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CONTRIBUTORS

Sonal Desai, Ph.D.

Chief Investment Officer,
Portfolio Manager

Nikhil Mohan

Economist
Franklin Templeton Fixed Income

Angelo Formiggini

Economist,
International Research Analyst

Patrick Klein, Ph.D.

Director of Multi-Sector Strategy,
Portfolio Manager
United States

John Beck

Director of Global Fixed Income,
Portfolio Manager
United Kingdom

David Zahn, CFA, FRM

Head of European Fixed Income,
Portfolio Manager
United Kingdom

Executive summary

There is a lot to pay attention to in fixed income markets. Recent developments include Donald Trump’s win in the US presidential election as well as the US Federal Reserve’s (Fed’s) continued easing of monetary policy with a 25-basis point (bp) cut in November, catching up to European Central Bank’s (ECB’s) total of 75 bps of cuts. Continued disinflation has opened the door for future rate cuts in both areas. The market is living from data point to data point, causing significant volatility in US Treasury (UST) yields.

We continue to call for a cautious stance on fixed income sectors as most spreads are hovering around 20-year lows. We still prefer high-quality, shorter-maturity assets that have attractive yields, which lessen the impact of spread widening.

In this issue, we look closely at the following themes and provide our outlooks for fixed income sectors:

Portfolio themes

  • The long and bumpy road: Looking at investment-grade corporate bond spreads.
  • What economic impact can we expect from Trump’s win: President-elect Donald Trump’s proposed tariffs could be a wild card for the US economy.
  • Fed: Playing with sharp objects? As the Fed tries to steer the economy toward a soft landing, there have been significant swings in the market around the number of rate cuts by the end of the year.

Overall risk outlook

We maintain our “neutral with reason for concern” outlook on overall risk. Spreads across most sectors are at or near 20-year lows, and we find it hard to identify catalysts for much additional spread tightening. In our view, this has left a risk-asymmetric profile, where the potential downside of widening spreads outweighs the likelihood of tightening. This does not mean we are not invested in spread products. Despite tight spreads, there are opportunities to pick up potential returns from interest-rate carry positions in shorter-maturity, higher-quality assets. By managing our exposure to spread movements, we think we can limit the downside of any material spread widening. Geopolitical risk, either in the form of increased tensions in the world or the US elections, is still an overhang to fixed income spread sectors.

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. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Floating-rate loans and debt securities are typically rated below investment grade and are subject to greater risk of default, which could result in loss of principal. Asset-backed, mortgage-backed or mortgage-related securities are subject to prepayment and extension risks.

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. To the extent the portfolio invests in a concentration of certain securities, regions or industries, it is subject to increased volatility.

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