Fixed Income Almanac

29 Pages·2015·1.9 MB·English

2015 Edition
Franklin Templeton
Fixed Income Almanac
Today’s global fixed income marketplace continues to offer Table of Contents
significant and diverse opportunities for investors; however, with
those opportunities has come tremendous complexity.
The myriad of events and measures that have occurred to lead us to 2015 have combined to
create a fixed income marketplace unlike any other we have experienced. Mixed signals in
Market Insights 3
the financial markets, continued record low yields combined with the looming threat of a
Franklin Templeton portfolio managers provide in-depth perspectives
rise in US interest rates, a lagging European economic recovery and oil price collapse, have
on their respective sectors.
made grasping the fixed income landscape even more difficult. It’s our belief that in order
to effectively navigate this complex fixed income setting, active management is essential. Reference Resources 35
Historical economic and fixed income performance data and statistics.
The Franklin Templeton Fixed Income Almanac was developed to give you an overview
of the opportunities and risks within this complex worldwide marketplace. By providing
you with detailed perspectives from investment leaders, as well as offering insights into Glossary 48
key sectors and metrics, we hope we’ve created an informational resource you will find Definitions of key fixed income terms.
insightful and valuable.
At Franklin Templeton Investments, we have been helping institutional clients navigate
core fixed income challenges through the years. With a full range of alternative fixed
income solutions available, we enable clients to gain exposure to a diverse and expanding
investment universe with the potential for enhanced risk adjusted returns.
As a global investment leader with more than $880 billion in assets under management, of
which more than $390 billion are in fixed income assets, and a team that includes over 170
dedicated fixed income professionals1, we believe Franklin Templeton is well positioned to
offer you a unique perspective on fixed income investing for 2015 and beyond.
1. As of 31 December 2014.
1
Market Insights
Rethinking Core Fixed Income in a Rising-Rate Environment 5
by Michael Hasenstab, Ph.D
US Credit Cycle Tiptoes into Middle Age 9
Q&A with Eric Takaha, CFA
Core Strength: The Importance 13
of Fixed Income Diversification
Q&A with Roger Bayston, CFA
Echoes of the Last Credit Boom Are Heard in 18
the Floating-Rate Loan Market
Q&A with Mark Boyadjian, CFA
Europe’s Dichotomy: The Prospect of Significant 23
Change vs. Continued Inertia
Q&A with David Zahn, CFA, FRM
Fixed Income Investing in a Rising-Rate Environment 27
Is it Prime Time for Floating-Rate Bank Loans? 31
Portfolio manager comments, opinions and analyses are as of January 2015, are for informational purposes only, and should not
be considered individual investment advice, tax advice or recommendations to invest in any security or to adopt any investment
strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses may change
without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market,
industry, investment or strategy.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
3
Rethinking Core Fixed Income
in a Rising-Rate Environment
by Michael Hasenstab, Ph.D
Michael hasenstab, Ph.D
CIO, Templeton Global Macro
Portfolio Manager
16 Years with
Franklin Templeton
Interest rates on government bonds still hover near historically low levels in many parts of
the world, near 0% for some core developed economies such as Japan and the eurozone.
However, we believe yields will eventually rise in many markets in the face of stronger
economic growth, albeit at various speeds given the disparate stages of recovery around
the globe. We believe that investors need to prepare for rising rates—investors may benefit
by investing in strategies that seek a negative correlation1 to US Treasuries, which may
help provide potential downside protection when rates rise.
Traditional Core US Fixed Income Portfolios May Face Dim Prospects with Rising Rates
The US Federal Reserve (Fed) concluded its asset purchase program in October 2014 and has indicated
that higher rates are ahead. In this environment, we believe that core US fixed income portfolios (managed
against a conventional benchmark) could face dim, likely negative return prospects due to their benchmark
constraints and inherent duration risks. In our assessment, unconstrained, global fixed income portfolios
that have unfettered ability to manage duration should be better positioned for rising rates.
Since late 2008, duration levels of traditional fixed income indexes have largely remained steady while
yields in many developed markets across the globe have been in decline, largely as a result of central bank
interventions aimed at pushing down borrowing costs to stimulate economic activity and revive growth.
Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Fund investment returns
and share prices will fluctuate with market conditions, and investors may have a gain or a loss when they sell their shares.
