Beyond Bulls & Bears

Silver Lining: Fed’s “Tapering” Signals Stronger Economy

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The Federal Reserve’s warning that it planned to scale back purchases of Treasuries sparked a storm on Wall Street, bringing instability to what had been a pleasant May in the US markets. Almost lost in the noise, however, is a silver lining: the Fed thinks the economy may be healthy enough to fly on its own. Eric Takaha, senior vice president and portfolio manager, says economic trends, including lower unemployment rates, have improved to the point where the Fed would have to at least consider reducing its Treasury-buying program. The Fed currently buys $85 billion in Treasuries and mortgage-backed securities

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every month. It began buying long-term debt in late 2008 to bring down long-term interest rates and encourage investors to move into riskier assets, such as stocks and real estate. More than four years later, with the US stock market soaring and home sales climbing, the Fed’s plan—or something—appears to be working, so it should come as no surprise that the Fed has announced plans to begin “tapering” its bond purchases, Takaha says. And, he adds, it’s probably a good thing that the Fed at least warned the market about its potential policy change.

Eric Takaha
“In fact, I think it’s a positive that the Fed’s coming out a bit earlier and providing some guidance so it’s not a surprise. You don’t want to have a situation where suddenly the Fed’s coming out, pulling back on their purchases and raising rates, which could really cause some dislocations in the markets. I think it’s a favorable statement that they are trying to do kind of a gradual approach to this change in policy. Now, whether it occurs over the next few months or over the next few quarters, it will likely be largely data dependent in terms of unemployment or some of the other key economic indicators that the Fed focuses on, but I don’t think it’s necessarily a negative that they are showing this hand going forward.” Keeping Calm and Carrying on It’s a given that fixed income investors will be affected when Treasury rates rise as a result of the change in Fed policy. But some worry that rates will climb haphazardly, creating chaos in the markets. And it may have already begun: in May, 10-year Treasury notes posted their largest monthly loss since 2009, bringing their yield to 2.23%, the highest since April 2012. Takaha takes a more measured approach when considering the effects of interest-rate changes on the investments in his portfolios, noting that different fixed income securities will be affected in different ways. “Certainly, there will be some impact. If you have a rise in rates, investment-grade corporates will probably be the most vulnerable. Securities such as high-yield corporates and bank loans tend to be less affected. That’s because, for high yield right now, about three-quarters of the overall yield is coming from spread [the difference in yield between the average of issues in the benchmark index and 10-year Treasury], not from the Treasury curve itself. So, if Treasury rates move up, it will have an impact on fixed income investors, but, in general, a lot of that could be absorbed in the spread; spreads could compress. Think about bank loans, which are floating-rate instruments. Although they have some minimum yield, in general, if you see short-term rates rise over time, you can actually see more income coming from your bank loan securities.1 “The global markets are, by definition, non-US and related to non-US Treasury curves. Although there can be some impact and some correlation between what the U.S. is doing in terms of rates, it tends to be much less direct.” Back to Basics Despite new worries about tapering, the keys to corporate credit performance are traditional drivers: basic balance-sheet fundamentals. Companies typically perform at their best in an economy with stable, but positive growth, Takaha says. And, fortunately, that describes the environment most US companies have found themselves in recently. As long as companies maintain their liquidity and keep their balance sheets in order, many ongoing risks can be reduced. But Takaha sees a few clouds on the horizon that could hamper future growth. [php function = 1] “Corporate earnings have slowed and profit margins have reached their peaks, so there are some concerns that things are starting to move in a negative direction. But, from where we stand today, we think corporations are pretty well positioned. So, what do we focus on? What keeps us up late at night? That tends to be the economy and earnings, but as we think about the balance of 2013 and looking into next year, we feel fairly comfortable with those fundamentals going forward.” Get more perspectives from Franklin Templeton Investments delivered to your inbox. Subscribe to the Beyond Bulls & Bears blog. For timely investing tidbits, follow us on Twitter @FTI_Global and on LinkedIn. 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. 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.

1. Treasuries if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. 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.