Franklin Strategic Income Fund Q2 2024 Commentary

Performance Review

Most fixed income spread sectors posted positive excess returns in the second quarter 2024 (Q2), with lower-quality sectors outperforming, as April and May’s positive results were only partially offset by negative excess performance in a number of sectors in June. Technical conditions were supportive as high all-in yields remained attractive leading to increased demand in both the primary and secondary markets. The US Federal Reserve (Fed) chose to leave the fed funds rate unchanged at its Q2 meetings as it stated that it did not see sustained deflationary progress towards its 2.0% target, and that the US job market was not yet in equilibrium. At its June meeting, the Fed reduced its median expectation to only one rate cut for the remainder of the year and that the bar for cuts was higher than it had been earlier in 2024. Investment-grade (‘IG’) corporate bond spreads widened by four basis points (bps), finishing the quarter at 94, and the benchmark 10-year US Treasury (‘UST’) yield rose 20 bps to 4.40% at the end of June.

Quarterly Key Performance Drivers

Click to enlarge

The fund’s corporate credit allocation was a main contributor to returns led by holdings in HY corporate bonds senior secured floating-rate bank loans, and CLOs. Security selection in IG and HY corporate bonds boosted performance, while selection in senior secured floating-rate bank loans detracted from returns. Over the course of the quarter, we increased our positions in IG and HY corporate bonds while reducing our exposure to CLOs. During the quarter, securitized sectors had a limited impact on performance, but security selection in MBS curbed our results for the quarter. During the period, we maintained our MBS positioning. Security selection in sovereign bonds from developed countries hurt our results. Our foreign currency exposure was a slight detractor from returns, led by our long Japanese yen position

One-Month Key Performance Drivers

Click to enlarge

Exposure to HY corporate bonds contributed to results for the month, but our allocation to IG corporate debt hurt returns. Security selection in IG and HY corporate bonds was accretive to performance in June. Security selection in MBS hindered our results for the period.

Outlook & Strategy

As the neutral real rate of interest theoretically serves as a long-run anchor for the fed funds policy rate, the implications are that current Fed policy is not overly restrictive and the progress on disinflation will not be fast. A further implication is the next Fed rate-cutting cycle will likely be short and shallow, in our view, especially considering the funding needs of a massive persistent fiscal deficit that the congressional budget office projects will keep boosting UST supply for the next decade. Consequently, after the next Fed easing cycle has played out, we expect in the medium and long term, UST yields are likely to drift back up, with levels greater than 5% looking more than plausible. In short, indications are that the high interest rate environment is here to stay, and markets should brace for potentially more volatility ahead.

Against this backdrop, in the corporate credit sectors we maintain our preference for an “up-in-quality” bias with shorter durations for now. For IG corporates, while credit fundamentals remain generally strong with relatively safe yield, providing most IG issuers substantial flexibility to manage through shifting economic conditions, current spread levels do not incorporate much cushion for downside surprises. We continue to advocate a focus on quality companies amid persistent market bifurcation. We maintain our emphasis on prudent security selection and individual company fundamentals.

For securitized sectors, our generally neutral stance remains largely unchanged. We believe MBS currently offers attractive income, compelling risk- adjusted returns, and diversification benefits for credit investments. Prepayment speeds remain near historic lows, and we expect prepayment risk will remain muted. We think projected rate cuts in the latter part of the year and a decrease in treasury and swaption volatility could be a tailwind for the sector and possibly lead to spread tightening. Despite our generally cautious stance, we are finding opportunities in higher-quality fixed income investments