Franklin Templeton's Brendan Circle discusses his pivot to fixed income as higher rates signal the return to long-term historical trends
This article was produced in partnership with Franklin Templeton.
It pays to be nimble in the markets. While some high-profile institutions have been learning that lesson the hard way, others saw new opportunities to generate returns for their investors.
For Brendan Circle, a senior vice president and portfolio manager at Franklin Income Investors, it was an opportunity to reposition his portfolio away from equities and back into fixed income. The shift, he says, marks a return to a historical trend where bonds usually have outyielded stocks.
“We've pivoted our portfolio to take advantage of the return to higher rates,” Circle explained to Wealth Professional in a recent interview. “While our benchmark is 50% equity and 50% debt, we were overweight on equities, so we shifted as yields rose and we’re now more 60-40 in favor of fixed income, taking advantage of pretty attractive spreads.
“The fixed-income market provides great opportunities for us right now in terms of both yield and total return.”
Circle, who serves as co-manager of Franklin U.S. Monthly Income Fund, says their migration out of stocks began two years ago, as they prepared for the end of cheap borrowing and the start of accelerating inflation.
“Our weighting in equity peaked in the spring of 2021,” he says. “Then we started to reduce exposure to some of the ‘growthier’ areas of the market, leaving the majority of that overweight allocation in utilities, energy, healthcare, consumer staples, and more defensively oriented sectors that held up pretty well during 2022.
“Then as we made the pivot from equities to fixed income, we really monetized and reduced our overweight allocations to those four sectors.”
Return to normal
Circle believes the move from equities to fixed income marks a return to a long-term norm for the markets.
“Going back to the 1970s, bonds have out-yielded stocks for most of the time,” he says. “It was really just the last 10 years – due to the financial crisis and an incredibly accommodative monetary policy during the pandemic – that we saw years where 40% of the S&P 500 had yields higher than the 10-year treasury.
“That's quite a unique environment where yield investors were pivoting their portfolios to take advantage of stocks.”
Circle expects that unique advantage for stocks is unlikely to return any time soon. While he believes short-term interest rates are near their peak, he sees little reason for them to start falling with inflation remaining stubbornly outside the Fed’s comfort zone.
The Fed has said the disinflationary process is still in its early stages, especially with stickier costs like wages and shelter taking a lot longer to roll over.
“We expect to see a long period where they maintain elevated rates because of their concern that inflation could come roaring back,” he explains. “Short of a severe downturn in the economy, I think the Fed's message is going to be, ‘we've done most if not all of the hikes this cycle, but we're going to keep rates here for a while.’ “
Asked whether there are any risks that could emerge to disrupt his outlook, Circle addressed two: the recent failure of several banks, and a soft landing for the economy that could spark a return to equities.
On banking, he believes the problems are isolated to individual institutions and not like the systemic failure seen in 2008.
“There are unique aspects to the failures of First Republic and Silicon Valley Bank that don’t represent the entire banking industry in terms of the mismatch in durations among their assets and liabilities,” Circle explains. “The banking system is in such a stronger position. The capital ratios and regulations put in place post-2008 have done a fairly good job of mitigating a broader contagion.”
However, this doesn’t mean there are no concerns, he adds. The failures could dampen a willingness to lend, which would then drag on the economy at large.
On whether inflation might cool faster than expected, resulting in lower rates that renew interest in stocks, Circle says it’s something they’re always monitoring, while feeling confident that their current investment profile is prepared for such a shift.
“Being overweight fixed income relative to equities, we see the biggest risk in tamed inflation and a soft landing resulting in the equity market grinding higher, but we think our allocation to corporate credit will hold up pretty well,” he says. “If we get a rate tailwind, you can get equity-like returns from high-quality fixed income.”
While Circle has repositioned his portfolio toward fixed income, he says equities still provide some interesting opportunities.
“Financials are way off their highs while tech had a very difficult 2022 despite a recent rally, so we’re turning over rocks to find opportunities within financials and technology,” he says. “There are some very strong balance sheets and great businesses in those markets. We’re not ruling any of them out.”
Circle points to two companies in particular. Texas Instruments has been able to navigate a lot of macroeconomic uncertainty while continuing to grow their dividends.
Broadcom is interesting as well, Circle says. Their planned acquisition of VMware presented an opportunity to buy high-quality investment grade corporate bonds yielding north of 6% for 10-year paper. This highlighted Franklin Income strategy’s ability to invest across the capital structure, he says.
“We look to have a high level of current income while maintaining prospects for capital appreciation. The dividend paying stock portion of our portfolio has historically provided both, and I think that will continue.”
Quick to adapt
The failures of Credit Suisse, Silicon Valley Bank and, more recently, First Republic, illustrate that even the most seasoned investment professionals can be caught off guard when the markets shift.
Circle says it’s important to have flexibility built into the investment portfolio and strategy.
“Income investors need to pivot as opportunities appear,” he says. ‘While our portfolio is tilted 60-40 in favor of fixed income, we have 10-15% in cash and treasuries – and that gives us the ability to be nimble.
“If we see a selloff in the equity markets that makes yield-oriented assets particularly attractive, we'll have the ability to pivot in that direction quite quickly.”
Who should invest in a U.S. monthly income fund?
The traditional profile of a person who invests in a U.S. monthly income fund is someone who wants a reliable source of income paid at regular intervals. While this often applies to retirees, Circle says his funds appeal to a much wider pool of investors.
“Obviously, a monthly dividend fund is a natural fit for retirees seeking a stable income,” Circle says. “But the portfolio meets the needs of people at many different stages of their investing cycle, and we have a number of investors who regularly reinvest those dividends instead of taking them out as income.”
Circle also points to their successful track record of tactically adjusting to shifts in the market – as they did against the backdrop of higher interest rates and the movement away from equities into fixed income.
“Our strategy isn’t pigeonholed as just for retirees. We've been able to generate attractive income for all investors on a monthly basis, and that’s important.”
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