By Adrienne Young, CFA
Portfolio Manager, Director of Credit Research, Franklin Bissett Investment Management
The phrase “hunt for yield” is by now a well-worn cliché among fixed income investors. Persistently low yields have led many investors to take on additional risk, and some have considered abandoning fixed income altogether.
We think this is a mistake. Even amid fluctuating yields, inflation jitters and pandemic-driven economic upheaval, fixed income can help maintain stability and preserve capital: if you know where to look.
Why Short-term now
For increasing numbers of investors, the short end of the yield curve is the place to be in the current environment. Short-term rates reflect central bank policy actions. Since the pandemic first took hold early in 2020, central banks have taken extraordinary measures to keep liquidity pumping into the marketplace, all without raising rates. Both the Bank of Canada and the U.S. Federal Reserve have so far left their overnight lending rates unchanged and have indicated their intent to continue along this path well into next year, and possibly longer. This predictability has stabilized, or anchored, short-term rates. In contrast, longer maturities have been prone to volatility as the stop-and-go nature of the pandemic has influenced economic reopening, inflation expectations and financial markets.
Franklin Bissett Short Duration Bond Fund is active in short-term maturities, with an average duration of 2-3 years. About 30% of the portfolio is held in federal and provincial bonds; most of the remaining 70% is invested in investment-grade corporate bonds.
Beyond stability, investments need to make money for investors. In this fund, duration and corporate credit are important sources for generating returns. Historically, the fund has provided investors with better returns than the FTSE Canada Short Term Bond Index1 or money market funds, and with comparatively little volatility.
In It for the Duration
Duration is a measure of a bond’s sensitivity to interest rate movements. Imagine the yield curve as a diving board, with the front end of the curve, where short-term rates reside, anchored to the platform. Like a diver’s body weight, pandemic-driven economic forces have placed increasing pressure further out along the curve. The greatest movement ― expressed as volatility ― has been at the long end, especially in 30-year government bonds. Currently, the fund has no exposure to these bonds.
Cushioned by Corporates
Corporate debt provides a cushion against interest rate volatility, and a portfolio that includes carefully selected corporate securities as well as government debt can therefore be a bit more protective. In addition, the spread between corporate and government bonds can provide excess returns.
We believe it is not unreasonable to anticipate stronger Canadian economic and corporate fundamentals in 2021 and 2022, as well as continued demand for bonds from yield-hungry international investors. These conditions support a continuation of the current trend of a slow grind tighter in spreads, with higher-risk (BBB-rated) credits outperforming safer (A and AA-rated) credits.
Credit Quality is Fundamental
In keeping with Franklin Bissett’s active management style, in-house fundamental credit analysis is a key element of our investment process for the fund. Unless we are amply compensated for both credit and liquidity risk (particularly in the growing BBB space), at this stage of the economic cycle we prefer higher-quality credit. We look for strong balance sheets, good management teams, excellent liquidity, clear business strategy and larger, more liquid issues.
Room for Measured Risk
The fund also contains a small percentage of higher-risk/higher reward securities, including corporate loans and high-yield corporate bonds. Because of Franklin Templeton’s size, we can draw on the resources of a dedicated loan goup in San Mateo and the much larger universe of U.S. high-quality loans. Size also matters for high yield; compared to the Canadian market, the U.S. high yield universe is expansive and far more liquid. By adding thoughtfully selected U.S. high yield investments to our portfolio rather than restricting ourselves to the Canadian high yield market, we can therefore reduce the level of risk to some extent while making the most of the higher returns these types of investments typically offer.
A Key Ingredient in our “Secret Sauce” for Stability: Derivatives
Used properly in an active management setting, derivatives are a highly useful tool for managing portfolio stability. We typically buy and sell derivatives in place of securities that we would rather keep in the portfolio. Interest rate swaps, for example, can be used to manage duration. Credit default swaps let us manage the fund’s credit exposure without having to sell bonds that are performing well.
Fighting Inflation with Short Duration
Whether the resurgence of inflation over the past few months is transitory or settling in for a longer stay is the subject of great debate these days, and no one can be sure of the outcome. In the meantime, we think investors concerned about protecting their capital should consider taking shelter from volatility in the shorter end of the yield curve.
Adrienne Young, CFA2 , is a vice president and director of corporate credit research for Franklin Templeton Fixed Income Corporate Credit and Bissett Investment Management3 in Calgary, Canada. Ms. Young is responsible for co-leading management of Franklin Bissett Corporate Bond Fund, Franklin Liberty Canadian Investment Grade Corporate ETF, Franklin Liberty Core Balanced ETF and Franklin Bissett Short Duration Bond Fund. She also leads the Franklin Bissett Fixed Income team’s fundamental credit research process through collaboration with portfolio management and trading desks to drive overall allocation to credit sectors and exposures to individual issuers.
1 As at September 30, 2021, Franklin Bissett, Series O (gross of fees) outperformed the FTSE Canada Short Term Bond Index over the 1 year, 3-year, 5-year and 10-year periods on an annualized basis.
2 CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute
3 Franklin Bissett Investment Management, part of Franklin Templeton Investments Corp.
Franklin Bissett Short Duration Bond Fund combines high quality Canadian short-term debt securities with non-core debt securities to create a multi-sector low duration solution.
Franklin Bissett has been managing fixed income investments for nearly 30 years for individual, institutional and high net-worth clients.
This commentary is for informational purposes only and reflects the analysis and opinions of the Franklin Bissett Investment Management fixed income team as of October 21, 2021. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus or fund facts document before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.