Beyond Bulls & Bears

Seeking a Fixed Income Fix

While governments worldwide continue to struggle with debt and budget issues, for the most part, corporations have turned lemons into lemonade and have become lean and mean.  While not without risk, corporate credit actually looks to be in fairly good shape, according to Eric Takaha who, as senior vice president and portfolio manager at Franklin Templeton Investments, spends a good deal of time analyzing the space.

The environment has actually been pretty good for corporations, both high yield as well as investment grade, and some of the bank loan issuers out there. Default rates for the last couple of years have been generally well below long-term averages for both high-yield credit as well as for bank loans. In general, management teams have been pretty conservative with their balance sheets. There’s been a lot of liquidity; a lot of refinancing activity has gone on, so they have pushed out their debt maturities over the next couple of years. We think the outlook—at least for the near term—is for a continuation of those trends. Investment-grade companies have been able to refinance at very low interest rates, so that’s helped their cash flow and earnings potential. So while default rates could tick up a bit, we think the corporate credit fundamental environment looks relatively tame. We think the credit risk in the marketplace is probably a bit below average.” 

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When looking at this type of investment, Takaha says it’s important to separate corporate credit margins from a company’s earnings results.

“If you look at corporate margins over the last couple of years, they’ve kind of reached historical highs, so you have seen some peaking over the last couple of quarters. That being said, fourth-quarter earnings, at least here in the U.S., look like they’ll still be an improvement year-over-year in 2012.

Eric Takaha

When you think about corporate credit, we don’t necessarily need to see significant growth in corporate earnings. What we really want is more stability of corporate earnings and corporate cash flow. And so even though certain markets look for significant growth as long as we have a flattish environment where companies still have good balance sheets and good corporate fundamentals, we don’t necessarily need to see the type of growth that you might be expecting in the earnings market.”

Rising Rates and Risk/Return

In much of the world, interest rates have been stuck in low gear for years, and in general some traditional government bonds have lost their luster as income-producers. Investors have either learned to lower their return expectations, or set out in search of alternatives. Here’s how Takaha sees it:

“When you think about the relative potential for something like a high-yield corporate bond or a leveraged loan or even an investment-grade corporate (bond), we think it still stacks up reasonably well relative to the alternatives, although the nominal return expectations need to be tempered. From my standpoint, I tend to focus much more on the fundamentals, which we think are fairly supportive right now.”

It’s pretty safe to say interest rates will eventually go up at some point, particularly when you have central banks around the world feverishly printing money to stoke their economies. Takaha notes that investment-grade bonds can be more sensitive to interest rate increases than non-investment-grade (high-yield) debt, and that’s something to be mindful of when rates do start trending upward. 

“If rates do start to rise, it’s usually because inflation is picking up and typically because the economy is doing a bit better. In that environment often you would see spreads narrow and so you may be able to cushion some of the impact from a rise in rates by seeing that spread over Treasuries narrow in a good economic environment. So obviously there are a lot of different outcomes that could happen, but we think that’s kind of the typical outcome if you see rates rising because the economy is doing better.”

Playing Politics

While macroeconomic and political challenges in both the United States and globally are likely to be top of mind in 2013, Takaha doesn’t expect that will have much of a negative impact on corporate bonds.

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“Whenever you have politics involved, it gets a little bit tricky in terms of predicting how some of these outcomes may unfold. Europe obviously has its own situation in terms of debt and balance sheets on the government side. Here in the U.S., we were able to push off the (fiscal cliff) crisis at the end of 2012, and now we have other deadlines coming up over the next couple of months in terms of sequestration as well as the debt ceiling. Politics being what it is, we expect there to be a lot of back-and-forth negotiation, a lot of posturing.  

“The question now is: can American government leaders really get the spending cuts needed to get their budget in order? That tends to be more difficult.  We think ultimately something does get done, but we expect there could be market volatility here in the coming months as negotiations go back and forth.”

Perhaps bloated governments ought to take a heed of what corporations had to learn: something’s gotta give.

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What Are the Risks?

The value of investments and the income from them may go down as well as up and you may not get back the full amount that you invested. Bond prices generally move in the opposite direction from interest rates.  In general, an investor is paid a higher yield to assume a greater degree of credit risk.  High yield bonds involve a greater risk of default and price volatility than other high quality bonds and US government bonds.  High-yield bonds can experience sudden and sharp price swings which will affect the value of your investment.

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