CONTRIBUTORS
Stephen Dover, CFA
Chief Market Strategist,
Head of Franklin Templeton Institute
Is now the time to invest in fixed income? That’s one of the biggest questions we get from clients today. For our latest “Investment Ideas” series, I posed this question to two of our leading fixed income portfolio managers, Josh Lohmeier of Franklin Templeton Fixed Income and Mark Lindbloom of Western Asset. Below are some highlights of our discussion:
Soft landing—or something else? The Federal Reserve’s (Fed’s) prior rate hikes are working through the economy, as there are signs of softening in recent inflation, economic and employment data. The market is pricing in as many as four Fed interest-rate cuts in 2024. But will the economy slow enough to warrant this much easing? Mark and Josh were on board with a soft landing as the most likely base-case scenario—marked by a slowing in growth and retreat in inflation—but perhaps not to the Fed’s targeted 2% inflation level. Both portfolio managers agree that the “hard landing” recession scenario seems less likely at present. Contrarily, Josh made a case for a stronger growing economy and pointed to the (surprising) resilience of the consumer supporting the economy on the upside. He also said his team expects just one rate cut toward the latter half of 2024, which is fewer than the market expects. Mark felt more strongly that while not at recession levels the economy will slow as will inflation and interest rates.
Extending duration. While our portfolio managers debated the nuances of the economic outlook, they agreed that the entry point for longer-duration assets looks very attractive today—perhaps the best seen in a decade—particularly if economic growth is weaker than anticipated. That said, there's still a role for shorter duration and keeping some money in cash as “dry powder” considering volatility. Reasons to begin pushing out on the yield curve include:
- Nominal and real yields appear to be at fair value levels when looking back historically.
- Inflation appears to be falling.
- The high correlation between stocks and bonds in 2022 has lessened this year, so the benefits of a mixture of equities and bonds in a portfolio have reasserted themselves in terms of better balancing risk and return.
- The downside of holding cash is that if rates drop, cash yields will also drop, and so moving into fixed income now allows investors to “lock in” higher interest rates.
Keep a watchful eye on the fiscal situation. Treasuries are needed to finance fiscal deficits, and the government’s need to borrow more has an impact on interest rates. While the slower-growth scenario discussed above is positive for fixed income investments, more government debt coming into the market would be an offset and will likely create more volatility. Josh noted that fiscal stimulus could increase the risk that inflation is “stickier” than anticipated, and growth could prove stronger for longer than expected.
Opportunities across fixed income sectors:
- Investment-grade securities as an attractive “baby step” from Treasuries. Default risk is low, they are generally very liquid and investors can get a bit more interest spread (corporate bonds are priced as a spread to Treasuries). In addition, corporate fundamentals have remained strong and appear able to withstand potential volatility in the macro economy should conditions worsen. Within investment-grade bonds, positioning more defensively seems prudent, and our professionals are exercising caution when it comes to the weaker parts of the market—the weaker triple B rated credits, for example.
- Municipal bond fundamentals are strong and benefiting from ratings upgrades. Josh favors longer-duration, high-quality taxable municipals, which offer good risk-adjusted return potential and can act as a portfolio diversifier. Mark favors intermediate tax-exempt securities, which look attractively priced relative to some of the other areas of fixed income, considering potential tax benefits for many investors. As municipal bonds are generally high quality, if the economy moves into a slower-growth environment, they should remain an attractive place to invest. And the muni market is very large with myriad characteristics.
- Agency mortgage-backed securities provide another higher-quality return stream. Mark said his team has shifted some US Treasury longer-duration exposure to agency mortgage-based securities for several reasons. They are generally very liquid, have little to no credit risk and have attractive valuations. In addition, given rising interest rates, there has been a lack of new mortgages, either through production or refinancings. Josh said his team was neutral weight on agencies amid volatility in spreads driven by the Fed’s quantitative tightening—the central bank is selling down its holdings of government debt and reducing exposure.
- High yield requires credit selectivity at this phase of the economic cycle. While yields are compelling, our managers saw reasons for caution and favor a lower allocation to high yield than in prior years. That said, portfolio allocation decisions matter. Compared to equities, high yield looks quite attractive, but compared to investment-grade credit, less so. There are still some idiosyncratic opportunities, however, such as single B rated credits drifting toward an upgrade to double B.
In sum, the case for fixed income seems quite strong, particularly for investors looking to move some portion of their portfolios out of cash. The correlation between equity and fixed income has dropped, so fixed income can play a valuable role within a balanced portfolio to help reduce overall risk and provide diversification. Agency securities and investment-grade credit look quite appealing to us right now as allocation destinations, particularly for more risk-averse investors.
Stephen Dover, CFA
Chief Investment Strategist
Head of Franklin Templeton Institute
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Active management does not ensure gains or protect against market declines.