How deep diversification and opportunism drive bond funds

The Franklin Bissett Core Plus Bond Fund is highly selective and can access valuable subsets of both the Canadian and U.S. markets

How deep diversification and opportunism drive bond funds

This article was produced in partnership with Franklin Templeton.

Whisper it but amid the uncertainty of rising interest rates and persistent inflation, fixed income has become interesting again. The market featured decades of predictability before the 2008 crash, after which came the lower-rates-for-longer era. But now, while technically still in a low-rate environment, they’ve come up significantly and volatility reigns, testing the mettle of fixed-income money managers.

Andrew Buntain, Institutional Portfolio Manager at Franklin Bissett Investment Management, admits it will be harder to eke out gains against a backdrop of continued volatility but that through its Core Plus Bond Fund, the firm is well positioned to take advantage of opportunities. However, several headwinds have shaken investors, with inflation top of mind.

CPI peaked in Canada in June 2022 at 8.1% and is still hovering around the 7% mark. In the U.S., inflation has dropped but remains in similar territory. In short, it appears the worst is over, but inflation remains elevated and far off central banks’ target of 2%. The aggressive rate-tightening cycles instigated by both the Bank of Canada and the Federal Reserve front loaded monetary policy, which is expected to remain tight over the near term.

Buntain believes the central banks were late raising rates, which resulted in a particularly aggressive 2022. “That has had significant fallout for the bond market in terms of total returns, which is why policy going forward in these next few quarters is going to be very important for shaping the term structure.”

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Given Bank of Canada’s fear of raising rates by too little, Franklin Bissett expects a few more rate hikes are likely, albeit potentially smaller and less frequent than those we saw in 2022. This will likely present investment opportunities and the Core Plus strategy is ready to capitalize. The fund is a 70-30 split between core Canadian and U.S., with the latter compensating for areas that either aren’t available in Canada or don’t trade well. This allows the fund to work in valuable subsets of the fixed-income markets that behave differently during periods of rising rates or stress, like high yield bonds, bank loans or floating rate notes.

“The US high yield market is so much deeper and broader as a market than here at home, and more liquid, which is also important,” Buntain explained.

Key to this diversification are corporate bonds – the fund is overweight - which will be vital in the coming year when security selection will be critical. The fund is also overweight the long end of the curve in the U.S. where it thinks there is a yield advantage.

Buntain said: “We're very selective. At the moment, we like the triple-B bucket because there's a wide range of candidates. There's not so good triple B, and there's pretty good triple B and a lot of range in between, and astute analysts and researchers can make a difference.”

This selective approach is designed to unearth quality. Corporate earnings have weakened and margins are under pressure given the higher cost of materials and labour. Some companies are set up to navigate these challenges better than others and the Core Plus strategy seeks to identify the more resilient businesses. Buntain said: “Even when we're playing in the high yield space, we're trying to focus on the upper most quality that we can find because in a period of strain or stress in the bond market, and especially among corporates, that credit quality is key.”

As well as inflation and rising rates, another significant headwind facing fixed-income investors is the legacy of a bruising 2022. Hit with an 11-12% downturn, some retreated into GICs, which may feel safer but will ultimately hurt purchasing power if, for example, you’re getting 5% and inflation is running at 7%. Those investors risk forgetting previous gains amid the maelstrom of 2022.

Buntain said: “If you stay in [GICs] long enough, it makes it very hard to keep retirement incomes and pension payments going. That [investor] headwind is [based] around the uncertainty of rate policy and inflation. But it's new ground for a lot of investors who aren't accustomed to these kinds of downturns.”

The company is expecting slower consumption and slower economic growth before rate cuts start to happen. The Franklin Bissett team are realistic about what lies ahead – more so than others, they believe – and resolve to be opportunistic, taking the emotion out of the investment process. However, in working with advisor clients on the front line, Buntain recognizes empathy is required, as is providing regular support and updates to ensure they remain invested through the full cycle.

He added: “We do anticipate a time in the future when bond prices should perform very nicely. And the real risk is that if somebody sold their bond fund today, locked in that 11% loss and went to a GIC, they've locked that money up for I don't know how many years.”

He added: “They then miss out if there's a significant recovery in the bond market, which will probably happen faster than people think because the bond market anticipates economic activity. If people are sitting in GICs, they could miss out on some of the early signs of recovery and that's something that I think would be very hard to explain to an investor afterward.”

Volatility beckons then but the Core Plus Bond Fund is primed to navigate potentially turbulent weather so investors can feel the full benefit of future bright skies.

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