CONTRIBUTORS
Mike Salm
Director of Multi-Sector Strategy
Josh Lohmeier, CFA
Director of Corporate Credit
Ben Barber, CFA
Director of Municipal Bonds
Outlooks for fixed income sectors are based on our analysis of macroeconomic themes and the technical conditions, fundamentals and valuations for each asset class. We rate each sector from bearish to bullish to express our projections for relative returns over the next 6-12 months. The Fixed Income Outlook Dashboard reflects a high-level sector overview, with specific sector insights provided in the Sector Settings Overview. Download the PDF to read our outlook.
Our Franklin Templeton Fixed Income investment professionals share their market insights.
Mike Salm, Director of Multi-Sector and Securitized
Investors can earn meaningful income in today’s environment, but they should be wary of reaching for risk the market is not paying them to take. Instead, we believe fixed income investors should focus on resilient borrowers, short- to intermediate-maturities, and carefully selected securities. With spreads generally tight across credit markets, we do not see a broad opportunity to rely on further spread compression. Instead, we favor areas that offer strong carry with less spread-duration and downside risk, particularly in short- to intermediate-maturity investment-grade credit and securitized products. Agency mortgages will also look appealing if rates settle into a more stable range, particularly in higher coupons that provide attractive carry.
We’re more cautious in the areas of the market that aren’t adequately compensating investors for taking additional risk, such as longer-duration corporates and high-yield credit. In securitized, weaker borrowers in consumer asset-backed securities are vulnerable to higher rates and persistent inflation, and refinancing pressure and idiosyncratic risks continue to pressure commercial real estate. Nonetheless, fundamental research can identify safer pools and broaden portfolio diversification without taking uncompensated risk.
Overall, the emphasis is on security selection, higher-quality income, shorter spread duration, and avoiding tail risks rather than owning broad credit beta.
Josh Lohmeier, CFA, Director of Corporate Credit
US investment-grade corporate bonds are experiencing negative total returns due to the material increase in US government bond yields. Investment-grade bond spreads remain at historically tight levels and corporate fundamentals remain strong, providing flexibility to navigate through changing market conditions. However, current spread levels offer limited cushion against further economic, market, or geopolitical surprises. This risk is particularly evident in the technology sector, where spreads have experienced significant volatility in recent months amid a sharp increase in capital spending and debt issuance to finance the artificial intelligence buildout.
Heavy new-issue supply, high energy prices, and uncertainty over the longer-term economic and market implications of artificial intelligence are also creating increased volatility. Against this backdrop, we believe spreads are more likely to widen modestly than tighten from current levels. This balances attractive yields and supportive fundamentals against tight valuations and rising technical risks, we maintain a neutral stance on investment grade credit while highlighting reasons for concern.
Ben Barber, CFA, Director of Municipal Bonds
Generationally high tax-exempt yields and strong fundamentals create a compelling opportunity in municipal bonds. The municipal market faced technical weakness characterized by elevated supply and tax-loss selling that led to historic underperformance and attractive tax-exempt income opportunities. Investment-grade municipal bond indexes now offer taxable-equivalent yields of approximately 8%-10%, depending on an investor’s tax jurisdiction, presenting an opportunity not seen since the turn of the century.
The outlook is further underpinned by sound municipal fundamentals, as steady employment and solid capital market returns continue to support record tax collections, while state and local government rainy-day funds remain well-funded. We expect persistent investor demand and the current income characteristics of the market to support the market over the medium term, while providing diversification when valuations across other investments remain elevated.
Glossary of Terms
Asset-backed security (ABS): a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities.
Carry: refers to a differential in interest rates across sectors, such that tactical profits could be generated by trading between them.
Collateralized loan obligation (CLO): a single security backed by a pool of debt.
Duration: A measure of the sensitivity of a bond’s price to interest rates.
Non-agency mortgage-backed securities (MBS): securities issued by private entities and not by federal agencies (Fannie Mae, Freddie Mac and Ginnie Mae); they are also called non-conforming loans.
Residential mortgage-backed securities (RMBS): a type of mortgage-backed debt obligation created from residential debt, such as mortgages, home-equity loans and subprime mortgages.
Sukuk: Financial certificates similar to bonds, but which comply with Islamic law/Sharia principles.
Tail risk: a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution.
Term premia: The amount by which the yield-to-maturity of a long-term bond exceeds that of a short-term bond.
Yield curve: The yield curve shows the relationship between yields and maturity dates for a similar class of bonds
Yield spreads/tights: Spreads are the difference between yields on differing debt instruments of varying maturities, credit ratings, issuers or risk levels. “Tight” in reference to spreads indicates small differences in yields.
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. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. 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 a 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. Leverage increases the volatility of investment returns and subjects investments to magnified losses and a decline in value.
Diversification does not guarantee a profit or protect against a loss.