The lingering low-rate environment in the U.S, Eurozone, Japan and some other nations has many yield-seeking investors feeling stuck in the mud. At its April policy meeting, the Federal Reserve pledged to keep its key short-term interest rate (the federal funds target) “exceptionally low” at least through late 2014.1 Some other global central banks, even in emerging nations, have pushed their rates lower too this year to spur growth. On top of that, many countries are also still trying to dig out of debt, but seem to be spinning their wheels. For insights into this sticky debt mess, we turned to Eric Takaha, portfolio manager with Franklin Templeton’s Fixed Income group, who happily shared his views on these and other challenges the markets are facing today, and where he’s finding investment opportunities. Key takeaways, in his words:
- In terms of the longer-term outlook, debt is still a major issue. I think we are looking at a number of years before these issues really move out of the headlines.
- In the U.S., we have concerns about tax policy and what that may mean for the deficit going forward.
- From the standpoint of the global financial markets on a short-term basis, there are liquidity measures in place, so the risk of some of the downside scenarios seems to have been pushed off.
- The reason that some governments are able to provide more easing for their markets is that inflation has remained subdued.
- When we look at the corporate markets and think about the yield opportunities relative to the risk, we find that to be an attractive space.
Debt issues have plagued a number of developed nations over the past few years, and in the most ailing Eurozone nations, austerity measures have been a bitter pill. Takaha perceives some progress, but said there’s still a ways to go toward solving these problems. The debt landscape to him looks a bit mixed:
“Consumers have been cutting back on leverage, particularly here in the U.S. We started to see a lot of mortgage debt coming down, and that’s a positive sign. Unfortunately, many governments continue to spend, whether in the U.S. or in some of the developed countries in Europe, so we have seen a ballooning of many government debt balances. Over the past several quarters, we have seen some measures taken by European governments to try to address those issues. On the positive side, there have been measures put in place like the LTRO (long-term refinancing operation), which provides liquidity support for many banks in those areas. However, in terms of the longer-term outlook, debt is still a major issue. Even in the U.S., we have concerns about tax policy and what that may mean for the deficit going forward. I think we are looking at a number of years before these issues really move out of the headlines. The good news from the standpoint of the financial markets is that on a short-term basis, there are liquidity measures in place, so it appears to us the risk of some of the downside scenarios seems to have been pushed off.”
Luckily, inflation hasn’t been a major problem for most developed markets, despite all the additional liquidity central banks have been pumping into the system since the most recent financial crisis. Even in many emerging markets, inflation has been tame enough this year to allow policymakers to provide their slowing economies a jump-start. Takaha further explains:
“The reason some governments are able to provide more easing for their markets is that inflation has remained subdued. When you have weaker economic growth, and relatively high unemployment, you tend not to have as many price pressures in the marketplace (particularly on the labor side). We have seen some recent inflation upticks here in the U.S in some areas., so it’s something we are paying attention to. It’s nothing in the near-term, but rates are relatively low, even compared to the current levels of inflation. But look at a country like Japan. It has had many, many years of low inflation and many, many years of low interest rates, so it doesn’t necessarily have to mean that rates are going to rise.”
So, it looks like interest rates could remain low for some time, and investors may very well just have to ride it out with an eye on the long-term. Takaha feels fixed-income investors may want to expand their horizons outside of pure government debt.
“There are a lot of different areas to look at: Corporate bonds, securitized assets—whether in U.S. or global fixed income—assets that are floating in nature rather than fixed in nature. Some of the developing markets where you can invest in both rates as well as currencies also look attractive relative to developed markets. We think the growth rates in some of those areas could encourage some currency appreciation over the long-term. We are fortunate to have a large number of resources to look for these opportunities. You have to understand the fundamentals and the risk that you are undertaking by investing in those sectors, but we see a lot of different opportunities across the global space right now.”
He’s been particularly bullish over the past several quarters on the U.S. corporate markets, whether investment-grade corporates, high-yield corporates or bank loans. Here’s why:
“If you look at the fundamentals for corporations, as opposed to some of the sovereign nations as well as some consumers, debt balances appear fairly well in check. Given the liquidity out there right now for many corporations, the debt markets have been open for them to issue and push out their debt maturities. Earnings have been positive for the last couple of years and default rates have remained relatively low. If you look at valuations in terms of how much yield is available above government bonds, they are still a bit on the cheaper side compared to historical averages. When we think of the corporate markets and think about the yield opportunities relative to the risk, we find that to be an attractive space to be.”
Given the environment we are in today, Takaha feels it’s important for investors to consider a broad spectrum of fixed-income investments. The late Sir John Templeton, also a proponent of diversification, would probably agree. In his words:
“The only investors who shouldn’t diversify are those who are right 100% of the time.”
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What Are the Risks?
All investments involve risks, including potential loss of principal.
Bond prices generally move in the opposite direction of interest rates. 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. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. Investing in derivative securities and the use of foreign currency techniques involve special risks as such may not achieve the anticipated benefits and/or may result in losses.
1 Source: Board of Governors of the Federal Reserve System, April 25, 2012.