The Federal Reserve’s warning that it planned to scale back purchases of Treasuries sparked a storm on Wall Street, bringing instability to what had been a pleasant May in the US markets. Almost lost in the noise, however, is a silver lining: the Fed thinks the economy may be healthy enough to fly on its own.
Eric Takaha, who manages Franklin Strategic Income Fund, says economic trends, including lower unemployment rates, have improved to the point where the Fed would have to at least consider reducing its Treasury-buying program.
The Fed currently buys $85 billion in Treasuries and mortgage-backed securities every month. It began buying long-term debt in late 2008 to bring down long-term interest rates and encourage investors to move into riskier assets, such as stocks and real estate.
More than four years later, with the US stock market soaring and home sales climbing, the Fed’s plan—or something—appears to be working, so it should come as no surprise that the Fed has announced plans to begin “tapering” its bond purchases, Takaha says. And, he adds, it’s probably a good thing that the Fed at least warned the market about its potential policy change.
“In fact, I think it’s a positive that the Fed’s coming out a bit earlier and providing some guidance so it’s not a surprise. You don’t want to have a situation where suddenly the Fed’s coming out, pulling back on their purchases and raising rates, which could really cause some dislocations in the markets. I think it’s a favorable statement that they are trying to do kind of a gradual approach to this change in policy. Now, whether it occurs over the next few months or over the next few quarters, it will likely be largely data dependent in terms of unemployment or some of the other key economic indicators that the Fed focuses on, but I don’t think it’s necessarily a negative that they are showing this hand going forward.”
Keeping Calm and Carrying On
It’s a given that fixed income investors will be affected when Treasury rates rise as a result of the change in Fed policy. But some worry that rates will climb haphazardly, creating chaos in the markets. And it may have already begun: in May, 10-year Treasury notes posted their largest monthly loss since 2009, bringing their yield to 2.23%, the highest since April 2012.
Takaha takes a more measured approach when considering the effects of interest-rate changes on the investments in his portfolios, noting that different fixed income securities will be affected in different ways.
“Certainly, there will be some impact. If you have a rise in rates, investment-grade corporates will probably be the most vulnerable. Securities such as high-yield corporates and bank loans tend to be less affected. That’s because, for high yield right now, about three-quarters of the overall yield is coming from spread [the difference in yield between the average of issues in the benchmark index and 10-year Treasury], not from the Treasury curve itself. So, if Treasury rates move up, it will have an impact on fixed income investors, but, in general, a lot of that could be absorbed in the spread; spreads could compress. Think about bank loans, which are floating-rate instruments. Although they have some minimum yield, in general, if you see short-term rates rise over time, you can actually see more income coming from your bank loan securities.1
“The global markets are, by definition, non-US and related to non-US Treasury curves. Although there can be some impact and some correlation between what the U.S. is doing in terms of rates, it tends to be much less direct.”
Back to Basics
Despite new worries about tapering, the keys to corporate credit performance are traditional drivers: basic balance-sheet fundamentals. Companies typically perform at their best in an economy with stable, but positive growth, Takaha says. And, fortunately, that describes the environment most US companies have found themselves in recently. As long as companies maintain their liquidity and keep their balance sheets in order, many ongoing risks can be reduced. But Takaha sees a few clouds on the horizon that could hamper future growth. [php function = 1]
“Corporate earnings have slowed and profit margins have reached their peaks, so there are some concerns that things are starting to move in a negative direction. But, from where we stand today, we think corporations are pretty well positioned. So, what do we focus on? What keeps us up late at night? That tends to be the economy and earnings, but as we think about the balance of 2013 and looking into next year, we feel fairly comfortable with those fundamentals going forward.”
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What Are the Risks?
All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in the Franklin Strategic Income Fund adjust to a rise in interest rates, the fund’s share price may decline. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. The risks of foreign securities include currency fluctuations and political uncertainty. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. Investing in derivative securities and the use of foreign currency techniques involve special risks as such may not achieve the anticipated benefits and/or may result in losses to the fund. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. The fund is actively managed but there is no guarantee that the manager’s investment decisions will produce the desired results. These and other risk considerations are discussed in the fund’s prospectus.
1. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.