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David Zahn, Franklin Templeton

Move out of gilts and better allocate strategic bond portfolios

David Zahn (pictured), manager of the Templeton Strategic Bond Fund, believes it is time for UK strategic bond funds to make use of allocations across a wider variety of fixed income asset classes in their search for real returns. Zahn, who has cut all exposure to UK gilts within the Templeton Strategic Bond portfolio argues the case for greater fixed income diversification in a low-interest rate environment…

Investors in UK strategic bond funds are used to a strong focus on developed markets, with a heavy domestic emphasis, in favour of UK government bonds (gilts). In past years, this approach has paid off, but it looks less useful now that so-called “safe-haven” sovereign bonds (including gilts) have reached such lofty valuations and deliver such paltry returns in exchange for the safety they are perceived to offer.

In a low interest-rate environment, it is hard to see how the traditional allocations common among UK strategic bond funds can achieve the diversification required to produce a reasonable level of income. In particular, exposure to low-yielding gilts is likely to hamper the generation of enhanced returns, an objective whose importance is increased by the corrosive effect of UK inflation, which has left real gilt yields in negative territory for some time.

In our view, it makes more sense to adopt a wider perspective across fixed income asset classes, in order to take advantage of better yield-generating opportunities and achieve a level of income to which investors have become accustomed.
Gilt yields plummeted to record lows in 2012 as fears peaked about the stability of the eurozone and its potential to spark another global recession. By July, the yield on 10-year UK sovereign bonds had fallen to the lowest since the figure was first documented in 1703. Even though the actions of the European Central Bank helped to calm the eurozone crisis in the latter half of 2012, gilt yields ended the year not far above these record levels. Demand for safe-haven assets remained high not least because of the expansionary policies of the Bank of England, which in February 2012 targeted purchases of GBP325 billion of gilts, more than a quarter of current outstanding stock.

For UK government debt, this marked the latest surge of a bull run that stretches back more than 20 years (see Gilt Yields and Inflation chart above). In large part, these gains occurred because UK inflation, previously the curse of gilt investors, fell so precipitously from its peaks in the early 1980s, while relatively strong economic growth (on average) over this period allowed the country’s public deficit to be kept in check. But now that these long-term themes have played out, we find it difficult to see the price of UK government debt rising much further, even though the gilts market is likely to remain underpinned by the Bank of England’s Quantitative Easing (QE) measures, keeping gilt yields low by historical standards for a while yet (of course, with the planned change in leadership at the Bank of England due in 2013, there may be a re-examination of QE, and that would be something we would monitor closely in order to determine any potential impact on fixed income asset allocations.)

This means a long-term investing strategy relying on a core allocation to gilts could potentially face challenges and struggle to maintain the high returns that investors have become used to. We believe that, without exposing a portfolio to significant capital risk, it is important to maximise the yield available in the prevailing market conditions. The strategic management of allocations to asset classes such as corporate and Emerging Market (EM) debt appears key to achieving those aims against the current uncertain backdrop.
The strong demand for corporate bonds seen in 2012 has illustrated that many investors share an appetite for higher returns and judge the risk/return profile of this asset class to be appealing. Despite the significant gains for both Investment Grade (IG) and High Yield (HY) corporate debt in the last 12 months, in our view, their fundamentals still appear attractive. Most companies have continued to carefully manage their overall debt levels, their debt maturity profile, and their liquidity, while interest expense has also come down for many thanks to low yields and ample financing capacity.

Though IG credit spreads have tightened markedly since peaking in the midst of the global financial crisis, they remain close to ten-year averages. With leading UK IG corporate indices yielding over 3%, we believe that a significant allocation is justified, particularly since UK interest rates seem likely to stay at current low levels for the medium term (in May 2012, the International Monetary Fund urged the Bank of England to cut rates to even lower levels). We would expect more modest total returns from an allocation to UK IG corporate debt in the next 12 months than were achieved in 2012, but nevertheless believe that the asset class remains attractive compared with gilts over an intermediate investment horizon.

In the current low-yield environment, HY bonds offer some of the highest levels of interest payments in the fixed income space. HY bonds delivered stellar returns in 2012, with the asset class not just among the strongest performers in fixed income, but across the investment spectrum. Some of the outperformance of the asset class undoubtedly resulted from relief among investors that the debt crisis in the eurozone appeared to have stabilised. However, HY debt has historically thrived in an environment where interest rates remain low and national growth rates are modest, much along the lines of what appears a likely scenario for European economies.

As has been the case among IG firms, many HY issuers have now taken advantage of low rates to refinance their short-term debt and the most recent baseline forecast by Moody’s predicts that default rates will continue the pattern of recent years, remaining steady at historically low levels of around 3% into 2013. While the higher volatility of the HY asset class argues for a more limited allocation, it still represents a potentially interesting segment of the market for investors seeking to increase diversification away from more established fixed income asset classes, and who have a higher tolerance for credit risk but an appetite for a higher income stream. 
In addition to diversification among corporate asset classes, we believe that greater value can be found by looking globally rather than by limiting a strategic bond portfolio to one or a limited number of markets. Investors should consider how geographical exposures can help to achieve an objective of enhanced yield. Traditionally, allocations among UK strategic bond funds have heavily favoured domestic investments as well as developed markets, while having only very limited exposure to EMs. The attractions of EM sovereign debt as an asset class are not widely appreciated by investors, even though the case for its inclusion within a UK strategic bond portfolio appears compelling, given its yield premium and the superior growth and debt characteristics of many EM economies compared with their developed peers.

We think the overall global outlook for growth remains at best subdued, weighed down by the deleveraging and austerity prevalent in much of the developed world. Nevertheless, bright spots of economic activity remain—notably in EMs, whose growth the International Monetary Fund forecasts will be 5.3% in 2012, far outweighing the 1.3% expansion it anticipates in developed markets[2]—and investors should try to take advantage of that superior growth.

As well as EMs’ better growth dynamics, the eurozone sovereign debt crisis has underlined the strong state of finances among EMs compared with some of the more indebted developed countries. This only serves to emphasise the anomaly that has arisen in sovereign debt markets, namely that the bonds of many EMs continue to offer significantly higher yields than government bonds from countries like the UK, US and Japan, as a result of not being deemed to be as “safe” as these high-deficit countries, despite the EMs’ far stronger growth and debt metrics.

Growing recognition of this inconsistency led to strong returns for EM debt in 2012. But we feel that the discrepancy will remain for some time yet and that opportunities still exist within EMs, not only in EM debt but also EM currencies. The strong economic and fiscal fundamentals of many emerging markets have made their currencies attractive in a world of excess liquidity, potentially boosting returns for investors in developed markets. Of course, EM currencies can experience high volatility in times of market stress, as was seen in the second half of 2011, and that is why, in accordance with the IMA sector requirements, the Templeton Strategic Bond Fund’s non-sterling currency exposure is limited to a maximum of 20%.
In summary, we believe it is justifiable to break from the traditional emphasis on domestic investments and developed markets—currently, the Fund does not own any gilts, preferring to hold investment-grade corporate debt—and to maintain a relatively high exposure to EM debt, high-yield corporate bonds, as well as a small allocation to EM currencies, in order to generate a level of yield that potentially provides an attractive real return to investors. In our opinion, this strategic approach to allocation will help to capture the value across fixed income asset classes going forward.


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