1. Correlation is a statistical measure of how two investments move in relation to each other. Negative correlation indicates a relationship in which one increases as the other decreases.
5
negative correlation since May 2010 Templeton Global Bond Plus Composite and Templeton Global Multisector Plus
3-Year Rolling Correlations to 10-Year US Treasury Composite Have Short Average Durations3 Relative to Their Benchmark Index
31 December 2007–31 December 2014 As of 31 December 2014
0.4
7.22
6.37
0.2
0.0
Relatively Low Correlation
Historically to the
“We use a truly
-0.2 10-Year US Treasury
1.49
and Negative Correlation unconstrained
1.01
since May 2010
-0.4 approach to global
Templeton Global JP Morgan Global Templeton Global Barclays investing that helps
Bond Plus Government Bond Multisector Plus Multiverse
-0.6
12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 Composite Index4 Composite Index5
us to discern potential
Templeton Global Bond Plus Composite Templeton Global Multisector Plus Composite All portfolio holdings are subject to change.
opportunities when
1 = Perfect Positive Correlation; 0 = No Correlation; -1 = Perfect Negative Correlation
others worry or even
The information is historical over the indicated time period and may vary significantly over other time periods.
Past performance is not an indicator or a guarantee of future performance. panic, and it equips us
Unconstrained Investing Provides the Flexibility to Navigate Shifting
Interest-Rate Conditions to react quickly when
As a result, yields remain extraordinarily low and longer-maturity government bond valuations have
We expect US rates to normalize toward historic norms over the medium
others may not.”
become relatively unattractive, in our view. We believe the income earned on low-yielding bonds is
term. In Europe, we believe rate normalization will likely lag the United States
insufficient to compensate against the risk of rising interest rates and the corresponding capital losses.
due to Europe’s much slower economic recovery. Fixed income strategies that
As such, we have aimed at a negative correlation with US Treasuries through short duration positioning
are constrained to the characteristics of an index may be less able to position
and by using currency overlays and credit strategies. As part of this approach, we have recently favored
defensively for rising interest rates and thus be more exposed to capital losses
a long position in the US dollar against short positions in the Japanese yen and euro. We believe growth
from higher duration exposures.
in the US economy will likely increase the global value of the US dollar while quantitative easing policies
in Japan and the eurozone are likely to depreciate the yen and the euro.
Active, Unconstrained Global Investing
Requires Comprehensive Resources
We have managed global and unconstrained strategies for decades; the Templeton
In our view, there are three key requirements for a global, unconstrained fixed
income strategy: How Investors Can Re-Think Global Bond Group was founded in 1986. Our unconstrained, global approach
1| The strategy needs active management to be able to adeptly invest in the Their Core Fixed Income Portfolio requires a different mindset from passive and traditional core market investing
relative strength of select countries and currencies while avoiding the weakness • Active management to navigate and involves more in-depth local research, trading capabilities, risk management,
of others—something an index cannot do. country and currency opportunities and operational infrastructure to operate at the scale required to invest fluidly
and responsibly.
2| It should be well poised to seek to deliver a negative correlation1 to US Treasuries • Negative correlation to US
given the seemingly inevitable eventual rise in interest rates. Notably, while some Treasuries, given the potential for
Global fixed income investing does not easily lend itself to passive strategies, in
strategies claim to have a negative duration,3 that is not synonymous with what rising rates
our view. We base our actively managed decisions on each investment’s inherent
we view as the more important goal of having an overall negative correlation to
US Treasuries. • Long-term track record over potential for strong risk-adjusted returns, not constraining our choices to the
multiple market cycles size limitations of specific index weightings. Additionally, our unconstrained
3| The strategy needs a long-term track record that investors can thoroughly analyze
over market cycles and unexpected events. These are some of the tenets of
our approach.
2. Sources: Correlation: © 2014 Morningstar, Inc. 10-Year Treasury data: Payden & Rygel. All information contained herein was obtained from sources P&R regards as reliable, but P&R does
not guarantee its accuracy. 4. Source: JP Morgan Chase & Co.
3. Duration is the measure of the sensitivity of the price of a fixed income investment to a change in interest rates. It is expressed as a number of years. 5. Source: Barclays.
