Where Should Fixed Income Investors Be Looking in 2013?

PERSPECTIVES: 2013 is going to be a tough year for holders of perceived safe-haven bonds but the demanding environment should not distract investors from the potential rewards in other areas, says Franklin Templeton

Franklin Templeton Investments 10 April, 2013 | 3:54PM

This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, John Beck, Senior Vice President and Co-Director at Franklin Templeton International Bond Group, Franklin Templeton Fixed Income Group, discusses why 2013 is going to be a tough year for holders of perceived safe-haven bonds but says the demanding environment should not distract investors from the potential rewards in other areas of fixed income.

Avoiding "Safe Havens" is Key to Improving Fixed Income Returns 

Amid much discussion of a “great rotation” out of bonds into equities, investors could be forgiven for thinking that the prospects for fixed income asset classes in 2013 look gloomy across the board. It is true that in recent months returns from many sovereign bonds perceived as “safe havens”—particularly those from the US, Germany and the UK—have turned negative as their yields have moved up from the historic lows seen in 2012 in the midst of the eurozone debt crisis. 

In January, holders of 10-year US Treasuries lost their entire 2013 coupon as a result of a negative capital return. More recently, yields on 10-year Treasuries have traded above 2%, up from the record low of 1.39% reached in July 2012, raising the possibility of a negative return over 2013 as a whole for Treasury investors. However, such an adverse outcome for US Treasuries and other perceived safe havens might not necessarily be replicated in other areas of fixed income. We believe investors can still earn a reasonable return this year by diversifying away from perceived safe-haven bonds into other areas, such as emerging market sovereign debt or high-quality corporate issues. 

Among the emerging-market government bonds that we find attractive are those from Lithuania, Chile and Mexico as well as from select Asian countries. In the case of Lithuania, the yield on its 10-year sovereign bond has declined from 8.5% a few years ago to current levels of around 4.5%. Despite this steep fall, we consider that the country’s relatively healthy economic and fiscal fundamentals make Lithuanian bonds still worth holding. For example, Lithuania’s debt-to-GDP (Gross Domestic Product) ratio of 25% compares favourably with an equivalent 85% figure in the US. While significant foreign funds have certainly flowed into emerging-market government bonds issued by countries such as Lithuania, this does not in itself provide a reason to sell out of the underlying credit in favour of perceived safe-haven bonds such as US Treasuries, in our opinion. 

Similar arguments can be put forward for our other favoured emerging markets. Yields on Chilean sovereign bonds have seen falls comparable to those of Lithuanian bonds, but equally, these declines have been supported by Chile’s healthy fiscal and current accounts as well as its low debt-to-GDP ratio. On top of these structural positives, the country is rich in resources and has a pension system that is fully funded, in stark contrast to the US. In Mexico’s case, its economy enjoys the additional advantage of being geared to US growth, which we believe should benefit the country as the US recovery slowly builds momentum. 

We have also favoured allocations to the local currency-denominated bonds of Asian countries such as Malaysia and South Korea. The yields on many of these issues remain potentially attractive, in our view, while the currencies of both countries may benefit from further appreciation against the US dollar over the long term. While we may tactically trim our exposure to these emerging-market bonds if we feel their valuations have moved far ahead of fundamentals, we have a hard time envisaging a scenario over the short to medium term in which we would eliminate exposure completely, given the environment and limited alternatives. 

That is not to say we believe no opportunities exist among developed market sovereign credits, despite our aversion to perceived safe haven bonds of the US, Germany, Japan and the UK. French and Italian government bonds trade, in our opinion, at reasonable value compared with German Bunds. Countries including Canada, Australia and much of Scandinavia share the distinction (along with our preferred emerging markets) of having superior growth prospects, as well as favourable debt‐to‐GDP ratios, increasing the attraction of their debt compared with that issued by relatively slow‐growth, indebted G‐3 countries (i.e., the US, the eurozone and Japan). 

Though periodic episodes of market volatility are likely to occur, as a result of, for example, elections in the eurozone, we still think 2013 is going to be a tough year for holders of perceived safe-haven bonds and we see a possibility of negative returns for some of these issues over this period. But, in our view, the demanding environment for perceived safe haven bonds should not distract investors from the potential rewards in other areas of fixed income, for example, US dollar-denominated government bonds from countries such as Lithuania, Chile and Mexico or local-currency sovereign bonds from issuers like Malaysia and South Korea.

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About Author

Franklin Templeton Investments  is one of the world's largest asset management groups, offering UK investors a range of over 80 funds across different market sectors.

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