PREPARING FOR RISING RATES - ASSET ALLOCATION MATTERS
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ASSET ALLOCATION MATTERS:
PREPARING FOR RISING RATES
Positioning your portfolio in a rising rate environment
Many clients are asking how they should prepare for a rising interest rate In Brief
environment. The fact is, no one knows when or by how much interest rates will • We expect short-term
rise — or what underlying economic factors will prompt policy decisions. What interest rates to rise
we do know is that all fixed rate bonds are subject to interest rate risk. As the more than longer-term
economic cycle shifts and markets evolve, new risks and opportunities will emerge rates in 2015.
that will require investors to evaluate their fixed income holdings and ensure that • Even a small rise in
their allocations are aligned with their risk tolerance and goals. interest rates can lead
to portfolio losses.
• The changing landscape
Our thoughts on the direction of interest rates creates both opportunities
and challenges for
For some time, interest rates in the United States have been declining. Since the
investors in the fixed
credit crisis began to unfold in 2007, the Federal Reserve Bank has kept short- income markets.
term rates artificially low to stimulate the U.S. economy. Now that the economy is
on more solid footing, the Federal Reserve will eventually adjust interest rates as • Diversify to minimize fixed
income interest rate and
we return to a more normal economic environment.
credit risk.
We believe the Federal Reserve will begin to increase the Federal Funds rate (the
• Avoid surprises; know
short-term interest rate at which banks lend balances to each other overnight) what you own.
later this year and that longer-term U.S. interest rates will eventually begin to
rise. At the same time, central bank policies in Europe and Japan will put pressure Talk to your Advisor to
on longer-term U.S. rates to rise more slowly. With interest rates very low in better understand the
Europe and Japan, certain global investors, such as central banks looking to buy changing climate and to
high quality developed market bonds, may favor longer-dated U.S. Treasuries with make sure your portfolio is
higher interest rates. properly positioned for your
risk tolerance and goals.
A SS E T A L LO C ATI O N M AT TE R S AP R I L 2 0 15 | 1Below is the J.P. Morgan Private Bank outlook for U.S. Treasury rates through
2015, as of January 2015. Interest rates and bond
prices: Interest rates are
S H O R T-T ER M U . S . T R E A S U RY R AT E S TO R I S E M O R E T H A N
one of the biggest drivers
LO N G ER -T ER M R AT E S I N 2 01 5*
of bond prices. As interest
This table shows rates on U.S. Treasury bonds of various maturities at the end
of each of the past two years, and the J.P. Morgan outlook for year-end 2015. rates rise, the value of a
The column on the far right shows the projected change in basis points from high quality bond or bond
year-end 2014 to year-end 2015, which are the equivalent of 0.01% — or 1/100th
of a percent. fund falls, and vice versa.
2015 Rate Projected
U.S. Outlook Change
Treasuries 2013 Rate % 2014 Rate % % Basis Points
2-Year 0.38 0.67 1.50 83
5-Year 1.74 1.65 2.25 60
10-Year 3.03 2.17 2.50 33
30-Year 3.97 2.75 3.00 25
Source: J.P. Morgan Private Bank U.S.
*
Rate outlook as of January 2015. Subject to change.
Our view on investing in fixed income
Interest rates are one of the biggest drivers of bond prices. As interest rates The goal of diversification
rise, the value of bonds and bond funds fall, and vice versa. of fixed income portfolios
Over the past few years, we recommended shortening the maturities in high has been to increase yield,
quality fixed income portfolios to protect asset values, given our view that diversify sources of return
historically low interest rates would rise as the U.S. economy recovered. In
and lower exposure to
today’s environment, it is important to remember that bonds and bond funds
are not immune to rising interest rates. interest rate volatility.
Our view is that diversification is key in a rising rate environment. The goal
of diversification in fixed income portfolios is to increase yield, diversify
sources of return and reduce exposure to interest rate volatility. This can be
achieved by diversifying fixed income portfolios across high quality and high
yield sectors and utilizing nontraditional fixed income managers who have
the flexibility to invest where they see opportunity.
A SS E T A L LO C ATI O N M AT TE R S AP R I L 2 0 15 | 2Strategies for today’s fixed income markets
Following is a summary of our perspective on the implications of rising rates for common fixed income scenarios. Your
personal circumstances and goals should dictate the best course for you. While we are not advocating that you take action
at this time, we hope this information prompts a conversation with your Advisor to help you better understand what you
own and to assess the allocation of your portfolio as interest rates eventually rise.