6 Fixed Income Almanac | Market insights 7
approach seeks to structure our portfolios with built-in liquidity that provides additional flexibility US Credit Cycle Tiptoes
during periods of extreme volatility. This enables us to maintain our investing convictions and patiently
wait for prices to move toward what we believe are their appropriate long-term valuations. We do not into Middle Age
use stop-loss systems (an order to sell a security when it reaches a certain price) because it is precisely
these moments of market panic that we believe provide some of the best opportunities to buy, and that
Q&A with Eric Takaha, CFA
simultaneously require us to maintain our long-term investing theses by resisting the pressures to sell
at distressed valuations.
Unconstrained Global Fixed Income May Help Protect against Interest-Rate Volatility eric takaha, cFa
Senior Vice President,
We believe traditional core strategies with necessarily high duration exposures appear ill-suited for Director of the Corporate
and High Yield Group
a rising-rate environment, and strategies that have relied on falling interest rates to generate returns
Portfolio Manager
are likely to face challenging times ahead if rates trend higher. Thus, a truly unconstrained strategy
23 Years with
that can invest flexibly across global fixed income markets can help reduce portfolio volatility while
Franklin Templeton
generating additional alpha6 potential. In our view, low interest rates currently present an asymmetric
risk/return in bonds; there is greater risk of capital losses with rising interest rates than reward of
capital appreciation from declining rates. Additionally, bouts of volatility from shifting interest rates
appear inevitable as rates are expected to rise in the future. We believe all of these conditions combine
to make a strong case for investing in a more actively managed, unconstrained fixed income strategy
that can effectively navigate periods of rising interest rates.
With every market swing, pundits debate whether the economic recovery is rolling along or getting
a little long in the tooth. Eric Takaha, SVP and Director of the Corporate and High Yield Group
provides his perspective on the current credit cycle and corporate bond markets today.
Q. There’s been much speculation out typically, interest rates are low, lending Q. Can we point to the financial crisis
there. Where do you think we are in requirements are relaxed, and there’s as the reason for a longer cycle this
the credit cycle? an increase in the amount of available time around?
Eric: Because access to credit is credit. The US has seen this transition Eric: Yes. We believe the current
a barometer for the health of an over the past few years, evidenced recovery is different from many
economy, we’re frequently asked how by the record-setting pace of supply others we’ve experienced previously
far along the United States is in its of bonds in the market across credit because it has progressed fairly slowly
current credit cycle. Unfortunately, sectors over the past couple years. and gradually. As many corporate
a scientific formula doesn’t exist to management teams and boards of
determine the answer to that question, The United States is coming up on its directors realized how severe the
A Note on Risk but we can offer an assessment based sixth year of economic recovery, and financial crisis was, they tended to
All investments involve risks, including possible loss of principal. Currency rates may fluctuate significantly over short on current trends and historical data. in a traditional credit cycle, it would be a bit more conservative with their
periods of time, and can reduce returns. Derivatives, including currency management strategies, involve costs and can create be well down the road toward the end balance sheets as a result. In our
economic leverage in a portfolio which may result in significant volatility and cause a portfolio to participate in losses (as In the early phases of a credit cycle, of the cycle, which usually runs about view, companies’ generally slow and
well as enable gains) on an amount that exceeds the initial investment. The portfolio may not achieve the anticipated benefits, corporations and consumers look to five to ten years from start to finish. steady approach to spending and
and may realize losses when a counterparty fails to perform as promised. Foreign securities involve special risks, including rebuild their balance sheets, reduce Overall, while we believe the United expanding has, in turn, delayed the
currency fluctuations and economic and political uncertainties. Investments in emerging markets involve heightened risks their debt balances, and improve their States appears to be more than halfway US economy’s progression through
related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments liquidity profiles. As the cycle moves through the credit cycle, we don’t think the credit cycle.
in lower-rated bonds include higher risk of default and loss of principal. Changes in interest rates will affect the value of along, funds become easier to borrow; we’re in the final stage.
a portfolio and its yield. Bond prices generally move in the opposite direction of interest rates. As the prices of bonds in
a portfolio adjust to a rise in interest rates, the portfolio’s value may decline. Changes in the financial strength of a bond
issuer or in a bond’s credit rating may affect its value.
