This strategy does the heavy lifting
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Persistent inflation has Franklin Bissett’s director of fixed income, Tom O’Gorman, opting to pick up the barbell
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INFLATION'S GRIP on the economy has not only persisted but has proven to be much more entrenched than analysts had previously estimated. August's economic data cemented what many experts had been debating: inflation will be more long-lasting than anticipated.
Tom O’Gorman, senior vice president and director of fixed income at Franklin Templeton, expressed his own surprise at the unexpected inflation dynamics. "Looking back at the long post-GFC crisis period, I never imagined we'd encounter this kind of inflation," he candidly admits.
Steering the Franklin Bissett Core Plus bond strategy through fluctuating interest rates, O’Gorman and his team had to rethink their strategy. In the fixed-income world, the primary concern lies in duration risk, spread uniformly along the yield curve. In these unpredictable times, O’Gorman suggests a barbell approach to spread out the risk. The advantage of this strategy lies in its balancing act. While the safe investments act as a protective barrier against the unpredictability of riskier assets, the high-risk component can significantly elevate the portfolio's overall performance. This duality ensures a protective cushion on one side and a growth engine on the other.
Franklin Resources, Inc. [NYSE:BEN] 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 is Franklin Templeton Investments Corp., which 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 more than 1,300 investment professionals, and offices in major financial markets around the world, the California-based company has over 75 years of investment experience and approximately US$1.4 trillion (approximately CAN$1.9 trillion) in assets under management as of August 31, 2023.
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Total return (%) after target horizon rate change simulation as of 10/04/2023
25%
“Canada, in comparison to the US, is in a worse place to deal with the interest rate increases, and they will have a bigger economic impact”
Tom O’Gorman,
Franklin Templeton
Reflecting on the post-financial crisis period, O’Gorman observed a noticeable change in the Bank of Canada's approach. Central banks, which once struggled to push the inflation rate above two percent, are now grappling to bring it down. The Bank of Canada and US central banks have inadvertently boxed themselves in by emphasizing a target inflation rate of two percent. O’Gorman believes achieving a rate below three percent for a sustained period would be a significant victory. But the Fed’s fixation on the number two has backed them into a corner, making any change seem like a credibility issue.
O’Gorman warns that Canada – despite cushioning homeowners with mortgage extensions and other forbearances – is in a delicate spot with rising debt levels.
Troubling signs are apparent, especially in sectors like the auto loan market and credit cards.
There seems to be a burgeoning consensus that the recessionary phase has already run its course and is behind us. O'Gorman suggests that the impact of rate hikes, given their typical lag, is yet to be fully manifest. As he says, this stabilization phase is “just getting started.” O’Gorman believes that the current plateau or pause signaled by the Bank of Canada is merely the beginning.
“Rate hikes are a very blunt tool. It's got a huge lag effect. Canada, in comparison to the US, is in a worse place to deal with the interest rate increases, and they will have a bigger economic impact. However, I will admit it's taking longer than I expected. I thought by now we'd be seeing concrete evidence, but there are a few reasons why. One is that the US and Canada both threw so much money at COVID.
“Banks seem to be quite lenient these days. Canadian banks have as much as 20 percent of their mortgage portfolios with extended amortization. In these cases, the unpaid interest and/or principal is being added to the principal amount.”
Of the hikes, O’Gorman believes the Fed still has one more in them; in Canada, while there may not be more increases, any hopes of significant decreases should be quashed till 2025 at least.
Considering these market aberrations, the Franklin Bissett Fixed Income team’s strategy is inclined toward the US dollar, viewing it as a potential hedge for Canadian investors against risk volatility.
O’Gorman says, “In our Core Plus strategy, we employ a versatile multi-sector strategy, primarily tapping into what we label as ‘plus sectors.’ These sectors extend beyond the Canadian bond domain, incorporating assets like US high-yield, US leveraged loans, and other global, non-Canadian sectors.
O’Gorman says, “This isn't an environment to be a hero and be taking maximum risk. This is a time to bring risk down. Currently we’re looking to earn safe yields and find opportunities for better entry points.”
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Understanding the interest landscape
Franklin Bissett’s defensive strategy
Published 12 November 2023
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“This isn't an environment to be a hero and be taking maximum risk. This is a time to bring risk down. Currently we’re looking to earn safe yields and find opportunities for better entry points”
Tom O’Gorman,
Franklin Templeton
Barbell structure – Potential high-earning opportunity with mitigated loss risk
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10 Year Government Bond
Barbell 50/50 Structure (10 years, 1 year gov. bonds)
As of August 31, 2023
Core US and Canadian INflation
0%
US Core PCE YoY
US Core CPI
Core Canadian PCI
2%
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6%
8%
10%
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Source: Bloomberg
“Though we do occasionally delve into the limited Canadian high-yield market, we also explore out-of-index securities like the limited recourse capital notes sold by banks. We're proactive in our use of derivatives for hedging purposes, and leverage currency not only for hedging but also as a return generator.”
O’Gorman’s team now has significantly reduced risk exposure. Although their allocation to corporate bonds might typically range between 40 percent and 70 percent, currently O’Gorman aims to stay well below that upper limit. This year, his allocation to corporate credit has been the lowest in his 13 years at Franklin Templeton. The current rewards don’t justify the potential impact of an economic slowdown or even a mild-to-severe recession.
With Core Plus, O’Gorman highlights, “We want to add risk when volatility is high. Our strategy for Core Plus is currently neutral in terms of duration. We anticipate that even though the yield curve is currently inverted, interest rates will eventually decrease. Hence, we're maintaining a neutral position, and at some point, may consider going longer in the future.
“We have a maximum long position in the US dollar, under the guidelines for the category that we're in. Our funds are all Canadian and therefore you're limited to how much active currency risk you can take.”
Taking the barbell approach
O’Gorman recommends distributing investments into two categories representing high and low risk. The visual of a barbell aptly captures this methodology. “Interestingly, the yield curve offers a lucrative spot at the front end. Short maturities, which yielded almost nothing a couple of years ago, now hover around five to 5.5 percent. This has raised the profile of strategies like Franklin Bissett’s Ultra Short Bond which, we believe, is quite attractive.”
As it stands, the return for Core Plus has been affected by the recent rate spike, but the Ultra Short portfolio remains robust because of its immunity to such rate movements.
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.
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As of August 31, 2023
Core US and Canadian INflation
Source: Bloomberg
0%
2%
4%
6%
8%
10%
12%
14%
16%
1980
1982
1984
1987
1989
1992
1994
1996
1999
2001
2004
2006
2009
2011
2013
2016
2018
2021
2023
US Core PCE YoY
US Core CPI
Core Canadian PCI
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Copyright © 1996-2023 KM Business Information Canada Ltd.
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Best in Wealth
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News
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Investments
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Best in Wealth
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Copyright © 1996-2023 KM Business Information Canada Ltd.