The tea leaves speak: now is the prime time for fixed income

Western Asset a specialist investment manager of Franklin Templeton on strategic yield opportunities

The tea leaves speak: now is the prime time for fixed income

This article was produced in partnership with Franklin Templeton

With the stars aligning for a rare occurrence of higher yields amidst a dovish turn from central banks, the Western Asset Management team emphasizes the critical timing for investment in fixed income securities. However, these conditions are fleeting, making it essential for advisors to act with urgency.

Travis Carr, a product specialist from Pasadena-based Western Asset Management - which boasts an impressive $514 billion in global assets under management[1] - further elaborates on the attractiveness of fixed income investments in the current market. He highlights Western Asset's comprehensive management across various fixed income sectors, underlining the firm's global presence and integrated approach.

Outperforming with non-treasury spread sectors

Carr says, “In Franklin Western Asset Core Plus Bond strategy, we've been dynamically allocating across various sectors for the last five years, showcasing an active management style that contrasts with managers who maintain a static focus.

“Our approach is informed by deep experience across sector teams, allowing us to adapt and shift our allocations effectively in response to opportunities in both U.S. and global markets. This agility, supported by both bottom-up sector analysis and top-down macro strategies, enables us to capitalize on opportunities and add value across diverse market conditions.”

The fourth quarter of the previous year, as well as the year in totality, showcased how macro strategies, particularly duration and yield curve positioning, contributed significantly to generating returns amidst a volatile rate environment. Despite a seemingly static year for the 10-year Treasury yield, the underlying volatility offered opportunities for astute rate positioning to add value.

From a portfolio perspective, Western Asset has been tactically overweight in non-Treasury spread sectors, recognizing opportunities in investment grade credit, high-yield credit, and mortgages. However, mindful of spread tightening and market dynamics, adjustments have been made to optimize positioning. Corporate credit remains attractive due to sound fundamentals and conservative management across corporations, although the Carr is cautious, recognizing that much of the positive outlook may already be priced in.

Residential mortgage spreads have widened, offering more attractive yields. Yet, the standout in the market is commercial mortgages, where spreads have dramatically widened, presenting investment opportunities with yields up to 10 percent on investment-grade bonds spanning 3 to 5 years.[2]

Despite the challenges facing the commercial real estate sector, especially in the office space, other areas such as family law retail properties, industrial warehouses, and leisure properties are performing well. This divergence highlights potential investment opportunities, particularly in structured products linked to commercial real estate.

Carr says, “Emerging markets, having had a strong performance last year, continue to show promise as well. With solid growth rates projected for these economies, we believe there is still considerable value to be found in these markets, such as Mexico for example.”

Yield increases and monetary policy shifts

Carr points out that the optimism in fixed income opportunities is also rooted in the recent yield increases, making valuations particularly attractive. The upward shift in yields throughout 2022 and into 2023 has positioned investment grade and high-yield bonds at compelling levels, with investment grade yields ranging from 4 to 6 percent and high-yield bonds offering 7 to 10 percent. This yield environment is among the most favorable in the last 10-15 years, establishing an excellent basis for fixed income returns.

Another significant tailwind is the anticipated monetary policy shifts. With central banks globally expected to ease rates, albeit at varying schedules, the environment is ripe for fixed income investment. Historical data from the last five U.S. Federal Reserve hiking cycles illustrates that periods following a pause in rate hikes often lead to strong fixed income returns. For example, the aggregate index, a broad benchmark for U.S. bonds, historically returned about 12 percent in the year following a pause.[3]

This return potential is not just from high yields but also from capital appreciation as yields decline. Considering a fund with a duration of six years, a 100 basis point drop in yields could lead to an additional 6 percent return on top of the initial yield, quickly pushing total returns into double digits. While past performance is not a reliable indicator of future results, these factors combined suggest the potential for double-digit returns.[4]

Beyond cash

Carr concludes, “For those wondering whether to stay in cash due to its currently attractive yields, it's important to consider the likelihood of falling cash yields as central banks begin to lower rates. By remaining in cash, you might miss out on potential returns that could be gained by expanding your fixed income exposure. Taking on some duration or interest rate exposure can be a significant driver of additional returns through capital appreciation when yields decrease.

“We are currently very optimistic about the prospects of fixed income investments. This period presents a particularly attractive opportunity to invest in bonds, especially with the Franklin Western Asset Core Plus Bond strategy.

“While the path to returns may not be linear, we certainly think that the return potential this year is setting up to be quite attractive.”

Important Legal Information
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

Commissions, trailing commissions, management fees, brokerage fees and expenses may be associated with investments in mutual funds and ETFs. Please read the prospectus and fund fact/ETF facts document before investing. Mutual funds and ETFs are not guaranteed. Their values change frequently. Past performance may not be repeated.

Franklin Templeton Canada is a business name used by Franklin Templeton Investments Corp.

[1] As of December 31, 2023, in CAD.

[2] As of December 29, 2023. Source: Bloomberg, Bank of America, Western Asset.

[3] Source: Bloomberg; As of 31 December 2023, 1988-2023.

[4] Source: Franklin Templeton, Bloomberg.