6. Alpha is a measure of a portfolio’s return in excess of the market return, after both have been adjusted for risk.
8 Fixed Income Almanac | Market insights 9
cycle, by contrast, we found M&A was Another factor that suggests we are Distress Has Generally Led Default Rate—Distress Remains Low1
In Times of Rising Rates often highly leveraged, debt-financed not near the end of the credit cycle is 31 January 1994–31 December 2014
In times of rising rates, high-yield buyouts. So even M&A, which the volume of lower-rated new debt Percent of Default
Distressed Debt Rate
bonds have historically outperformed typically hastens the economy’s march issuance. This level tends to creep up
28.0% 9.6%
investment-grade bonds because their
through the cycle, has not had much in the final years of a credit cycle. In
21.0% 7.2%
higher yields may help to cushion
of a negative effect so far, in our view. 2007, for example, aggressive issuance
the impact of higher rates. 14.0% 4.8%
stood at 5.1% of market size. At the
7.0% 2.4%
Floating-rate bank loans are the Q. What indicators do you track to end of 2014, the level was only 2.3%.2
one asset class that may actually 0.0% 0.0%
gauge the cycle’s progression, spe-
benefit from a rising interest-rate cifically in the high-yield corporate Q. What’s your outlook for 1/94 1/97 1/00 1/03 1/06 1/09 1/12 12/14 “ We believe the current
environment. As short-term interest Default Rate Distressed Debt
bond asset class? defaults in 2015?
rates rise, over time the income on recovery is different
This is for illustrative purposes only. Past performance is not an indicator or
the floating-rate bank loan may rise Eric: In addition to credit spreads over Eric: Default rates have been low
a guarantee of future performance. from many others
as well. government bonds and default rates, during the last few years. While we
we closely monitor distressed debt. wouldn’t be surprised to see an uptick we’ve experienced
Both high-yield corporate bonds that do transpire due to excessive leverage, a region we need to be aware of. With
Typically we have seen that the level in default rates going forward, we
and floating-rate bank loans have missteps by individual companies and some of the sovereign challenges previously because it
historically been less correlated to of distressed debt rises before default believe they may remain below their
longer-term trends that are moving particularly from a few of the oil exporters
US Treasuries as their performance rates rise, so the distressed debt level long-term averages as we head into has progressed fairly
against certain industries. In particular, in the region, you could see some stress in
is typically tied more to the overall can be used as a leading indicator of 2015. In general, companies that have
weakness in commodity prices in 2014 certain corporates. So, overall we are still slowly and gradually.”
economic outlook and corporate
defaults. For example, the distressed taken advantage of lower interest rates
earnings landscape than interest rates. may add stress to select energy and constructive and believe default rates
debt level spiked to more than 30% to refinance their debt have improved
mining issuers, absent a recovery in in both developing and developed
in 2008, roughly one year before the their cash flow metrics, and many have
select commodity prices in 2015. market may remain below the long-
Nonetheless, as you would expect default rate rose to more than 10%. By a cushion that we think should enable However, overall the proportion of term averages over the near-term, but ETFs, which are even faster in terms of
several years into a recovery, we comparison, today the distressed debt them to weather at least a temporary companies in the market that are there could be some pockets of stress money moving in and out, also have
have found that many companies level continues to hover below 2%.1 slowdown in economic growth. Now, considered distressed remains low, over the coming quarters. become bigger players.
there likely will be selected defaults
increasingly have been using leverage which we believe tends to be a pretty
The result is a market in which dealers
to engage in what are typically good indicator for default rates over Q. Some regulatory changes
carry less inventory to trade, and a larger
considered late credit-cycle activities. the next year or so. following the financial crisis may
buyer base that tends to move a bit more
For instance, they’re pursuing have affected liquidity and trading.
quickly with its purchases and sales
shareholder-friendly activities, Q. What’s the outlook for defaults in Can you describe what has changed?
