits Financing Growth Source:Bloomberg

9 Structural bearish USD environment:  Exposure to Asian fixed income securities Range-bound yield environment:  Considerations for Structured Securities Investment Outlook Implications

10 A Case for Asian Bonds

11 Asian Bond Outlook: Changing Dynamics How would the current situation evolve? Our central scenario: Situation/DevelopmentInvestment Implication Current statusHigh growth, inflation risingLong Asian FX Pegged currency/interventionLong Asian Equities Low real interest ratesLong Asian Credits Central banks following fed actionLong local short end bonds 1-2y horizonAsia moves to floating regimeLong Asian Credit Central banks raise ratesLong Asian FX Growth rate begins to moderateNeutral Bonds Longer term outlookHigh rates reining in inflationNeutral FX Interest rate peaks/growth slowsLong Asian local bonds

12 Asian increasing need for moderate risk assets –Changing demographics –Barbelling portfolio between cash and equities Liability matching –Too much US dollar as reserves? –Increasing integrated in trade activities Active management opportunities –Uneven growth and inflation trends –Central Banks’ dilemma and varying response –Lack of cross-border investor Growing Demand for Asian Bonds

13 Range of Instruments –11 Asian countries with local currency debt market –US Dollar, Japanese Yen and Euro issuance from Asian Sovereigns and Corporations –Credit play from AAA rated governments to high yield issuers Currency Exposure –Appreciation against USD and other major currencies –Protection against inflation risk Upgrade potential –Strength of Asian economies from strong growth and exports –Reduction of country/sovereign risk –Positive ratings outlook Alpha Potential in Asian Bonds

14 Alpha Potential: FX volatility and Yield Correlation

15 Status of Asian Bond Market: USD Issuance Statistics USD bonds has been the issuance of choice for Asian Issuers Sovereign and Corporate names Issuance share are dominated by a few names (Hutch, Korea and Philippines sovereigns) US Dollar Bonds issued by Asian borrowers, 1985-2003 (US$ bn) US Dollar Bonds issued by Asian borrowers, 1980-2003 (US$ bn) Source: Bondware, Citigroup

16 Status of Asian Bond Market: JPY Issuance Statistics Very limited JPY issuance post 1998 High profile downgrade has deterred Japanese Investors Korea high grade are the lone exception Credit enhancement required for lower credit ratings issuers Yen denominated Bond issuance by Asian issuers (US$ mil) Yen Bond issuance by nationality of issuer (Yen bn) Source: Bondware, Citigroup

17 Non-Japan Asia Local currency bond market has doubled from 1997 to 2002 Account of GDP 47% at end of 2003 (vs. 20% in 1995) Bond share of total financing raised to 19% (vs. 11% in 1995) EMEAP (Executives’ Meeting of East Asia and Pacific Central Banks) initiative: –Bilateral swap agreement totally >36B on foreign currency reserves to pool mutual support –Asian bond fund: 1 st series launched with 1B USD invested in USD debt on EMEAP countries –Asian bond fund: 2 nd series will be launched in early 2005 Expected to increase turnover in Asian bond markets Increase public awareness of bonds as alternative instruments Status of Asian Bond Market: Local Currency Bonds Development

18 Status of Asian Bond Market: Local Currency Bond Issuance Statistics Asia’s local currency Bond market Return comparison of local Bonds vs US Treasury (Jan 01 – Mar 04) Source: HSBC, BIS Makeup of local bond issuers varies quite widely Local currency bonds provide diversification against US Treasury

19 Capital Control Issues –Differing rates between onshore and offshore rates –Convertibility Withholding tax issues Asian Corporations issuing in USD to achieve wider investor base Relatively low transparency in price quotations, wide bid-ask spreads Turnover remains generally low Status of Asian Bond Market: Local Currency Bonds Impediments

20 USD credit index: HSBC ADBI, JPM JACI, iTraxx Asian series Local currency index: HSBC ALBI, JPM ELMI+ iTraxx Asian Series –Merger of TRAC-X and iBoxx in June 2004 –Equal weight basket of credit default swaps (CDS) –Highly liquid HSBC ALBI –Historical data since 2001 –Country weights based on HSBC Impediment Index –Varying selection criteria for country indices –Duration instability across different countries JPM ELMI+ –Inception since 1997 –Basket of tradable local money market bonds or non-deliverable forwards Benchmarking Selection: Available Indices

