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CONTRIBUTORS

Christy Tan

Investment Strategist
Franklin Templeton Institute

Lukasz Labedzki, CFA

Senior Analyst
Franklin Templeton Institute

Investment implications

It is increasingly evident that the fixed income market is broadening out beyond core US fixed income opportunities. In this paper, we see value in maintaining a diversified portfolio, with the following views on key sectors:

Developed markets credit: We find the combination of a short duration profile and attractive total yields to be desirable qualities in the current environment. For this reason, we favor high-yield bonds—particularly US high yield. Fundamentals remain solid, and we do not see refinancing risk as a meaningful concern over the coming year. While spreads may be volatile in the months ahead, strong yield cushions should help offset this risk.

Emerging market debt (EMD): We remain constructive on emerging market debt, viewing the macroeconomic environment as supportive of further EM central bank rate cuts. Real yields remain attractive, particularly when taking a selective approach. The recent build-up of international reserves has made many EMs fundamentally more resilient. We favor a split allocation between local and hard currency debt, with a tilt toward the former.

Euro bonds: For US dollar (USD)-based investors, hedged benchmark Bund yields look increasingly compelling, offering opportunities even as we maintain a neutral stance on European fixed income. Our neutral view is premised on the European Central Bank (ECB) bringing its policy rate to a more neutral 2%, having already delivered eight interest-rate cuts. While moderating inflation could permit further rate reductions, the easing cycle is clearly in its mature phase. Meanwhile, large fiscal programs and a potential rebound from depressed growth levels may create headwinds for longer-term yields.

US Treasuries: We continue to see the most attractive risk-reward in the short-to-intermediate part of the yield curve, while remaining cautious on longer-term bonds. Fed policy expectations primarily drive the shorter end. Although the Fed does not appear to be in a hurry to cut rates, once it starts, the pace of cuts could be more aggressive than currently anticipated. Longer-term bonds are influenced by both Fed policy expectations and the term premium—the latter potentially limiting the scope for significant declines in longer yields.

Currencies: We see headwinds persisting for the US dollar. Structural factors, such as the rebalancing of flows, are likely not over, and Fed cuts could ultimately add to dollar downside, even though the bearish narrative has eased after recent declines. We believe it remains prudent for non-USD investors to consider hedging currency risk when building exposure to foreign fixed income products denominated in USD.

WHAT ARE THE RISKS?

All investments involve risks, including 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. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.

The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results.

International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

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Any share class with “(Hedged)” in its name will attempt to hedge the currency risk between the base currency of the Fund and the currency of the share class, although there can be no guarantee that it will be successful in doing so. In some cases, investors may be subject to additional risks.

Please contact your financial advisor if you are in doubt of any information contained herein.

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Unless stated otherwise, all information is as of the date stated above. Source: Franklin Templeton.

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