From volatility to victory: Looking forward to a year of gains for bonds

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Franklin Templeton’s director of Canadian Fixed Income, Tom O’Gorman, details how bonds emerge stronger

THE BOND MARKET last year experienced significant volatility as traders and investors steered through the uncertain waters of inflation forecasts and economic predictions, ranging from a severe recession to a soft landing or even avoiding a recession entirely. Advocates of the recession cited the inverted yield curve as a clear indicator that an economic downturn is imminent. However, Canada’s biggest trading partner, our southern neighbour, has yet to experience the anticipated recession, and the inversion of the yield curve has significantly decreased, suggesting that the economic landscape may not be as precarious as once thought. Contrary to the tumultuous ride it seemed to be, the bond market produced favourable returns in 2023, buoyed by a fourth-quarter rally. After a nasty 2022 – the bond market’s lousiest in history – bonds were due for some good news. Corporate bonds performed well with an 8.37 percent return, as the narrow yield spreads over government bonds indicated limited investor concern over potential economic impacts on corporate financial health.

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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“For the first time in many years, the symmetry of returns appears highly favourable for fixed income investments”

Tom O’Gorman, Franklin Templeton

The prospects for fixed income investments in 2024 have brightened as inflation rates, although still surpassing central bank goals, have seen a notable decrease. Director of fixed income at Franklin Templeton, Tom O’Gorman, highlights, “For the first time in many years, the symmetry of returns appears highly favourable for fixed income investments. Last year, all the returns Franklin Bissett Core Plus Bond strategy saw happened in November and December. “However, while there are opportunities in credit and risk sectors, it isn’t just a throw all your money in corporate bonds and go to sleep at night. Investors need to be discerning, practising selectivity, in terms of avoiding names that are subject to higher interest rates.”

O’Gorman expresses cautious optimism surrounding the trajectory of inflation, pointing out progress toward achieving central banks’ inflation goal. However, he underscores the persistent challenges, such as supply chain disruptions, that central bank policies may not directly address. “Markets are displaying a curious optimism, with risk assets near all-time highs, excluding fixed income, which has seen a decline due to interest rate increases. Yet, corporate debt spreads are at their tightest in 15 years. This presents a

paradox: how can the economy be perceived as weak enough to warrant interest rate cuts while market indicators suggest robust health?” O’Gorman asks. The inclusion of mortgage interest costs in Canada’s inflation measurements is critiqued by O’Gorman, who argues that it creates a paradox where the Bank of Canada, by raising rates, inadvertently fuels inflation. This, he suggests, contrasts with methodologies in other countries like the United States, potentially skewing perceptions of inflationary pressures. O’Gorman says, “Interestingly, during a recent call with an advisor, I addressed the misconception that falling inflation should immediately result in lower store prices. We had to remind them that inflation falling means [prices are] just rising less than they were before. Prices are still rising, just at a lower rate. You need deflation for prices to fall, which is not the case right now.”

The US high-yield market alone surpasses the entire Canadian bond market in size. The US bond market encompasses a vast array of bonds, totalling about 55 trillion dollars, ranging from treasuries and agency mortgages to corporate bonds and high-yield leveraged loans. In contrast, Canada’s bond market stands at around five trillion dollars. This size discrepancy highlights the potential for diversification beyond the Canadian market, which is heavily concentrated in sectors like energy and financial services and exhibits high sensitivity to interest rate changes with limited exposure to broad industrial sectors. Investing in high-yield bonds issued by US for-profit hospital systems presents a unique opportunity, says O’Gorman. Such investments are largely uncorrelated with the Canadian market, given the stark differences in healthcare systems. Moreover, leveraged loans in the US offer another diversification avenue. These are floating-rate instruments whose yields increase with rising bank rates, providing a hedge against interest rate risks.

This size discrepancy highlights the potential for diversification beyond the Canadian market, which is heavily concentrated in sectors like energy and financial services and exhibits high sensitivity to interest rate changes with limited exposure to broad industrial sectors

“I hope that we steer clear of returning to interest rates that hover around 0 to 2 percent,” O’Gorman says. “If the Bank of Canada were to lower rates to such a degree, it would mean we’re facing severe economic challenges. It would indicate a major crisis is underway, another pandemic or a global recession, if not a depression. “My desire for the next five years is to bring a return to normalcy, where interest rates fluctuate naturally, reflecting genuine market dynamics rather than being heavily influenced by central bank interventions. We’ve experienced a prolonged period, nearly 15 years, where the economy has

heavily relied on central bank and fiscal stimulus to stay afloat. “Moving forward, I look for a scenario where the economy can demonstrate resilience and growth through the natural mechanisms of the market, with minimal interference from central banks and government policies.”

As of Feb 29, 2024

Candlestick chart and data of financial market

The state of inflation and central bank policies

Diversification beyond borders

Published March 6, 2024

YIELDS BY FIXED INCOME SEGMENTS

Yield (%)

Canada Treasury Bills: 1–3 months

Canada - Intermediate-Term Treasury

Canada – intermediate-

Canada – Long-Term Treasury

Canada Aggregate

Canada Corporates

15-year range (max–min)

Current level

Source: Bloomberg, Bloomberg Canada Aggregate Corporate Total Return Index Value Unhedged CAD (Legacy Ticker: LCANTRDU), Bloomberg Canada Treasury Bills: 1–3 Months, Bloomberg Canada Aggregate Total Return Index Unhedged CAD, Bloomberg Barclays Canada Aggregate Index, flagship measure of the Canadian investment-grade bond market, Bloomberg Canada Aggregate – Treasury – Intermediate TR Unh CAD, Bloomberg Canada Aggregate – Treasury – Long TR Index Unhedged CAD.

Forward-looking perspective

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.

Source: Bloomberg, as of December 31st, 2023; values presented in Canadian dollars (CAD)

Source: Morningstar, as of December 31st, 2023

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