21 Bond inclusion difficulty: –Size of issuance small –Credit rating limit varies Country weights –Driven by country budget situation, e.g. Japan –Market capitalization can change quickly between countries –Duration between countries indices vary significantly Replicability: –Bid-ask spreads generally wide –Certain issues see small turnover from buy and hold investor Total return approach, focus on alpha generation Benchmarking Selection: Dilemma

22 One of the world’s leading asset management companies with over US$730B* under management 167* fixed income investment professionals manage over US$380B* fixed income mandates globally, with over US$12B* in Asian fixed income and balanced portfolios Dedication to Asia with over 90* investment professionals and over US$56B* under management Regional product offering and market coverage includes: –Pacific and Global Balanced Funds –China Balanced Fund ** –Bond and money market funds in HKD, TWD, THB *** –Asian Credit Research –Asian Convertible Bonds –Plus customized institutional mandates JPMF Asian Bond Presence: Our Capabilities * As of 30 September, 2004 ** via JV China International Fund Management *** via JV Ayudhya JF Asset Management

23 Opportunities in Structured Securities

24 MBS and ABS securities offer attractive return enhancement Source: J P Morgan Corp and MBS data 1990 -2004. ABS data 1992 - 2004 Excess return of market sectors over Gov’t 1-3yr index, unadjusted for duration

25 YTD 2004 in the Lehman Aggregate MBS and ABS securities offer attractive return enhancement Source: Lehman Brothers YTD Excess Returns to Treasuries (Duration Neutral)

26 Introduction to Mortgage Backed Securities

27 Mortgage from local bank American Homeowner 6% Investor buys AAA MBS security 5.50% Agencies combine mortgages Mortgage from local bank 5.75% American Homeowner 2 American Homeowner 3 How does a US mortgage work? Key features: –Usually fixed rate –Prepayable with low costs –Redeemed if mortgage holder moves to a new home

28 GNMA FNMA&FHLMC Agencies are considered ‘AAA+' credit quality with actual or implied U.S. Government guarantees Backed by the full faith and credit of the U.S. Government Government-sponsored entities which, given their position in the marketplace and their explicit mandates for housing finance, carry an implicit U.S. Government guarantee Both entities have a direct line of credit to the U.S. Treasury

29 Mortgage-backed securities make up 35% of the Lehman Aggregate Index 60% of the US mortgage market is securitized The market has a diverse lending base The market has a diverse investor base, with diverse motivations The US residential mortgage sector is the largest component of the US fixed income market As of October 31, 2004 Lehman Aggregate: Percent by par amount outstanding

30 Benefits of MBS for asset allocation Highly liquid  Low transaction costs Minimal credit risk Yield advantage versus U.S. Treasuries Diversification

31 Market Conditions   Mortgage spreads ranged from 138 to 150 bps versus 5/10s treasury blend during the quarter. In September mortgage spreads widened by 8 bps as the yield curve flattened and rates rallied.   Gross fixed rate supply was moderate, as 50% of gross issuance was comprised of Adjustable Rate Mortgages, and net supply of fixed rate mortgages was close to zero. Mortgage rates steadily declined during the quarter from 6% to 5.5% and as a result refinancing activity and supply increased.   Implied volatility was at the lowest levels of the year during July and August. As rates rallied, however, volatility increased as convexity needs of mortgage investors rose. Current Coupon 30-Year Mortgages Prepayment Sensitive (Residential) Mortgages As of September 30, 2004 Outlook   Convexity needs of mortgage players will increase in a market rally of 25bps or more as refinancing activity and fixed rate mortgage supply pick up. Implied volatility should increase further and mortgage valuations should appear less attractive.   Sponsorship from banks will continue, but to a much lesser extent than in the past as Fed Funds are at 2% and the yield curve has flattened by 90 basis points in 2/10s.   Mortgage spreads are at the tighter end of the range for the last year. Given current spread levels, uncertainty regarding future GSE portfolio activity, the flatter yield curve, and increased refinancing risk mortgage spreads are vulnerable to widening.