» If you own bonds or bond funds for income
Core investment-grade bonds new bonds purchased when rates rise, the WHAT THIS MEANS FOR BOND OR
value of bonds purchased at an earlier BOND FUND HOLDERS
are an important component of date will fall. Fund managers actively
diversified portfolios, but bear in monitor interest rates and manage • Understand the potential risks of bond
against those losses, but it may take and bond fund investments, including,
mind that as interest rates rise, time for mutual fund portfolios to reflect among others, interest rate, credit,
bond values will fall. higher-yielding bonds. In some cases the inflation and liquidity risks.
manager may be limited to the kinds of
We expect heightened market volatility as bonds, e.g., maturities and qualities, that • Bonds, especially high quality bonds and
the Fed raises short-term interest rates as can be purchased. funds that invest in them, are sensitive
expected in 2015. For those investors who to changes in interest rates.
Despite our expectation that interest
buy (or bought) a bond and intend to hold rates will rise, core bond holdings remain • Consider total return, not just current
it until it matures, rising rates won’t have an important component of diversified yields.
any effect on the income they receive. portfolios. Core bonds are often the
Investors will continue to earn or accrue • Core bond holdings are still an
anchor of a portfolio when equity markets
interest at the rate expected when the important part of a diversified portfolio.
are volatile. Investors making their own
bond was bought. However, when interest decisions and buying these instruments • If a temporary jump in longer-term
rates rise and investors need to sell a in a rising rate environment should keep interest rates occurs (as a result of
bond before it matures, they should be an eye on total return and be prepared speculation and fear rather than
aware that the value may have gone down to experience capital losses as bond market fundamentals such as demand,
and the bond may sell at a loss. values fall. inflation or credit risk), do-it-yourself
In contrast to individual bonds, bond investors may look to opportunistically
mutual funds don’t have a final maturity, buy longer-dated bonds in brokerage
and therefore provide no assurance accounts to lock in those higher market
Total Return: A crucial rates. This is particularly relevant for
that an investor’s full principal will be
returned. Depending on the composition measure of performance, income-focused, long-term investors.
of a mutual fund, the total return may
it represents your interest
go down as rates rise. Total return is
a crucial measure of performance and income plus your capital
represents the combination of interest
gains or losses.
income plus capital gains or losses. While
investors may enjoy higher income on
A SS E T A L LO C ATI O N M AT TE R S A P R I L 2 0 15 | 3» If you own municipal bonds or municipal bond funds
Municipal bonds and bond funds are In today’s municipal bond market, we WHAT THIS MEANS FOR
recommend a “laddered” approach for MUNICIPAL BOND OR MUNICIPAL
also subject to interest rate risk. We high quality municipal bond portfolios.
believe their after-tax yields look A laddered approach entails blending BOND FUND HOLDERS
bonds of various maturities from short- • Some tax-sensitive investors tend
more attractive today compared to to longer-term, which provides liquidity to overweight their portfolios with
taxable bonds of similar quality; and flexibility for reinvestment to access municipal bonds. While tax advantages
potentially higher yields. are important, so is diversification
tax-sensitive investors may wish to
Today’s municipal yield curve (see chart across bond sectors to help reduce risk
consider bonds with maturities in the and volatility.
below) is steepest out to about 10 years,
1- to 10-year range. where investors are paid incrementally • As with all bond holdings, complementing
more for each additional year of maturity. a core municipal bond portfolio with
Beyond 10 years, investors are not as well other classes of fixed income and
Many of our clients invest in the more tax-
compensated for buying longer-dated investment styles may provide more
efficient municipal bond market. Unlike
bonds. Bonds maturing from about 1 to 10 income, reduce interest rate risk and
taxable government and corporate bonds,
years are a good tradeoff between earning increase the probability of higher total
the interest earned on most municipal
yield and taking interest rate risk, and returns in an environment where we
bonds is exempt from federal and, in
are in line with our current approach for expect interest rates to rise.
some cases, state income taxes. Municipal
managed portfolios.
bonds are more attractive on an after-tax
basis for clients who may be subject to the
highest marginal tax rate or the surtax on
investment income. For these investors, it
is important to be aware of tax-equivalent
yields (the yield an investor would have
to earn on a taxable bond investment to
equal the yield of a comparable tax-free
municipal bond).