Downturn Repair according to flows. This combination
such as stock buyback and dividend Funding pressures, Cleansing of Europe and Asia? Eric: Following the financial crisis,
creates a more challenging liquidity
increases, as well as mergers and falling asset prices, balance sheets Eric: In Europe, they weathered the a number of new regulations were put
increased defaults environment than existed pre-crisis. In
acquisitions (M&A). 2011–2012 euro crisis fairly well without in place raising capital requirements
this environment, when there are large
defaults jumping up. So we would expect and placing greater oversight on
THE flows coming in and out, there tend to
Although those activities could lead defaults to remain fairly benign over broker-dealers. In response, broker-
Expansion CREDIT be more rapid moves in prices.
to a correction in the cycle, they Increasing amount of the near term given the QE and some dealers have not been willing to carry
CYCLE3
haven’t occurred to the extent we debt on balance sheets, bottoming in the European economy the same inventory levels to facilitate
have seen in previous cycles, and, rising volatility and relative to what it was a couple of years trades as they did prior to the financial Q. What does this change in liquidity
speculation, growing numbers levels mean for investors?
in particular, the previous cycle of leveraged buyouts, Recovery ago. If you look over in Asia, even though crisis. Rather than holding their own
that ended in 2007. In fact, much of mergers and Rinicsrineags firnege mcaasrhg iflnosw, , the economies have been slowing led by proprietary books of bond holdings, Eric: For more short-term oriented
the M&A that has occurred in this acquisitions, falling leverage China, they are still growing at a decent they are simply crossing trades investors, it’s important to be aware
and capital
cycle has been large-capitalization expenditures rate. We think that will support low level between buyers and sellers. This that prices can move a bit more
companies using their stock to of default rates broadly in Asia. However, reduction in brokers’ accounts has had quickly because of technical factors.
acquire other companies. In the last This is for illustrative purposes only. there will be pockets of areas that you have an impact on liquidity. But from a longer-term perspective,
it doesn’t change the fundamentals
to keep an eye on. For instance, real estate
At the same time, you have a much for any of the companies that we’re
in China, given the slowdown in relative
larger percentage of the market being investing in. We can even look to take
growth, you could see some areas of
represented by mutual funds, which advantage of these dislocations, and
1. Source: JP Morgan, as of 31 December 2014. Distressed debt is defined as the corporate bonds of companies that have filed for bankruptcy or appear likely to do so in the near future. distress in Chinese real estate. Looking
2. Source: JP Morgan, High Yield Default Monitor as of 5 January 2015. Note: Aggressive issuance as of 12/14 includes lower rated securities, excluding refinancings. outside of Asia across some of the other tend to be a little bit faster than, say, as active managers, we have the
3. Graphic: Franklin Templeton Investments. Reference: US Department of Treasury, Office of Financial Research 2014 Annual Report. pension funds or insurance companies. flexibility to do so.
emerging markets, Latin America is
10 Fixed Income Almanac | Market insights 11
Q. Is this opportunity greater for active managers? Core Strength: The Importance
Eric: We think so. For example, we can buy names that we believe are being sold simply because of
technical pressure, while having no change in fundamentals. Conversely, if prices on bonds are gapping of Fixed Income Diversification
higher because of high demand, we might pare off positions that we believe are being unduly
influenced by the flood of money coming in.
Q&A with Roger Bayston, CFA
Index funds do not have this flexibility. Because they are more limited to owning the same issues that
are represented in their respective benchmarks, they cannot choose which bonds to buy or sell as
opportunities arise. roger bayston, cFa
Senior Vice President
Director, Fixed Income
Q. With the ECB quantitative easing, what does the potential divergence between US and European
Portfolio Manager
credit markets mean for investors?
23 Years at
Eric: In general, quantitative easing in Europe is a positive for both European and US credit as it adds Franklin Templeton
liquidity to the overall system and increases the demand for fixed income investments that yield more
than government bonds. It’s a direct positive for European credit because the European treasury and
yield curves have been pushed lower by the influx of actual buying from the governments, which has
helped its overall performance. Some of this has trickled over to the US as you see international buyers
also looking to increase yield and income. It doesn’t have a huge impact in terms of fundamentals, but
in general lowers interest costs for European borrowers. In terms of US versus Europe in relative
value, US still has a better economic and earnings outlook. On the flipside, the extent that European
QE has lowered the valuation of the euro relative to the US dollar helps a lot of the exporters in
Europe. So, we think it’s positive globally for credit and incrementally more so for European credit. The proliferation of new products in the fixed income arena leaves one to wonder—
That said, we still think fundamentals in the US are a bit stronger than in Europe on a broader basis. is there a problem at the core of fixed income today? Roger Bayston, SVP, Director,
and Portfolio Manager, addresses some of the current issues surrounding fixed income
Q. In summary, what is your outlook for corporate bond markets in 2015?
including low yields and rising rates.
