Finding high yields and high-grade ideas in a world hungry for income opportunities

In less than three years, the central banks of the G7 + Australia have increased interest rates by 4,000 basis points. The massive hikes have been the single biggest driver of investors' thirst for income opportunities - and specifically, fixed income assets after many years of abnormal correlations and a general absence of yield. 

Enter the JPMorgan Income Fund and its sister ETF, the JPMorgan Income Active ETF (CBOE: JPIE) which has just been listed on Cboe. Both products follow the same income strategy and are managed by the same portfolio management team with the Income Fund currently running a yield to maturity of 8% (Source: J.P. Morgan Asset Management as at 30 June 2023). 

That's better than government bonds, most corporate credit options, the ASX 200, and just about every term deposit out there. And as co-portfolio manager Drew Headley told me, the opportunity set has not looked this good for a long time.

"From a valuation perspective, the opportunities are more attractive than we've seen a long time, even going back to the Global Financial Crisis in 2008," Headley said. "There's an opportunity for investors to lock in yields for longer and to be able to capitalise on that opportunity by generating income in their portfolios," he added.

In this interview, Headley shares with me the team's overarching macro views, its process for finding top-quality fixed income assets, and how it guards its investors from downside risks and black swans.

Why should Australian investors consider global fixed income?

Here in Australia, there's a plethora of options for income. Dividends from equity holdings have always been the most popular option of them all followed by distributions from passive products. 

Outside of the twice-yearly payouts, various corporate bonds can fetch anything from 5-6% for a bank bill to as much as 10% for a buy-now-pay-later convertible bond. And even if you don't want to try your luck in the bond market, a Big Four term deposit can now fetch you close to 5% for just two years' waiting.

So why should an Australian investor consider global fixed income? Headley presented a two-part thesis. The first part is what Headley called "the cash trap" - a concept where investors feel they are at an inflection point with multiple possible avenues. In this case, the inflection point is that central banks are near the end of an almighty rate hiking cycle and that doesn't bode well for cash holdings.

"The reality is that your total return is only as good as your next rate reset," Headley said. 

"In fact, when you look at historical periods of Federal Reserve rate cutting cycles - and if we're right about our recession scenario that the Fed could be cutting in the not too distant future - the investor might want to have longer duration investments that will have more total return potential," he added.

The other reason is correlation. For most of the market's history, equities and bonds tend to move in opposite directions (hence why professional asset allocators like to have the "60/40" portfolio where bonds insulate an equity market's downfall and vice versa). But after several years of the inverse occurring, Headley believes investors should be preparing themselves for a return to the old world.

"Leaving money in cash may dampen volatility, but we think that owning some fixed income in a portfolio could actually have a better and more meaningful impact," he said.

The overarching macro view

The most predicted recession of all time still has not arrived but Headley said the team still has not ruled out a recession starting within the next 6-12 months. 

"It may take a recession to get inflation down to the Fed's target levels," Headley said. "The Fed is going to have to remain restrictive and until we see sufficient signs that things are slowing," he added. 

So what assets do you want to own in that kind of an environment? The following list is just a sample of what the team have been changing in the fund's allocation decisions over the last few months. 

• Adding to longer-duration bonds (18 months ago, the average duration of the fund was under two years. These days, it's now over four years.)

• More high quality products, less high yield products (high yield corporate bonds generally presents more yield because they are issued by riskier companies)

Finding quality assets

To evaluate which assets the fund will invest in, the team undertake a series of stress tests to work out if investments will be able to stand the test of market volatility.

"It's not only thinking about what our base case expectations are for default rates and recovery rates*, but also using multipliers of that to help us understand how things will perform across different types of risk scenarios," Headley said.

"It helps us really focus on not only where we are comfortable in terms of protection but also are we getting well compensated for those risks or not?," he added.

Protecting downside risk

And as is the case with every good fixed income fund, there's multiple elements of downside protection built into the process. For Headley and his team, that process is multi-layered and spans both human and proprietary tools.

"The first line of defense is always the portfolio managers and every day, we look at our exposures and make sure things are matching our expectations," he said. "Performance attribution tools can be very helpful."

The second layer is the fixed income-sector risk team which discuss and debate the various risks that could emerge in portfolio constructions.

"We are using tools that look at tracking error expectations or volatility expectations, scenario analysis, stress testing, liquidity management, most of which have been built internally," he said.

Finally, there is the independent risk management team who work outside of the fixed income asset class who undertake their own assessments of what's in the portfolio and ensure it remains consistent with client objectives.

*The corporate default rate measures the percentage of issuers in a given fixed-income asset class that failed to make scheduled interest or principal payments in the prior 12 months. Recovery rate is the extent to which principal and accrued interest on defaulted debt can be recovered, expressed as a percentage of face value.

Attractive and consistent income with the JP Morgan Income Fund

The JPMorgan Income Fund leverages a team of 270+ investment professionals to generate high-conviction income ideas, and is now available as an active ETF for Australian investors. 

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