Beyond Bulls & Bears

Rethinking Core Fixed Income

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Michael Hasenstab, chief investment officer, Global Bonds, Franklin Templeton Fixed Income Group®, says it is time for fixed income investors to think outside traditional boxes. He believes that with today’s market environment and the prospect of rising US interest rates on the horizon, investors need to rethink their core fixed income portfolio. He makes the case for an actively managed, global, unconstrained fixed income strategy.

Three key requirements exist. First, the strategy needs active management to be able to adeptly invest in the relative strength of select countries and currencies while avoiding the weakness of others—something an index cannot do. Second, it should be well poised to deliver a negative correlation1 to US Treasuries2 given the seemingly inevitable eventual rise in interest rates. Notably, while some strategies claim to have a negative duration,3 that is not synonymous with the more important goal of having an overall negative correlation to US Treasuries. Third, the strategy needs a long-term track-record that investors can thoroughly analyze over market cycles and unexpected events. These are some of the tenets of Dr. Hasenstab’s approach.

Michael Hasenstab
Michael Hasenstab

Michael Hasenstab, Ph.D.
Executive Vice President

Chief Investment Officer, Global Bonds
Portfolio Manager, Franklin Templeton Fixed Income Group®

Interest rates on government bonds still hover near historically low levels in many parts of the world, near 0% for some core developed economies such as Japan and in the eurozone. However, we believe yields will eventually rise in many markets in the face of stronger economic growth, albeit at various speeds given the disparate stages of recovery. We believe it is imperative that clients prepare well for that by investing in strategies that demonstrate a negative correlation to US Treasuries. We believe that doing so will help provide investors with downside protection when rates rise.

The United States continues to gain ground in its economic recovery, with the International Monetary Fund forecasting a growth rate for the US economy of 1.7% for 2014 and 3% for 2015.4 We believe improving US growth should have a broad-based positive aggregate demand effect on the rest of the world and help support the economic health of the global economy.

Dim Prospects for Traditional Core US Fixed Income Portfolios

The US Federal Reserve (Fed) has been winding down its asset purchase program and signaling higher rates are ahead. In this environment, we believe core US fixed income portfolios traditionally managed to a conventional benchmark could face dim, likely negative, return prospects due to their benchmark limitations and inherent duration risk. In a rising-rate environment, we believe that unconstrained, global fixed income portfolios that have the flexibility to manage duration should be better positioned to outperform.

The duration of traditional fixed income indexes has largely remained steady while yields in developed markets across the globe have been declining since late 2008, largely as a result of central bank intervention aimed at pushing down borrowing costs in a bid to stimulate economic activity and revive growth.

As a result, longer-maturity government bond valuations have become relatively unattractive, in our view, and the income earned would be insufficient to compensate against the risk of rising interest rates. As such, we seek negative correlation with US Treasuries in our strategy. While many other managers are focused on negative duration, we feel it’s more important to design a portfolio that delivers an overall negative correlation to US Treasuries while reducing interest rate risk. We strive to achieve this in part by being short duration. In addition, we overlay currency and credit strategies. For example, we remain long the US dollar and short the Japanese yen and euro as we believe the US economy’s growth will likely increase the value of the US dollar while the quantitative easing in Japan and the eurozone is likely to persist, putting pressure on those currencies relative to the US dollar.

Looking Beyond an Index

Being global and unconstrained runs deep in our DNA; these fundamental elements have been refined over decades of experience within the Templeton Global Bond Group which was founded in 1986. Both require a completely different mindset from passive and traditional core market investing and involve more in-depth local research and trading capabilities, risk management, and operational infrastructure to operate at the scale required to put money to work fluidly and responsibly.

Global fixed income investing does not yet lend itself to passive strategies. Strong risk-adjusted return potential, not the size of a country’s index weighting, drives our investment choices. In our view, taking an active management approach to fixed income investing is essential in volatile market environments and/or during shifts in interest rates. We and many others are expecting such a rise in US interest rates in 2015.

We use a truly unconstrained approach to global investing that helps us to discern potential opportunities when others worry or even panic, and it equips us to react quickly when others may not. Our combination of in-house, bottom-up country research and fundamental analysis as well as macroeconomic modeling assists us in identifying high-conviction investment opportunities. This process gives us the tools to enable us to take contrarian views to the market.

We believe our investment time horizon of two to five years  enables us to take advantage of inefficiencies that generally require a longer holding period to generate alpha (measure of performance on a risk-adjusted basis).

Duration and Risk

My team and I strive to position our portfolios with built-in liquidity, giving us additional flexibility during periods of extreme volatility.  This enables us to maintain our convictions and patiently wait for prices to move toward what we think is their long-term fair value. Moreover, unlike some managers, we do not use stop-loss systems—an order to sell a security when it reaches a certain price—as we have often seen these moments of apparent panic as opportunities to buy.

As the Fed continues to wind down its asset-purchase program, we expect US rates to continue to normalize toward historic norms over the medium term. In Europe, we believe rate normalization is likely to be slower than in the United States due to Europe’s more tepid economic recovery. Under this scenario of rising rates, we believe traditional core US fixed income strategies have greater vulnerability to capital losses as many target duration to be within a range—within two years, for example—relative to the duration of their respective benchmarks, generally exposing these portfolios to interest-rate risk regardless of the health of the economy. The strategy of just using negative duration could leave investors vulnerable to price depreciation in the short term should interest rates decline and, depending on the implementation, could leave investors with more interest rate exposure than they intended.

In our view, the United States has likely passed the inflection point in interest rates and may be in the early stages of the normalization period in monetary policy. By contrast, we believe interest rates are likely to stay anchored in Europe amid further stimulus from the European Central Bank (ECB); however, we also believe yields are likely to rise eventually as the region’s recovery gains more ground. We believe the limitations of traditional bond benchmarks diminish the performance potential in terms of income generation and duration gains given the extremely low levels in interest rates. The limitations may also increase the beta (market) risk—or risk of general market movement—for core US fixed income portfolios, particularly in a rising-rate environment.

We believe traditional core strategies with concentrated duration exposure appear ill-suited for this type of environment, and those that have relied on falling interest rates to generate returns are likely to face challenging times ahead if rates trend higher. Thus, we believe an allocation to an opportunistic and truly unconstrained strategy that can invest flexibly across global fixed income markets can help to reduce bond volatility and generate additional alpha potential.

In our view, increased Fed tapering, the asymmetric risk/return in bonds based on today’s low rates, and the inevitable bouts of volatility make a strong case for shifting assets towards more actively managed, unconstrained fixed income.

Hear more from Hasenstab about current market conditions and how he’s positioning his portfolios in this short video.

Read more about Hasenstab’s approach in “Investing for What’s Next: Going the Extra Mile to Find Reward.”

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The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and 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 information provided in this material is rendered as at publication date and may change without notice and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

What Are the Risks?

All investments involve risks, 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. Changes in interest rates will affect the value of a portfolio and its yield. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in a portfolio adjust to a rise in interest rates, the portfolio’s yield may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. 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. 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.

 


1. Correlation is a statistical measure of how two securities move in relation to each other. Negative correlation indicates a relationship in which one increases as the other decreases.

2. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Fund investment returns and share prices will fluctuate with market conditions, and investors may have a gain or a loss when they sell their shares.

3. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. It is expressed as a number of years.

4. Source: IMF, July 2014. © by International Monetary Fund. All Rights Reserved.