Higher-term premium—distraction not disruption

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Introduction

Franklin Templeton Institute's US Fixed Income Navigator (FIN) fourth quarter (Q4) 2023 model has demonstrated an improved conviction, signaling a positive turn on the horizon. Several key observations underpin this shift in perspective. Firstly, we believe yields within the fixed income sectors have entered a favorable value zone, rendering bonds historically appealing and relative to equities. Secondly, the Federal Reserve’s (Fed’s) tightening cycle has matured, and various growth-supporting factors are waning, bolstering optimism for bonds. Nonetheless, it is essential to acknowledge the looming risks emanating from the burgeoning US budget deficits and the increasing supply of coupon bonds, which could sustain a “bear steepening”¹ of the yield curve in the near term.

Q4 2023 Highlights

• In Q4 2023, the model-based conviction has improved, bringing us on the verge of positive territory.
• Opportunities—Yields across the fixed income sectors have entered a favorable value zone, making bonds look attractive both historically and relative to equities. Additionally, the mature state of the Fed tightening cycle and the fading of several growth-supporting factors are encouraging signs for bonds.
• Risks—Growing budget deficits and higher supply of coupon bonds. Furthermore, a “bear steepening” of the yield curve could persist for some time.

Opportunities in bonds—stirred not shaken

The Institute’s FIN for Q4 2023 remains in neutral territory. However, it has improved relative to the previous update, and we believe we are currently on the verge of positive territory. A more favorable valuation that was partially unlocked during the recent spike in long-term yields mostly drove the improvement. Specifically, we believe 10-year US Treasury (UST) yields now look attractive on a relative basis, when we compare them with S&P 500 earnings yields or cap rates that investors get from buying a house and renting it out, or you name it—there are many comparisons that make bond yields look good at this time. Also, fixed income yields look attractive to us relative to their own history as we haven’t seen yields that high for high-quality bonds in the last 15 years.