Eric: As we look at high-yield and investment-grade bond markets in the US, Europe, and more globally,
in general, our expectation is for credit metrics not to improve—they’re even more likely to remain flat
Q. Given the current low interest-rate environment, what is the case for core fixed income
or to deteriorate somewhat in 2015. This is not because earnings are declining; we believe earnings are
investments today?
still modestly growing. Rather, the deterioration may be a result of companies becoming a bit more
Roger: High quality (investment grade), or traditional core fixed income has historically delivered
aggressive with their balance sheets, and being willing to take on more debt.
two key benefits: income and diversification. The case for it today remains the same. If income
and diversification are needed for an investor’s portfolio—and I would argue that most portfolios
The environment continues to evolve and there are conditions that need to be watched: companies are
could benefit from these to a greater or lesser degree—then the asset class remains a potentially
becoming slightly more aggressive, the commodity sectors remain under pressure, and economic
valuable component.
challenges exist in Europe and Asia. However, our overall outlook for high-yield and investment-grade
fundamentals remains largely supportive. Given the severity of the financial crisis, management teams
have remained more cautious than they would typically be five or six years into recovery. It’s my opinion Q. What about the increased correlations among asset classes experienced since 2008? Does core
that the credit cycle has not yet run its course. fixed income still deliver a diversification benefit?
Roger: Stocks and bonds as broad asset classes have historically been natural diversifiers within a portfolio;
traditionally, the two asset classes have not been too closely correlated. Generally speaking, when conditions
largely favoring stocks occur—strong economy, job growth, rising demand—they often produce higher
inflation. To keep the economy from overheating, the Fed playbook is to raise interest rates, which can
A Note on Risk
cause bond yields to rise, knocking bond prices down. Conversely, the Fed uses more accommodative
All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of policies when the economy is weak, so interest rates fall and bond prices typically rise in periods when
interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio stocks, as a reflection of that weak economy, are not doing well.
may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields
reflect the higher credit risks associated with certain lower-rated securities. Floating-rate loans and high-yield corporate
bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—
a risk that may be heightened in a slowing economy. The risks of foreign securities include currency fluctuations and political
uncertainty.
12 Fixed Income Almanac | Market insights 13
Historical Correlation of Stocks to key Fixed Income Sectors1 10-Year Treasury Yield and Real Yield4
15-Year Period Ended 31 December 2014 31 March 1962–31 December 2014
18%
US US MoRTGAGe- MUNICIPAL ASSeT- GLoBAL INveSTMeNT- FLoATING- eMeRGING HIGH-
TReASURIeS AGeNCIeS BACkeD BoNDS BACkeD BoNDS GRADe RATe MARkeT YIeLD
SeCURITIeS SeCURITIeS CoRPoRATeS LoANS DeBT BoNDS
10-Year US Treasury Yield
12%
SToCkS
-0.33 -0.24 -0.15 0.00 0.06 0.08 0.21 0.49 0.51 0.64
1 = Perfect Positive Correlation; 0 = No Correlation; -1 = Perfect Negative Correlation 6% “Many income investors
This is for illustrative purposes only and does not reflect the performance of any Franklin Templeton strategy. Past performance is have moved down the
not an indicator or a guarantee of future performance.
credit ladder in order
0%
to access higher yield
Real Yield
Within fixed income, the highest corporate bonds and municipal bonds backward, remembering the absolute
potential. Most probably
quality bonds—such as Treasuries and suffered modestly negative returns, but yields they earned in the past, and
-6%
other government bonds (that carry the aggregate of traditional core fixed they start looking elsewhere for realize they have taken
3/62 2/68 12/73 10/79 8/85 7/91 5/97 3/03 1/09 12/14
some form of government and/or income proved a good diversifier for equivalent yields.
on more credit risk in the
This is for illustrative purposes only and does not reflect the performance of any
agency guarantee)—historically have the harsh negative equity results.
Franklin Templeton strategy. Past performance is not an indicator or a guarantee of process, but they may not
been the least correlated with stocks. Q. Why shouldn’t investors consider future performance.