T H E S W E E T S P O T F O R A A A M U N I C I PA L B O N D M AT U R I TIE S
3.5
3.0
2.5
This chart illustrates that
2.0
beyond 10 years, investors are
1.5 not as well compensated for
buying longer-term bonds.
1.0
0.5
0.0
1year 5year 10year 15year 20year 25year 30year
Source: J.P. Morgan as of 2/26/2015
A SS E T A L LO C ATI O N M AT TE R S AP R I L 2 0 15 | 4» If you own high yield bonds or bond funds
High yield bonds provide bonds, for example, but investors must
be willing to accept a greater risk of
WHAT THIS MEANS FOR HIGH YIELD
diversification and potentially BOND OR HIGH YIELD BOND FUND
default. Over the past few years, high yield
higher yields; we believe these are companies have had the opportunity to HOLDERS
refinance much of their debt, effectively • We believe that it may make sense
appropriate for investors who are lowering their costs and pushing out the to own some high yield bonds in a
being compensated for their higher maturities of those bonds. As a result, diversified fixed income portfolio for
in recent years default rates have been two reasons: higher yields and
risk profile. below historical averages of 3.5% to 4%, moderate interest rate risk.
and are expected to remain that way
The high yield bond market has had a (2.5% projected default rate in 2015).* • While bond defaults may affect the
wild ride since the credit crisis. Investors value of a high yield investment, we
in high yield bonds were paid 19% more The largest sector in the high yield bond believe that investors are currently
than investors in U.S. Treasuries in 2008. market is composed of energy companies. being compensated adequately for
By 2010, that “spread” (yield advantage) Recent oil price volatility poses a risk this risk.
over Treasuries had fallen back to more to the health of some energy-related
normal ranges (see chart). In contrast, companies and their ability to pay their • Given the historical performance of high
today’s high yield investors are paid debts. Consequently, they have recently yield credit spreads (the yield advantage
about 5.5% over Treasuries. Despite influenced the direction of prices for higher-risk bonds offer investors) in
these significantly lower spreads, high the entire high yield market. Investors rising rate environments, our view of
yield bonds still may make sense in should consider trends in the energy modestly rising longer-term U.S. interest
a diversified fixed income portfolio. sector, in terms of both potential risk rates and below-average expected
and opportunities. defaults, we are comfortable holding
In addition to interest rate risk, credit some high yield fixed income bonds in
quality also affects risk. High yield bonds diversified portfolios in 2015.
may pay a higher yield than government
H I G H Y IE LD B O N D S PR E A D S R E M A IN AT T R AC TI V E G I V EN D EC LIN IN G
Credit or default risk:
D EFAU LT R AT E S
Relates to the probability
The chart illustrates the yield advantage — or spread — of high yield bonds over
that a borrower (the bond
Treasuries over the past 15 years. Though spreads are lower, they remain
issuer) will default on its attractive today.
debt obligations. Investors
20%
Spread to Worst
typically demand more 16%
yield for greater perceived 12%
risk. 8%
4%
0%
*Source: J.P. Morgan
Source: Morgan Markets, as of January 30, 2015
Source: Morgan Markets, as of December 31, 2014
A SS E T A L LO C ATI O N M AT TE R S A P R I L 2 0 15 | 5» If you have borrowed against an investment portfolio
Using securities to collateralize a loan enables clients to WHAT THIS MEANS FOR CLIENTS WHO HAVE BORROWED
use the borrowing power of their portfolio holdings to AGAINST THEIR PORTFOLIOS
finance liquidity needs without disrupting their long • Many clients have recognized an opportunity to borrow against
their portfolios at relatively low interest rates to meet liquidity
term investment plan. Clients who have these loans must needs while keeping their investment portfolios intact.
always keep in mind that short-term rate increases may
• Depending on how the portfolio that collateralizes a loan is
result in rising borrowing costs, along with potential invested, the cost of borrowing may be higher than a portfolio’s
return. Clients should fully understand the terms of their loan,
margin call risks.
including restrictions, and how changing market conditions
may affect their investment account, as well as their ability to
Many clients have taken advantage of loans collateralized by draw against the line of credit.
securities over the past few years, borrowing against their
portfolio holdings for various purposes. The cost of these loans, • Loans collateralized by securities involve certain risks; these
typically lower than that of other forms of credit, is at the current include, but are not limited to, liquidation in the event of a
rate of one-month U.S. dollar LIBOR (the rate banks charge margin call.
each other for short-term loans) plus a fixed spread. We expect
the Federal Reserve to begin raising the Federal Funds rate • This strategy may not be suitable for all investors.
