“Bonds are fine” – the subtleties of global fixed income for portfolio diversification

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How bonds offer stability and opportunity, according to Franklin Templeton ’s John Beck

THOSE FIXATED on the daily swings of equity markets might overlook a valuable opportunity within the bond market. Given their potential for current income and capital gains, bonds may become an essential component of a diversified investment portfolio. John Beck, senior vice president and director of Global Fixed Income for Franklin Fixed Income, London, UK, says, “I think that the bond markets now represent reasonable value. That may not be a terribly exciting thing to say, but it's a perfectly reasonable thing to say. “The situation isn't about diving into warm waters without a

Franklin Resources, Inc. [NYSE:BEN] is a global investment management organization with subsidiaries operating as Franklin Templeton and serving clients in over 150 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 specialization on a global scale, bringing extensive capabilities in fixed income, equity, alternatives, and multi-asset solutions. 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$1.6 trillion (approximately CAN$2.2 trillion) in assets under management as of January 31, 2024.

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cANADIAN, u.s. AND wORLD INFLATION

25%

“I think that the bond markets now represent reasonable value. That may not be a terribly exciting thing to say, but it's a perfectly reasonable thing to say”

John Beck, Franklin Templeton

hint of danger; it's not as perilous as swimming with sharks, [but neither] is it as wonderfully cozy as lounging in a wellness spa. Essentially, bonds are fine.”

Despite market speculations and historical pressures on central banks to adjust interest rates, Beck asserts that a fundamental shift has occurred. Central banks are now more determined to adhere to their core mission of combating inflation, influenced by lessons learned from past financial upheavals. According to Beck, looking at individual data points takes you away from what central banks want to create. Inflation is, of course, an important story to a fixed-income manager; however, as Beck points out, “The market's early predictions, based on the rate structure, were that the Fed would cut rates six to eight times in 2024. Franklin Fixed Income group has consistently challenged this outlook. We weren't massively caught up in the euphoria. “Inflation was likely to decrease due to base effects. There's nothing terribly revolutionary in what that means. It was high a year ago; when that falls out, then the base effect improves, and therefore inflation comes under control. It was always our view that the underlying economy was reasonably robust. This makes the persistence of inflation, to some extent, unsurprising.” Beck’s skepticism regarding the market's initial rate-cut expectations for the year was informed by a broader historical context. His experience suggests that, for the past two decades, central banks have often been compelled to act in response to various crises – from the dot-com bubble and 9/11 through the global financial crisis and the European debt crisis, to more recent events like COVID-19 and the Russia-Ukraine conflict. The default response to these shocks has typically been, “Please Mr. Central banks, could you cut interest rates?” The inflation surge following COVID-19 and the ensuing supply-chain issues, particularly with China and exacerbated by the Russia-Ukraine conflict, necessitated a return to the central banks' primary mission of inflation control. Yet, even with a potential victory over inflation, a return to the ultra-low interest rates of the past seems unlikely. Inflation remains persistently high, but this situation might align well with central banks' fundamental policy goals, suggesting a deliberate strategy rather than a failure to control inflation.

The current levels of inflation and interest rates bear resemblance to the late 1990s, and increase the attractiveness of bonds. Beck advises, “Given the relatively small size of the Canadian market within global fixed income, it does pay people to kind of look outside Canada's borders. In our fund, we mitigate currency risk by hedging back to the Canadian dollar, which always reveals opportunities for better value compared to others – for instance, the local Polish bond market or regions like Europe and the UK, where we’re overweight in our interest rate risk, believing rates there will likely drop sooner. “There are always areas where, in a global portfolio, you can find things that are exciting, and, equally, things that you want to avoid. Japan is an example of that ... when the Bank of Japan announced the end of its 20-year stint of negative interest rates with its first rate increase in two decades, the market response was tepid. Consequently, we’re underweight in Japanese bonds, viewing them as relatively expensive both in terms of absolute yield and when adjusted for inflation.” Beck maintains that the global fixed-income portfolio allows clients to balance investments and seek out areas that are currently sensible. The Japan and China contexts highlight this approach well. In 2022, these markets were safe havens, as their interest rates remained stable while rates in Europe, the US, Canada, and most of the world climbed rapidly. Thus, there are always regions that, to a bond manager, offer excitement - as far as a bond manager can be excited - and the chance to diversify.

Not all global opportunities are considered, despite appearing lucrative, however; Beck expressed reservations about investing in Chinese equities and bonds due to ESG criteria, highlighting the nuanced challenges of investing in such a pivotal yet complex market. “For ESG reasons, we’re not invested in China,” Beck stated, underlining the strategic decision to prioritize investments that align with certain ethical and governance standards. Despite the potential opportunities in China, Beck's firm opts for a cautious stance, reflecting a broader industry trend toward responsible investing. Acknowledging China's significant impact on the global

In fixed income, there’s a discernible shift toward seeking yield, though it doesn’t mean gravitating exclusively toward the lowest rungs of investment-grade corporate bonds to chase the highest yield spreads. Reflecting on some strategic adjustments Franklin Templeton has made in the portfolio, Beck notes, “Three years ago, we notably scaled back our exposure to US mortgages. This decision was grounded in the mechanics of mortgage prepayments. For instance, anyone fortunate enough to have secured a mortgage at a fixed rate of 2.5 to three percent a few years back would likely go to great lengths to retain that rate, avoiding major life changes like divorce or moving. This scenario creates a dilemma for us as investors in mortgages, turning these assets into ones with exceptionally long durations. “Fast forward to now – we’ve removed that underweight, achieving a neutral stance toward the mortgage sector. We're now comfortable with – and, indeed, eager to benefit from – the higher interest rates these mortgages can offer, despite the complexities introduced by their prepayment schedules. “In US investment-grade corporates, we find ourselves overweight compared to US Treasuries, embracing higher yields amid careful risk assessment. Similarly, this strategy is applied in our investments across Europe and Asia, tailoring our exposure to capture the best yield opportunities.” Beck emphasizes again a pivotal aspect of his investment strategy is that the exposure to foreign currencies is hedged back to the Canadian dollar. This approach allows investors to benefit from broader diversification and enhanced investment opportunities without bearing the brunt of currency risk. By neutralizing the volatility associated with foreign currencies through hedging, investors still gain the advantage of exposure to multiple interest rate cycles instead of being confined to a single domestic cycle. This is a compelling reason for Canadian investors to consider allocating a portion – not necessarily the majority, but a part – of their bond asset allocation to global fixed-income markets. It offers a balanced blend of risk management and potential for higher returns, making it an attractive proposition for diversifying investment portfolios.

Interest rates, bond market, yield and prices

Insights into inflation and central bank strategies

Insights into global trends

Published April 30, 2024

“In US investment-grade corporates, we find ourselves overweight compared to US Treasuries, embracing higher yields amid careful risk assessment”

John Beck, Franklin Templeton

As of January, 2024

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economy, John remarked, “China is still, even though we're not invested in China, obviously quite an important large economy.” He touched on the country's slowing growth, transitioning from a period of rapid expansion to more modest gains, and its implications for global demand and inflation.

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Disclaimer 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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