32 Introduction to Asset Backed Securities

33 What are asset-backed securities? ABS derive cash flow and credit characteristics from a pool of underlying assets The goal is to isolate the asset pool from the originator –pool is independent of the originator in the event of bankruptcy ABS contain credit enhancements –allows the securities to attain a higher rating higher than the originator Issuer motivations True sale of assets –free up equity and regulatory capital –liquefy assets –asset liability management Access to capital –attractive funding at “AAA” levels –diversify funding sources

34   Aircraft and computer leases   Agricultural and equipment loans   Unsecured consumer loans   Trade receivables   Student loans   Marine receivables   Truck loans   Emerging markets asset classes   Entertainment royalties ABS collateral is many and varied... Auto loans and leases Credit card receivables Home equity loans Manufactured housing contracts Recreational vehicles Utility stranded costs Dealer floor plan receivables Commercial loans

35 Market Conditions AAA par-priced spreads to swaps/LIBOR tightened in the third quarter on strong demand for short duration assets and limited fixed rate supply. Two-year and five-year swap spreads tightened 5-8 bps to Treasuries. Subordinates and off-the-run names tightened as well. AAA Home Equity floaters were the one area of softness due to heavy supply as interest rates remain low and originations high. AAA 3-yr.Corp. BondAgency 3-yr. DebtAAA 3-yr. Credit Card AAA 3-yr. AutoAAA 3-yr. HEL Note: Spreads are nominal spreads to U.S. Treasuries Asset Backed Securities Spread to U.S. Treasury (bps) Asset Backed Securities are an attractive short duration asset As of September 30, 2004 Outlook Year-to-date issuance volume is up 30% from 2003, led by subprime home equity. Supply may moderate as the Fed lifts rates but will remain robust. AAA spreads to swaps are still relatively tight and may experience widening at the margin as market participants take a defensive stance in the fourth quarter. Subordinate spreads are backstopped by strong fundamentals in the competing corporate debt market and by CDO demand.

36 Sources: Various $ billion Annual new issuance 1985 — 2004 ABS outstanding exceeds $1.5 trillion

37 Benefits of ABS for asset allocation High credit quality: Over 90% issued securities are rated “AAA” Diversification Attractive yields Minimal event risk Stable average life Diverse maturities and structures Liquid secondary market: – over $1.3 trillion of public ABS outstanding – average duration of slightly over 2 years – average deal size of over $500 mm

38 Risk Implications for Portfolio Management

39 Risk implications for investing in MBS and ABS The primary risk to investing in MBS is prepayment risk Operationally complex  back office headache! Collateral and structure risk must be monitored for ABS securities

40 Prepayment risk in MBS A borrower may prepay all or part of the outstanding principal of his mortgage at his discretion Prepayment motivations –relocation –access home equity –cheaper finance Interest rates drive prepayments Interest ratePrepaymentMBS Duration

41 The duration of the mortgage index fluctuates with interest rates MBS returns are volatile Mortgage index duration is volatile Mortgage index duration fluctuation with time

42 MBS45 Degree LinePoly. (45 Degree Line)Poly. (MBS) US Government Bond excess return Sector excess returns Excess returns of MBS to US Treasuries Increasing US interest rates Falling US interest rates Underperformance in disaster years -5.00 -4.00 -3.00 -2.00 0.00 1.00 2.00 3.00 4.00 5.00 6.00 -3.00- Source: Lehman Brothers US MBS Index from February 1989 to April 2003 and JP Morgan US Government Bond Index from February 1989 to April 2003 Note: All figures are expressed as monthly excess returns over US 3 month Treasury Bill and normalised to a 5 year duration Return profile for MBS MBS underperform in major market moves MBS outperform during stable periods