(short-term rates) in mid- to late 2015. The chart at bottom right
shows the historical Fed Funds rate as well as Federal Reserve
projections.
T H O U G H S TI L L LOW…T H E CO S T O F B O R R OW I N G R I S IN G S H O R T-T E R M IN T E R E S T R AT E
W IL L I N C R E A S E A S R AT E S R I S E E X P E C TATI O N S FO R 2 0 1 5
This chart illustrates that borrowing against portfolios may
This table illustrates how the cost to borrow $250,000 would
continue to be advantageous through 2015 for individuals
increase from $7,550 at today’s rates to $9,113 as the Federal
in need of liquidity.
Funds rate rises, as expected, to approximately 0.63% by
year-end 2015.
Loan amount: $250,000
TODAY* 12/31/2015**
Fed Funds Rate 0 – 0.25% 0.63%
1-Month LIBOR 0.17% 0.80%
Loan Spread 2.85% 2.85%
Cost of Loan (%) 3.02% 3.65%
Cost of Loan ($) $7,550 $9,113
Cost of loan based on 1-month LIBOR of 0.17% plus 2.85%
*
Source: Federal Reserve, J.P. Morgan. Federal Reserve Year-End
Cost of loan estimated based on Fed Funds projection and historic
**
Estimates and Long Run Projection data as of March 18, 2015.
spread to 1-month LIBOR
Source: Morgan Markets
A SS E T A L LO C ATI O N M AT TE R S AP R I L 2 0 15 | 6» If you own a fixed annuity
Risk-averse clients who own fixed annuities seeking In addition to the tax-deferral advantage, income earned from a
fixed annuity, but not yet distributed, is not counted for purposes
income alternatives must understand that the interest of the alternative minimum tax or the taxability of Social Security
rate locked in at the time of purchase reflects the then- benefits. An annuity can be a good investment if it is part of a
well-structured plan with a specific purpose.
current market environment.
WHAT THIS MEANS FOR FIXED ANNUITY HOLDERS
Fixed annuity contracts issued by insurance companies offer
risk-averse income investors an alternative in today’s uncertain • Fixed annuities can offer potential benefits that often cannot
markets. Investors who own fixed annuities lock in current rates be duplicated by other types of investments.
of return that are comparable to, and may be slightly higher
• Investors who purchase a fixed annuity while current interest
than other long-term fixed rate investments. These risk-averse
rates are low may be missing an opportunity to benefit from
investors seek other potential benefits that often cannot be
higher rates in the future.
duplicated by other types of investments, including favorable
tax treatment and a guaranteed, predictable income stream that
cannot be outlived. Fixed annuities can play an important role in
overall financial planning efforts. Fixed annuity holders should
make sure to understand the interest rate environment as well as
applicable fees and restrictions.
In Summary
A stronger U.S. economy and expectations for policy changes by the Federal Reserve in 2015 lead us to believe that interest
rates will gradually rise. As markets respond to a changing economic cycle, new risks and opportunities will emerge for
investors in both stock and bond markets.
With respect to fixed income holdings, we expect interest rates to eventually rise. Investors should remember that all
bonds, even investment-grade bonds, are subject to changing interest rate risks and can be negatively impacted by rising
rates. Diversifying fixed income allocations and staying informed are key in a changing interest rate environment. Whether
investors already own bonds — individually or through mutual funds — or are planning to purchase them, it is important
to understand the principles that underlie fixed income investing. As with any investment, it is important to know what
you own.
TAKE THE NEXT STEP
Today’s ever-changing markets require investors to be informed. We encourage you to have a conversation with
your Advisor to better understand the changing climate and ensure that your investment portfolio is aligned with
your long-term goals.
See next page for disclosures and to learn about our authors.