Some sectors, such as high yield, have Q. Many may say the income other areas of fixed income that offer realize they have lost some
had a greater correlation to equities, benefit is not as compelling as higher yields? of the diversification benefit
since much of their yield spread is built in the past. Roger: There is no reason not to than +11%. Of course, in 2009, the Another “spread” sector historically has
that core fixed income
upon the likelihood of being able to Roger: And they’d be right. For 30 years, consider bonds outside of core fixed opposite occurred. Stocks rose +26%, been emerging market debt. A strong
repay the debt. An improving economy interest rates have generally been falling, income as part of a diversified fixed high yield bonds rebounded +54% US economy favors more imports, has historically provided.”
is generally favorable for stocks, but it’s which has been very good in terms income portfolio. However, investors and intermediate Treasuries fell which is beneficial to the economies
also generally favorable for companies of generating total returns but has need to understand the tradeoffs. a little more than -1%. And what was of exporters which improves their
with high-yield debt. come at the expense of lower current Many income investors have moved the performance of the Barclays US likelihood of repayment. But you
Aggregate Index? It gained +5.93%, cannot forget that negative geopolitical
yields. With low Treasury yields and down the credit ladder in order to
Along came the financial crisis in slightly more than the year before.2 events—and there are many, including
tight yield spreads for most investment access higher yield potential. Most
2008, and while the market turmoil those in South America, Eastern
grade bonds, traditional core fixed probably realize they have taken on
and uncertainty caused correlations But it’s not just the really extreme Europe, and the Middle East, not to
income doesn’t generate the level of more credit risk in the process, but
among many asset classes to rise, the events. Look at the latter half of 2014 mention black swan occurrences—tend
income that it did five years ago, let they may not realize they have lost
higher quality fixed income space did and the unexpected decline in the to favor a flight to quality in the fixed
alone 30 years ago. some of the diversification benefit
deliver that diversification benefit. price of oil. For the most part, that’s income market.
that core fixed income has historically
That’s why the Barclays US Aggregate But it’s important to keep real yields in a great benefit to the US economy,
provided.
Index delivered a +5.24% return mind. This decade has had an average but the oil companies are big issuers Q. What about the impact of rising
in 2008, while stocks, high-yield inflation rate of less than 2.5%—part Going back to 2008, for example, when within the high-yield bond market. rates on bonds? Won’t that be a head-
bonds, and emerging market bonds of the reason that the Fed has been so stocks lost -37%, high-yield bonds Those bonds rapidly went out of favor wind for core fixed income?
had double digit losses of varying accommodative.3 Unfortunately, as lost more than -26%. Conversely, and impacted the high-yield market Roger: Higher quality fixed income
magnitudes.2 Even investment grade yields have come down, investors look intermediate Treasuries gained more in general. High-yield spreads which does tend to be more interest-rate
had compressed to less than 400 basis
sensitive. The assumption is—and
points (bps) in June—well below the
has been for a couple of years now—
long-term average—rapidly widened
that rates will likely rise in the near
to over 600 bps in December, before
Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. future. But I would caution about the
pulling back into year end.
1. Source: © 2014 Morningstar Direct. US Treasuries represented by Barclays US Treasury Index, Asset-Backed Securities represented by Barclays ABS Index, Municipal Bonds represented
by Barclays Municipal Index, US Agencies represented by Barclays Agency Index, Investment-Grade Corporates represented by Barclays US Corp IG Index, Mortgage-Backed Securities
represented by Barclays US MBS Index, Global Bonds represented by Citi WGBI, High-Yield represented by Credit Suisse HY Index, Floating-Rate Loans represented by Credit Suisse Leveraged
Loan Index, Emerging Market Debt represented by JPM EMBI Global, Stocks represented by the S&P 500 Index.
2. Source: © 2014 Morningstar, Inc. All rights reserved. See additional source information at www.franklintempletondatasources.com.
Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed.
3. Source: US Bureau of Labor Statistics, 31/12/2014.
Indexes are unmanaged and one cannot invest directly in an index. 4. Sources: Bloomberg, US Bureau of Labor Statistics.
14 Fixed Income Almanac | Market insights 15
certainty of that assumption and its Quantitative easing has ended in the without the world joining in. As a result, Q. Whether it’s structured products, unconstrained fixed income, credit alternatives, etc., it seems
implications. First of all, look back US, but while the Fed has signaled its rates may stay lower for longer than that many financial advisors are looking at everything BUT traditional core fixed income recently.
at all of the predictions at the start of intent to begin raising the Fed funds many imagine. Why do you think that is?
