Contrary view propels Core Plus strategy

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Tom O’Gorman, director of Franklin Bissett Fixed Income, explains why markets are misguided and how defensive positioning could pay off long-term

TOM O'GORMAN is confident about future returns in fixed income, but believes the market has jumped the gun in expecting imminent interest-rate cuts. O’Gorman, SVP, director of Franklin Bissett Fixed Income at Franklin Templeton Canada, pointed to both US and Canadian markets as misguided in thinking the recession has already come and gone. The Canadian government two-year bond, for example, is 84 basis points below policy rate as of February 2, 2023 – it has been as much as 90 basis points – which is an aggressive stance given the Bank of Canada has signalled it will now pause. O’Gorman, who co-manages Franklin Bissett’s Core Plus bond strategy, told WP that given the long lag between rate hikes and their subsequent impact, this plateau period “is just getting started.”

Franklin Resources, Inc. is a global investment management organization with subsidiaries operating as Franklin Templeton and serving clients in over 155 countries. In Canada, the company’s subsidiary operates as Franklin Templeton Canada. Franklin Templeton’s mission is to help clients achieve better outcomes through investment management expertise, wealth management, and technology solutions. Through its specialist investment managers, the company offers boutique specialization on a global scale, bringing extensive capabilities in equity, fixed income, multi-asset solutions, and alternatives. With offices in more than 30 countries and approximately 1,300 investment professionals, the California-based company has 75 years of investment experience and approximately CAN$1.9 trillion in AUM as of December 31, 2022.

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canada 10 year - yields

2005

“We have lots of capacity to increase risk, and this has worked out well for us. It's sort of contrarian – when people are buying, we tend to be selling and doing the opposite”

Tom O’Gorman, Franklin Bissett Fixed Income

He said, “If you look at three-month over three-month annualized inflation, it's come down a lot, but it's still well above [the central bank’s] target. Year over year numbers are higher, and are likely to keep falling for a few more months, but it's unfathomable to me they would throw away [that progress] and just start cutting before reaching their target with some confidence that inflation will stay there.”

A flattening yield trade has worked well because long rates are well below short rates, while floating rates and long bonds have also performed. The Franklin Bissett Core Plus Bond Fund strategy remains underweight at the front end but likes the US dollar, which O’Gorman says may be a good hedge for Canadian investors when risk sells off. As of January 31, 2023, Franklin Bissett Core Plus Bond Fund is close to its max position long the US dollar. Given the fund’s contrarian view of the market, it’s positioned defensively, with less corporate exposure than at any time since O’Gorman joined the company 12 years ago. It has sold corporate bonds and gone up in quality into sectors that the manager believes will fare better. In addition, the fund has credit hedges in place, using put options on investment-grade and high-yield credit default indices. If spreads widen, those options go up in value and protect the downside.

O’Gorman believes Canada is going to have a recession this year, and, if you look back at other typical downturns, there has been a sweet spot for investment-grade credit at around an index spread of 200bps. But with spreads moving in the opposite direction (see chart), O’Gorman believes you should be paid more for your credit risk given the growth outlook and earnings picture. He said, “The compensation for credit risk is just not priced that way – hence we are very defensive and have tons of dry powder to buy when we think it's appropriate. We have lots of capacity to increase risk, and this has worked out well for us. It's sort of contrarian – when people are buying, we tend to be selling and doing the opposite.”

“We’re pretty max-long the US dollar, we believe credit will underperform, we have a lot of hedges, and it'll provide an opportunity at some point to add all of that credit back’

Tom O’Gorman, Franklin Bissett Fixed Income

A contrarian view

Nimble diversification

As of February 01, 2022

2010

2015

2020

0.5%

1.5%

2.5%

3.5%

4.5%

Source: Macrobond

Source: Bloomberg

canadian yield curve

February 06, 2021 to February 06, 2023

0.5%

1.5%

2.5%

3.5%

4.5%

100%

200%

300%

400%

500%

10Y

20Y

30Y

Change - 17 Mid YTM (02/06/21-02/06/23)

Change - 17 Mid YTM (02/06/22-02/06/23)

Canada Sovereign Curve on Feb. 6, 2021; Mid Yield-To-Maturity

Canada Sovereign Curve on Feb. 6, 2022; Mid Yield-To-Maturity

Canada Sovereign Curve on Feb. 6, 2023; Mid Yield-To-Maturity

Source: Bloomberg

US and canadian corporate credit spreads

As of January 18, 2023

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

2022

Canadian Corporate Credit Spreads

US Corporate Credit Spread

It’s an approach that reaped rewards during the energy crisis when the likes of Suncor and Canadian Natural Resources were cheap, while in 2020 its core analysis set up the fund for an “unbelievable once-in-a-career opportunity to buy” after the pandemic hit. Given the sensitivity to housing in Canada and his prediction of a recession, O’Gorman believes a similar strategy may pay off again. Critical to this position, however, is Core Plus’s ability to factor in diversification, especially given the size of the Canadian market. O’Gorman, therefore, looks to the US for opportunities to diversify away from those factors that drive the Canadian economy – for example, a high-yield bond from a for-profit hospital system, which has no correlation in the Canadian economy or credit markets. He said, “We're looking, to the extent possible, for low or negative correlation, and those are the places you get it. Tying it all together is how you manage the currency, and we're very active in opening up [our fund] to that US-dollar exposure when it’s attractive, and hedging it when it’s not.”

Counterintuitively, as rates are rallying, so are risk assets. The tightening of spreads suggests investors are accepting less compensation for credit risk just as growth is starting to slow. Again, O’Gorman can’t see how these valuations make sense, and believes not only that is this not fully pricing in a recession, but also that the assumption that the Bank of Canada and the US Federal Reserve will start cutting policy rates right after they reach their peak policy rates of 4.5 percent and five percent respectively is misguided. “We think the markets have overreacted a little bit. As the Franklin Bissett Fixed Income team, we're neutralized to duration, maybe leaning a little bit short because if they're

He added, “We’re pretty max-long the US dollar, we believe credit will underperform, we have a lot of hedges, and it'll provide an opportunity at some point to add all of that credit back. That’s the next evolution in our strategy for this year.” Holding some cash and having some dry powder ready to deploy is thus prudent as we barrel into an unpredictable period. O’Gorman is confident in his positioning, which, while out-of-step with bond markets, has him excited about future return potential.

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going to stay at these higher rates, the term structure of yields in the US and Canada needs to move back up a little bit. It doesn't have to move a lot, but it needs to better reflect that [policy rates] are going to be on hold for a while.”

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Source: Bloomberg

canadian yield curve

100%

200%

300%

400%

500%

0.5%

1.5%

2.5%

3.5%

4.5%

Canada Sovereign Curve on Feb. 6, 2021; Mid Yield-To-Maturity

Canada Sovereign Curve on Feb. 6, 2022; Mid Yield-To-Maturity

Canada Sovereign Curve on Feb. 6, 2023; Mid Yield-To-Maturity

Important Legal Information This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. Commissions, trailing commissions, management fees, brokerage fees and expenses may be associated with investments in mutual funds and ETFs. Please read the prospectus and fund fact/ETF facts document before investing. Mutual funds and ETFs are not guaranteed. Their values change frequently. Past performance may not be repeated. Franklin Templeton Canada is a business name used by Franklin Templeton Investments Corp.