43 Extra dimensions of risk management required for MBS

44 Option adjusted Analytics Historical based valuations Gross and Net Mortgage Issuance Activity of major investment classes Recent performance vs. other sectors Dollar Roll Level of liquidity CMO Arbitrage A multitude of resources are critical to mortgage investment strategy Evaluate current conditions and valuations Forecast changes in the mortgage market trends Position portfolios to benefit from changing markets In evaluating current mortgage market conditions, the following aspects are considered:

45 Sponsor/Servicer Master Trust InvestorInvestorInvestor Class A Class B Class C Class A Class B Class C Class A Class B Class C (Each C Class has a Reserve Fund) Certs. “A” “BBB” $ and Seller Interest “AAA” Certs. $$$ Reserve Fund - Trap excess spread Receivables Traditional credit card ABS structure

46 Initial transfer Bankruptcy remoteness Trust owns receivables Security interest in receivables Legal Structure Ongoing cash flow structure Payment priority Available liquidity Credit enhancement Cash flow characteristics Macro and micro economic analysis Originator underwriting practices Servicing expertise Pool characteristics Historical credit performance Collateral analysis Originator Servicer Credit support provider Trustee Swap counterparties Main participants Structured finance investing requires a disciplined credit approach Analytical framework for investing in ABS

47 Fixed 5 Year AAA spread to Treasuries Home Equities CMBS Credit Cards Swap Spreads

48 Quantitative and market analytics Average life –Cash flow timing may be uncertain –Tranching controls cash flow timing Prepayments –ABS prepayments are less interest rate sensitive than MBS –Home loan ABS must be monitored to predict prepayment trends Embedded options –Most transactions have servicer call options (i.e., 5 - 10% of original balance) –Pool credit performance triggers may alter cash flows

49 ABS credit enhancement Unique to the originator and the asset type Sized to withstand a multiple of future expected losses Available in several forms: –excess servicing –over-collateralization –subordination –cash reserve –third-party guarantee Financial models evaluate default frequency, loss severity, prepayments, and interest rates.

50 Ongoing monitoring of transaction credit and prepayment performance creates opportunities Transaction monitoring Ongoing review sessions Assess the economy/key subsectors/market technicals/regulatory initiatives/relative value Periodic security analysis Actual security credit performance versus the expected case Sufficiency of security credit enhancement Financial condition of key transaction participants Develop a watch list Key variables/economic data for selected securities/sectors Make trade recommendations

51 Conclusions Given the current investment climate, Asian bonds and structured securities will provide good opportunities for investors Asian bond market development has picked up and will provide excellent alpha potential MBS and ABS are also attractive to fixed income investors given: –Safety –Return –Liquidity –Diversification Active management will be required given the range of markets in Asian bonds and the complex risks involved in structured securities

52 JPMorgan Fleming Asset Management The information contained herein employs proprietary projections of expected returns as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital markets theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees and other costs. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Performance results represent the investment performance record for a size-weighted composite of similarly managed, unconstrained discretionary accounts. Performance results are gross of investment management fees. The deduction of an advisory fee reduces an investor’s return. Actual account performance will vary depending on individual portfolio security selection and the applicable fee schedule. Past performance is not a guarantee of comparable future results. Fees are described in Part II of the Advisor’s ADV which is available upon request. Indices presented are representative of various broad base asset classes. They are unmanaged and shown for illustrative purposes only. An individual can not invest directly in an index.

53 The following is an example of the effect of compounded advisory fees over a period of time on the value of a client’s portfolio: A portfolio with a beginning value of $100 million, gaining an annual return of 10% per annum would grow to $259 million after 10 years, assuming no fees have been paid out. Conversely, a portfolio with a beginning value of $100 million, gaining an annual return of 10% per annum, but paying a fee of 1% per annum, would only grow to $235 million after 10 years. The annualized returns over the 10 year time period are 10.00% (gross of fees) and 8.91% (net of fees). If the fee in the above example was 0.25% per annum, the portfolio would grow to $253 million after 10 years and return 9.73% net of fees. The fees were calculated on a monthly basis, which shows the maximum effect of compounding. JPMorgan Fleming Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. The investment strategy described in this presentation is managed by J.P. Morgan Investment Management Inc. 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. Copyright 2004 J.P. Morgan Chase & Co. JPMorgan Fleming Asset Management


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