A SS E T A L LO C ATI O N M AT TE R S A P R I L 2 0 15 | 7Authors:
Anne Gray Philip Guarco Stacey Solomon
Senior Vice President Executive Director and Fixed Income Specialist for
and Head of Investment Global Head of Fixed the J.P. Morgan Private Bank
Solutions and Financial Income Strategy for the
Planning for Chase J.P. Morgan Private Bank
Stacey provides strategic
Wealth Management*
and tactical advice across
Phil focuses on tax-aware and taxable
Anne’s responsibilities developing and fixed income solutions.
include overseeing implementing the
annuities and secured Private Bank’s fixed
credit solutions. income strategy
globally.
Chase Wealth Management (CWM) consists of the Chase Private Client and Chase Investments product and service offerings within J.P. Morgan Chase & Co.
*
Important Information
The views and opinions expressed herein are those of J.P. Morgan and may differ from those of other J.P. Morgan employees and affiliates. Opinions and statements
of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. This information in no
way constitutes J.P. Morgan Research and should not be treated as such. The views expressed may differ from those contained in J.P. Morgan research reports.
This material is not intended to be a forecast of future events or a guarantee of future results or investment advice. Nothing in this material shall be considered
a solicitation to buy or an offer to sell securities. The views and strategies described may not be suitable for all investors. Any mention of an individual security,
investment or strategy is provided for informational purposes only and should not be construed as a recommendation. We believe the information provided here is
reliable, but it should not be assumed to be accurate or complete. Asset allocation and diversification do not guarantee investment returns and do not eliminate the
risk of loss.
Past performance is never a guarantee of future results.
Investing in fixed income products is subject to certain risks, including interest rate, credit, inflation, call, prepayment and reinvestment risk.
Bonds are subject to interest rate risk and credit risk of the issuer. Bond prices generally fall when interest rates rise.
High yield bonds are speculative noninvestment-grade bonds that have higher risk of default or other adverse credit events which are appropriate for high risk
investors only.
Investors should understand the potential tax liabilities surrounding a municipal bond purchase. Certain municipal bonds are federally taxed if the holder is subject to
the alternative minimum tax. Capital gains, if any, are federally taxable. The investor should note that the income from tax-free municipal bond funds may be subject
to state and local taxation and the Alternative Minimum Tax (AMT).
When investing in mutual funds or exchange-traded and index funds, please consider the investment objectives, risks, charges and expenses associated with the
funds before investing. You may obtain a fund’s prospectus by contacting your investment professional. The prospectus contains this and other information, which
should be carefully read before investing.
JPMorgan Chase and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only and is not intended
to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any
transaction.
Please note: Loans collateralized by securities involve certain risks; these include, but are not limited to, liquidation in the event of a margin call. As such, this
strategy may not be suitable for all investors.
Lines of credit are extended at the discretion of J.P. Morgan, and J.P. Morgan has no commitment to extend a line of credit or make loans available under the line of
credit. Any extension of credit is subject to credit approval by the lender in accordance with the terms contained in definitive loan documents. Loans collateralized
by securities involve certain risks and may not be suitable for all investors. Market conditions can magnify any potential for loss. If the market declines, you may be
required to deposit additional securities and/or cash into your account.
The securities in your account may be sold to meet a collateral/maintenance call, and J.P. Morgan may sell your securities without contacting you. In exercising its
remedies, J.P. Morgan will not be required to marshal assets or act in accordance with any fiduciary duty it otherwise might have. Some or all of the securities sold
to meet a margin/maintenance call may be sold at prices higher than their initial cost, which may result in adverse tax consequences. You should consult your tax
advisor in order to fully understand the tax implications associated with pledging securities in connection with a margin loan. Please read your client agreement
carefully so that you understand your obligations.
An annuity does have limitations. If you decide to take your money out early, you may face fees called surrender charges. Plus, if you’re not yet age 59½, you may
also have to pay an additional 10% tax penalty on top of ordinary income taxes. If you do take an early withdrawal, your death benefit and the cash value of the
annuity contract will be reduced. You should also know that an annuity contains guarantees and protections that are subject to the issuing insurance company’s
ability to pay for them. An annuity is a contract between you and an insurance company and is sold by prospectus. While it may take some time, you should read
these documents. They describe risk factors, fees and charges that may apply to you.
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affiliates. These assets are segregated by law and are not subject to FDIC or SIPC coverage. Securities (including mutual funds and variable products) and investment
advisory services are offered through J.P. Morgan Securities LLC (JPMS). Annuities and insurance products are provided by various insurance companies and offered
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