JPIE: An Attractive Way To Take Advantage Of Fed Cuts

Thesis

We were the first to cover the innovative JPMorgan Income ETF (NYSEARCA:JPIE) on the Seeking Alpha platform here, highlighting the structural features of the fund and collateral allocation within the larger macro framework. Since our coverage in April 2023 there have been significant market changes, including further rate hikes, a market swoon and now an expected monetary easing via lower rates. The fund delivered a positive return since our original coverage, and we expect it to outperform in the next year as the Fed starts cutting rates.

In this article we are going to re-visit the current fund composition and duration metrics, and put an analytical framework around expected returns in the next year based on implied market rate cuts and fund collateral composition.

Collateral composition – Ideally set-up for today’s environment

The fund is a fixed income ETF, containing a multi-asset portfolio:

MBS represents the largest allocation, with AAA Agency MBS at 28.1%, while non-Agency bonds represent 6.2% of the collateral pool. The next largest sleeve is represented by HY corporates at 24.7%, followed by asset backed securities at 15.1%.

We like the collateral pool and think it is ideally set up for today’s environment because the fund is long rates via its MBS sleeve, while taking a bar-belled approach to enhance yield via its HY collateral. The ratings profile is a reflection of that composition:

Only 33% of the collateral is sub-investment grade, with the rest mostly concentrated in AAA MBS bonds.

The current portfolio composition ideally takes advantage of a ‘peak rates’ environment, containing duration risk mostly and only moderate credit risk. The fund has a 3-year duration and a 4.66 years average life.

How to take advantage of Fed cuts in a smart way

The Fed cutting Fed Funds will have an outsized impact on the front end of the curve:

As we can see from the above graph the long end has already shifted lower following the market pricing of monetary easing. The red line represents the yield curve as of December 4, 2023, while the blue line is the yield curve as of January 26, 2024. The Fed controls the front end via their policy rate, while the market controls the 1 year and out nodes.

Let us see how the 3-year duration point has done historically versus Fed Funds:

There is a strong correlation for this node in the curve with Fed Funds (FFs). As FFs move lower, the 3-year yield also moves lower, with a negative basis during monetary easing (i.e when the Fed cuts). The current yield on 3-year treasuries is 4.15%, the market already pricing in over 100 bps in cuts. If the Fed moves more aggressively against expectations this node in the curve will move lower.

At this stage of the macrocycle, when contemplating monetary easing, as a retail investor you want to be long fixed rates. Why? Because you will get an additional gain from the duration impact as rates move lower.

JPIE is a very active fund

Unlike many passive fixed income ETFs, JPIE actively trades its portfolio:

Its 12 months trailing turnover ratio is 216%, meaning it turned-over its portfolio two times in the past year. This is an egregiously high number, with many funds seeing figures below 30%.

One of the explanations for this figure lies with the collateral the fund trades:

If we have a gander at its top holdings, we notice a lot of ‘TBA’s:

Mortgage-backed securities in the United States are generally traded on a “to-be-announced,” or TBA, basis. The key feature of a TBA trade is that the identity of the securities to be delivered to the buyer is not specified exactly at the time of the trade, facilitating a liquid forward market.

TBAs can be considered MBS futures, and they require a very small balance sheet allocation until settlement date. By their nature, they are short dated. The fund could possibly trade various TBA arbitrage strategies (there are different coupon TBAs) and thus the high turnover ratio.

Performance

Let us compare JPIE’s performance versus a Treasuries ETF and an MBS ETF:

iShares 1-3 Year Treasury Bond ETF (SHY) is a treasuries only fund with a 2-year duration, while the iShares MBS ETF (MBB) is a mortgage only fund with a 5 years duration. JPIE has outperformed both in the past year.

What is notable is the unit of risk taken by the fund to achieve its performance:

One can find the above metrics on the Seeking Alpha platform under the ‘Risk‘ tab. The ETF has a low 4.6% standard deviation, and an annualized volatility of only 4.3%. When benchmarked against its yield we can notice why the fund is so appealing:

The fund has a 6% 30-day SEC yield, and a 6.61% yield to maturity. When a fund’s annualized volatility is below a 30-day SEC yield, that tells you as an investor that you have a very high confidence level that the fund’s dividend will compensate any potential drawdown during that year.

If a security comes with an 8% yield but a 25% annualized volatility, the risk/reward ratio is not attractive. A high yield does not always compensate for volatility, hence an investor needs to look at both return and risk.

Expected returns

We believe rate hikes are behind us, and the Fed will cut in 2024. The question is by how much and how aggressively. The fund is long duration via its portfolio and also modestly long credit spreads via its HY bucket. The fund does a good job of breaking down its duration component, and the allocation for the HY bucket is 0.9 years. We feel the main risk here is a significant credit sell-off that would move HY spreads higher by 100 to 200 bps. The max impact to the fund from such a move is -1.8% (assuming a close figure in CS01 sensitivities to the DV01s figures), without taking into account any potential moves lower in rates from a risk off environment.

In our base case we see the fund realizing its 30-day SEC yield in the next year plus a modest 1% gain from its duration component, with 3-year yields moving closer to 4%. That translates into retail investors penciling in a 7% total return with a -2% theoretical drawdown.

Conclusion

JPIE is a fixed income ETF from JPMorgan. The fund is very active, with a 12-months turnover ratio that is higher than 200%. The fund’s composition is centered on Agency MBS bonds, and the ETF holds TBAs, which can explain the high turn-over figures. The ETF is ideally set-up for today’s environment, being long rates via its MBS sleeve, while only modestly long credit spreads via a 33% high yield allocation. What is extremely appealing about JPIE is its shallow drawdown profile, with its risk figures below its 30-day SEC yield of 6.07%. We find JPIE very attractive for the current macrocycle and have taken a position in the name, with a 7% total return penciled-in for the next 12 months.