2014. Rates were expected to begin rate in 2015, there is no absolute Roger: All those newer products speak to the fact that advisors are concerned with whether a portfolio
rising, first when the tapering from certainty that will occur. The US Second, a broad assumption has been that mirrors the Barclays US Aggregate Index can still deliver what it has been able to over the last 30 years.
the Federal Reserve’s QE (quantitative economy finally seems to be getting that once short-term rates begin rising, It’s performed well over time in part because interest rates have been generally falling over that time frame.
easing) program was announced, into gear, but Europe appears to long-term rates should follow suit. If you had been a passive investor in a fund that mirrored that index, you did fairly well. But most believe
then, once the US started showing have continuing problems getting We believe that the Fed funds rate may we are in a new environment—if not rising rate, then perhaps an extended period of low rates.
job growth over 200,000 per month its economy started. China has been begin to rise this year, perhaps even
on a consistent basis, and then when slowing. Emerging markets may not sooner than some predict, but that the And everybody is seeking lower risk, or better ways to diversify their portfolio risk. In my opinion,
QE ended. Where was the 10-year be able to grow without robust export long end of the market may not react this is where the true value of active management comes into play. You could have a static allocation
Treasury yield at the start of 2014? markets. The US may not be able to strongly. So we think it’s possible we that mirrors the Barclays US Aggregate Index, but if interest rates do start their expected rise, do you
Three percent. Where was it more grow as rapidly as anticipated may see an overall flattening of the want to have a static allocation of more than one-third Treasuries over which you cannot control the
recently? 1.91%.5 So it hasn’t gone yield curve. duration? I’d prefer somebody managing the interest-rate risk of that portfolio.
exactly as everybody had assumed.
The Risk/Reward Profile of Fixed Income Asset Classes6
10-Year Period Ended 31 December 2014
12%
n
ur
Ret 9%
al
ot Emerging Market Debt
T
nual High-Yield Bonds Long-Term US
n Treasury Bonds
A
e
ag Investment-Grade
er 6% Corporate Bonds
v
A
Mortgage-Backed Securities
Intermediate-Term US Treasury Notes
Floating-Rate Loans
US Agencies
Global Bonds
3%
90-Day US Treasury Bill
0%
0% 3% 6% 9% 12% 15% 18%
Annualized Risk (Standard Deviation)
This is for illustrative purposes only and does not reflect the performance of any Franklin Templeton strategy. Past performance is
not an indicator or a guarantee of future performance.
A Note on Risk
All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of
interest rates. As the prices of bonds in a fund adjust to a rise in interest rates, the fund’s share price may decline. Changes in
Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed.
the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer, or guarantor, may affect the
5. Source: Bloomberg. 3.03% as of 31/12/13, 1.91% as of 13/1/15.
6. Source: © 2014 Morningstar, US Bureau of Labor Statistics. 90-Day US Treasury Bill represented by the Payden & Rygel 90-Day US Treasury Bill Index, US Agencies represented by the bond’s value. Floating rate loans and high-yield corporate bonds are generally rated below investment grade and are subject
Barclays US Agency Index, Mortgage-Backed Securities represented by the Citigroup USBIG Mortgage Index, Investment-Grade Corporate Bonds represented by the Barclays US Credit Index,
Global Bonds represented by the Citigroup World Government Bond Index, Floating-Rate Loans represented by the Credit Suisse Leveraged Loan Index, Intermediate-Term US Treasury Notes to greater risk of default, which could result in loss of principal, a risk that may be heightened in a slowing economy. The
represented by the Payden & Rygel 10 Year US Treasury Bond Index, Emerging Market Debt represented by the J.P. Morgan Emerging Market Bond Index Global, High-Yield Bonds represented
risks of foreign securities include currency fluctuations and political uncertainty. Investments in developing markets involve
by the Credit Suisse High Yield Index, Long-Term US Treasury Bonds represented by the Payden & Rygel 30-Year US Treasury Bond Index. Past performance does not guarantee future results.
Indexes are unmanaged and one cannot invest directly in an index. heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.
16 Fixed Income Almanac | Market insights 17