Harnessing the power of duration

THE investment landscape now is very different to 12 months ago, when there really was no alternative to equities, and investors were locked into a desperate search for yield across all asset classes. The US Federal Reserve’s (Fed’s) singular focus on controlling inflation last year resulted in an aggressive cycle of rate rises, which in turn tightened financial conditions, leading to a sharp rise in yields and spreads on fixed income assets.

A year ago, yields on high-quality credit did not seem attractive to us, prospects for total returns were poor, and bonds were not acting as a diversifier. Today, we believe the positive correlation with stocks is also breaking down, allowing fixed income to offset equity market volatility. As a result, Franklin Income Investors continues to invest with a preference for fixed income, moving closer to a 60/40 split in favor of bonds over equities.

Moving forward, our allocation decisions will be driven by what happens with interest rates and inflation this year. We believe the move higher in rates is likely almost done, but we expect a long pause from the Fed before any pivot, meaning our attention will be focused on the effect rate hikes have on the economy and inflation. The uncertainty lies in whether the lagged effect of tightening financial conditions and a more challenging growth environment results in a real pullback in fundamentals.

IMPROVED TOTAL RETURN POTENTIAL WITHIN FIXED INCOMEAllocation within the fixed income asset class will also depend upon where markets go, although investment-grade credit is currently our preferred asset class in terms of total return, income and risk management. In a positive economic scenario, we believe these assets have the potential to make double-digit returns as rates move lower and spreads narrow, while they should also outperform other risk assets should fundamentals deteriorate.

However, our assessment of US Treasuries has also improved as interest rates have risen, given they currently offer attractive yields and downside protection should a recession increase equity market volatility. When 10-year Treasury yields were around 2% they were unattractive to us, but extending duration to lock in yields at 4% is much more compelling from an income perspective. This means US Treasuries will form a core part of our ongoing strategy this year.

Elsewhere, the HY bond sector is, in our view, more resilient than many investors believe, absent a significant negative impact on corporate earnings. Most HY issues won’t need to be refinanced in the next few years, and therefore a recession this year with a modest pullback doesn’t overly concern us. As a result, while the investment community focuses on whether spreads are wide enough to justify a move into credit, we see opportunities at current yields, which have shot up to levels not seen for 15 years. We don’t think spreads are likely to rise significantly, which means we are very comfortable being in the credit space, particularly at such low prices.

Against this background, we believe it is a relatively straightforward call to add selectively to HY credit at the expense of higher volatility equity holdings that, in a recessionary scenario, should underperform credit. In a worst-case scenario, a prolonged period of higher rates or further tightening would eventually put pressure on over-levered companies that need to refinance their debt. Under those circumstances, it is possible to engage with public companies to help them refinance their debt on a private basis, however, we believe the opportunities for healthy returns in the public markets are currently so attractive that private investments would likely not be adequately compensated for the additional illiquidity premium.

MANAGING EQUITY UNCERTAINTYWe still see opportunities for selective investment in equities to maximize yield and total return while navigating increased volatility. For equities to rally, we believe it would take a favorable trajectory around inflation and economic growth, while earnings would also need to remain relatively robust. We would also want to see the Fed pause rate hikes, move into a position to normalize rates, and get back to a neutral setting. Alternatively, there could be further downside for equities if the economy feels the impact of tightening this year and earnings suffer.

In our opinion, equity-linked notes (ELNs) offer a way to manage this uncertainty, while expanding the universe of stocks available for investment. ELNs enable investors to derive income from exposure to equities that offer little or no dividend and can be used in conjunction with common stocks to access both yield and price upside potential. These instruments can also be used to smooth volatility and hedge exposure.

THE POWER OF DURATIONIn summary, we believe the current investment environment promises to provide much greater potential for yield and total return than we saw last year. In our analysis, locking in attractive yields through duration is the best way to achieve income goals, while investing in fixed income assets at attractive prices should deliver robust returns if rates fall and spreads narrow due to looser Fed policy.

Additionally, we think higher-quality bonds offer significant downside protection should any recession prove deeper than expected. Elsewhere, in our opinion, broad equity exposure remains important should an improvement in economic sentiment trigger an equity market rally.

This document is for information only and does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it.

Ed Perks is the chief investment officer at Franklin Income Investors.