Like food and fashion trends, investments can go in and out of favor with the masses. Traditional fixed income investments like government bonds have started to lose their appeal of late, particularly in the developed markets where returns may feel a bit unpalatable. There’s even been talk we could be in the midst of a “great rotation” out of fixed income and into equities. However, investors might want take a look at where they are headed—and why—before joining any sort of mass migration, says John Beck, Co-Director of Franklin Templeton’s International Bond Group. He believes fixed income investments still hold merit, particularly in light of ongoing uncertainties in Europe and elsewhere, and is also looking off the beaten path in spots where many aren’t looking such as emerging markets or high-quality corporate debt.
Senior Vice President, Co-Director, International Bond Group,
Franklin Templeton Fixed Income Group®
Amid much discussion of a “great rotation” out of bonds into equities, investors could be forgiven for thinking that the prospects for fixed income asset classes in 2013 look gloomy across the board. It is true that in recent months, returns from many sovereign bonds perceived as “safe havens,” particularly those from the U.S., Germany and the UK, had turned negative as their yields have moved up from the historic lows seen in 2012 in the midst of the eurozone debt crisis. In January, holders of 10-year U.S. Treasuries lost their entire 2013 coupon as a result of a negative capital return. In February and March, yields on 10-year Treasuries traded above 2%, up from the record low of 1.39% reached in July 2012, raising the possibility of a negative return over 2013 as a whole for Treasury investors.
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However, an adverse outcome for U.S. Treasuries and other perceived safe havens might not necessarily be replicated in other areas of fixed income. We believe investors can still earn a reasonable return this year by diversifying away from perceived safe-haven bonds into other areas, such as emerging market sovereign debt or high-quality corporate issues. Among the emerging-market government bonds that we find attractive are those from Lithuania, Chile and Mexico as well as from select Asian countries. In the case of Lithuania, the yield on its 10-year sovereign bond has declined from 8.5% a few years ago to about 4.5% more recently. Despite this steep fall, we consider that the country’s relatively healthy economic and fiscal fundamentals make Lithuanian bonds still worth holding. For example, Lithuania’s debt-to-GDP (gross domestic product) ratio of 25% compares favorably with an equivalent 85% figure in the U.S. While significant foreign funds have certainly flowed into emerging-market government bonds issued by countries such as Lithuania, this does not in itself provide a reason to sell out of the underlying credit in favor of perceived safe-haven bonds such as U.S. Treasuries, in our opinion.
Similar arguments can be put forward for our other favored emerging markets. Yields on Chilean sovereign bonds have seen falls comparable to those of Lithuanian bonds, but equally, these declines have been supported by Chile’s healthy fiscal and current accounts as well as its low debt-to-GDP ratio. On top of these structural positives, the country is rich in resources and has a pension system that is fully funded, in stark contrast to the U.S. In Mexico’s case, its economy enjoys the additional advantage of being geared to U.S. growth, which we believe should benefit the country as the U.S. recovery slowly builds momentum. We have also favored allocations to the local currency-denominated bonds of Asian countries such as Malaysia and South Korea. The yields on many of these issues remain potentially attractive, in our view, while the currencies of both countries may benefit from further appreciation against the U.S. dollar over the long term.
[perfect_quotes id=”1376″] While we may tactically trim our exposure to these emerging-market bonds if we feel their valuations have moved far ahead of fundamentals, we have a hard time envisaging a scenario over the short to medium term in which we would eliminate exposure completely, given the environment and limited alternatives. That is not to say we believe no opportunities exist among developed-market sovereign credits, despite our aversion to perceived safe-haven bonds of the U.S., Germany, Japan and the UK. French and Italian government bonds trade, in our opinion, at reasonable values compared with German Bunds. Countries including Canada, Australia and much of Scandinavia share the distinction (along with our preferred emerging markets) of having superior growth prospects, as well as favorable debt‐to‐GDP ratios, increasing the attraction of their debt compared with that issued by relatively slow‐growth, indebted G‐3 countries (i.e., the U.S., the eurozone and Japan).
Though periodic episodes of market volatility are likely to occur, as a result of, for example, elections in the eurozone, we still think 2013 is going to be a tough year for holders of perceived safe-haven bonds, and we see a possibility of negative returns for some of these issues over this period. But, in our view, the demanding environment for perceived safe-haven bonds should not distract investors from the potential rewards in other areas of fixed income, for example, U.S. dollar-denominated government bonds from countries such as Lithuania, Chile and Mexico or local-currency sovereign bonds from issuers like Malaysia and South Korea.
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What Are the Risks?
All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investments in the precious metals sector involve fluctuations in the price of gold and other precious metals and increased susceptibility to adverse economic and regulatory developments affecting the sector. The risks of currency fluctuation and political uncertainty are associated with foreign investing. 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. Investments in smaller companies can be particularly sensitive to changing economic conditions, and their prospects for growth are less certain than those of larger, more established companies.