Franklin Templeton favours non-core fixed-income

US asset manager Franklin Templeton is advising retail and institutional clients to diversify fixed-income holdings away from "core" markets -- such as their domestic markets or very liquid global markets -- to avoid concentration and correlation risks.

"This trend really started to kick-off five years ago and in the past two years has sped up," says Michael Hasenstab, San Mateo, California-based portfolio manager of Templeton's global bond fund. "It's accepted now that such strategies reduce risk rather than increase it. Whereas in the past there was a feeling that it was less risky being invested in your own country, for example, now it's accepted that local concentration of exposure may increase your risk."

Hasenstab's funds have very limited exposure to core bond markets -- for example, no holdings in US Treasuries, Japan government bonds or UK gilts, and limited allocation to European government bonds. Instead, he is seeking exposure to currencies that he believes will benefit from rising interest rates and whose countries have strong fundamentals, such as the Norwegian krone, Israeli shekel and Australian dollar.

Another strategy Hasenstab favours is going long commodity-based currencies, because they will perform in an environment of rising inflation. He cites developed-market currencies, such as Australian dollar and Norwegian krone and emerging-market units such as the Brazilian real, Indonesian rupiah and Malaysian ringgit.

He says these two strategies warrant positions of one to two years. "Obviously things can change, but we feel these are positions for the next couple of years," adds Hasenstab, who was visiting Asia last week.

As for returns, he declines to give specific targets, but says performance will be a function of the likely performance of the currencies in question. For example, some Asian, Scandinavian and Latin American currencies are 10-20% undervalued.

Meanwhile, some emerging sovereign credits are offering yields as high as 15-16%, while others are offering around 7%. "We feel they have potential for good carry over the next couple of years," says Hasenstab.

As the liquidity crunch ended, Franklin Templeton closed out the large long positions it had in the yen and Swiss franc a year ago. "In fact we're now in a negative position on the yen," he says. "That's a big shift."

It helps that it's getting easier to invest in Asian emerging-market fixed income. For example, South Korea has come on in "leaps and bounds" in that it's a lot easier to invest in fixed income in the country now than it was when Templeton began to buy domestic securities years ago, he says. And that has benefited local asset prices, Hasenstab says.

"Obviously some markets, such as China and India, are still pretty restrictive on investors coming into their fixed-income markets," he adds. "But there's clearly an incentive to allow it to happen, as foreign investment can be very beneficial."

Hasenstab concedes that bond yields are a lot tighter than they were six to nine months ago, but says liquidity conditions and fundamentals are much improved. And while credit spreads have tightened, they are still trading wider than historic averages.

For example, the spread on the JP Morgan emerging-market government bond index at the end of October was more than 100 basis points wide of the three-year average up to the collapse of Lehman Brothers. So bonds don't look overvalued, he says, and "spreads are still going to grind tighter generally across the board".