Eric Takaha is a v.p. and director of high-yield research at Franklin Templeton Investments in San Mateo, Cal. He is also a portfolio manager for the roughly $600 million Franklin Strategic Income Fund, a multi-sector mutual fund that can invest in virtually any fixed-income sector, including foreign securities.
Describe your current investment philosophy and some of the fund's allocations
We still have a decent overweight to corporates. If you include high-yield, investment-grade and convertibles, corporates account for half of the fund. Overall, high-yield accounts for about 40%, investment-grade for about 8% and about 5% to convertibles.
Will the high-yield market's rally continue?
Although we have brought down the weighting and taken a little off the table, we still feel that valuations on a relative basis are pretty attractive. For example, the average high-yield bond is yielding about 700 over comparable Treasuries. You still have to look at the fundamentals, but relative to long-term historical trends, 700 over is still a little cheap, especially since default rates have been coming down and are expected to continue to decline. And, in terms of technicals, there is a lot of demand for high-yield and we don't see that abating significantly. We also see a huge prospect for refinancing. All in all, you have a few factors that are certainly working in the right direction and on a relative basis, we still see some value there.
What do you think of the new issue pipeline for high yield?
When new issues began to start pumping out earlier this year, there was some value. But, now the new issues have been coming much tighter to the overall market, so we frankly have been a little more hesitant and selective on the new issue front and are more active in the secondary market. Specifically, we prefer some of the higher-beta names, and have a decent weighting in wireless, utility, industrial and healthcare bonds. But the one tradeoff to the secondary market is lower liquidity, so you certainly have to look out.
In terms of liquidity, which firms support the market well? Some Wall Street firms have reported higher earnings of late, due largely to their success in the bond market. How does this play into their roles as market-makers?
There's probably half a dozen firms that do a good job of market-making. Of course, even in this rally we haven't seen liquidity improve to the levels where it was in the late 1990s. A lot of the dealers that are doing well are making money in all parts of the bond market, not just in high yield, even though the spreads they are making in our market are more robust. On the margin, we have seen a pickup in liquidity as the market has improved and there's been a little more aggressiveness in taking positions.
What's your thinking on other sectors of the portfolio?
We've had a moderate position on the mortgage-backed and asset-backed side. MBS has really lagged because of prepayment risk. But, our second-largest allocation is to bonds of foreign, developed countries. We only buy sovereigns, and the play in that area is the currency for one, and the rate differential versus U.S. Treasuries. That's about 17-18% of the portfolio and we've almost doubled that over the last year. Even with the euro having run so significantly, we still believe there will be some further dollar depreciation. And on top of that, we're still picking up some incremental yield over Treasuries by being in foreign debt. And we're not in just the euro countries, but also the dollar block countries. We believe the U.S. still has a lot of wood to chop in terms of its deficit and Europe has a lower inflationary environment.
In light of all the concerns about equity research and conflicts of interest, what does this mean for fixed-income side? Do you see any conflicts between fixed-income research and banking?
Obviously, the regulatory focus has not been on the fixed-income side. Compared to equities, there was never the same volume of research on the fixed-income side. We rely primarily on our own research and use the sell-side research as a supplement. We've never used it for specific recommendations, it's more for general industry backgrounds and trends. But, there still is some value in sell-side research, especially when it pertains to new deals.