Opportunities in U.S. and European Corporate Bond Markets U.S. Corporate Bonds

Given what we believe to be supportive fundamental credit trends and still reasonable valuations, we remain optimistic about U.S. credit markets in 2010 across both investment-grade as well as high-yield corporate bonds. Last year was historic in terms of performance, as investment-grade corporate bonds delivered their strongest returns since the 1980s, while high-yield corporates had their best-ever calendar-year return. However, it is important to note that 2009 started from a point of historically cheap valuations and depressed price levels for the corporate indexes, which enabled these markets to deliver such strong performances as valuation levels normalized over the course of 2009. However, for investors seeking the potential for relative outperformance compared to government bonds, as well as an attractive income stream, we still think corporate credit offers reasonable value.

We believe one of the keys to future performance for the corporate market is credit fundamentals. At least in the near-term, and particularly in the U.S., these corporate credit metrics seem likely to move in a favorable direction given the healthy year-over-year gains in corporate earnings, the amount of liquidity companies (in aggregate) have kept on their balance sheets, and the ability of many issuers to access the credit markets to refinance and extend their debt at relatively attractive rates. Moreover, although the financial industry is likely to remain in the headlines with regard to regulatory reform, from a bondholder standpoint, the financials sector has significantly improved its capital position compared to its standing in 2008. In addition, from the standpoint of investor demand for corporate bonds, the continuation of historically low short-term interest rates combined with some lingering investor hesitation toward the stock market may provide support for credit markets as we move through 2010.

In terms of individual sectors, we have continued to find good value within investment-grade financial issues. We have seen a strong recovery, particularly among banks and insurance companies, as the U.S. government stepped in and private capital was raised to strengthen equity ratios and rebuild balance sheets. Although we have seen significantly positive price performance for many financial credit issues over the past year, we believe the sector still provides good long-term value given that current trading levels are still cheap compared with non-financial issues.

Looking at the high-yield market, we do believe that we are in the midst of an economic recovery, although we realize that it may be somewhat moderate by historical standards, particularly considering the magnitude of the decline experienced over the past two years. Nonetheless, during the first few months of 2010, we have seen high-yield default rates drop meaningfully from 2009 peak levels. Assuming that the current pace of economic growth continues, we expect defaults to continue to decline over the course of this year. In fact, the proportion of "distressed" credits in the market-companies that have a high likelihood of defaulting over the near term-has come down dramatically over the past year, reducing the chances of a significant spike in defaults in 2010. With high-yield valuations hovering near long-term averages, we feel that this improving fundamental credit outlook may support high-yield bond prices while investors continue to receive an above-average yield from this asset class.

However, high-yield corporate bonds remain an asset class in which individual security selection is paramount to driving longer-term performance. Therefore, our in-house high-yield credit research analysts are very focused on both looking for attractive investment opportunities as well as being mindful to try and avoid those issuers that may encounter future credit difficulties.

European Corporate Bonds
Recent financial market volatility and concerns about European sovereign risk have impacted the European corporate bond market, an asset class that posted exceptionally strong performance from early 2009 through the first quarter of 2010. The financial market sell off caused corporate bond-yield spreads to rise, as investors demanded greater compensation for risk. The unprecedented measures announced this month by the European Union, the International Monetary Fund, and the European Central Bank (ECB) to contain the sovereign credit crisis have helped reverse the slide in asset prices and returned some stability to the markets. The situation will likely continue to evolve over the coming months, but we still believe that European corporate bonds present a solid investment opportunity because of a combination of attractive valuations, improving corporate fundamentals and better global economic conditions.

European corporate bond valuations, as measured by yield spreads over government bonds, are much tighter than levels seen at the peak of the global financial crisis in early 2009, but as of mid-May 2010, they remain wide by historical standards. These wide spreads offer both an attractive interest income stream to investors and the possibility of capital appreciation if spreads were to tighten further. Demand for corporate credit has been exceptionally strong over the past year, which has helped to drive performance in the sector despite heavy new issue supply. We also believe that the recent focus on sovereign creditworthiness may cause investors, many of whom previously viewed corporate bonds as significantly more risky than sovereign debt, to reevaluate their allocations to the asset class.

On a fundamental basis, we have seen many corporate issuers report improved earnings and cash flow in recent quarters, bolstering their credit standing. In addition, the difficult conditions experienced during the global financial crisis caused many issuers to rethink their liquidity and debt positions. As a result, many companies decided to preserve cash and lower debt, often at the expense of dividends or share buybacks. The positive market conditions over the past year also allowed many companies to refinance upcoming debt maturities, eliminating worries about refinancing their debt.

On a sector basis, we are still very positive on the health care sector, particularly the pharmaceuticals industry. Overall, we believe that European economic conditions have shown signs of stabilization and improvement, although we remain mindful of the possible impact of further fiscal austerity measures in a number of countries.

Importantly, we have seen more demonstrable signs of economic improvement in Asia and the Americas. Recovery in these regions is a positive for many multinational European companies that have business interests across the globe. The recent weakness of the euro versus many other currencies may further help the competitiveness of European companies and potentially result in better foreign earnings when translated back into euros.

Given current conditions, we believe the ECB is likely to maintain an accommodative monetary policy for the foreseeable future. We think low interest rates should help to underpin economic growth and provide a supportive backdrop for corporate bonds, since the asset class often performs best during periods of moderate growth. In this environment, companies generally have strong enough earnings to service their debt but tend to maintain more conservative financial policies.

Overall, we continue to believe that European corporate bond valuations remain moderately attractive at current valuations. Recent market events have renewed investor focus on credit risk, but the volatile conditions have also created a number of market dislocations that may provide attractive corporate bond investment opportunities going forward. Uncovering those opportunities requires an experienced portfolio management team supported by strong credit and sovereign risk research.

Please click for more information on the following:
FTIF - Franklin Strategic Income Fund
FTIF - Templeton Emerging Markets Bond Fund
FTIF - Templeton Global Bond (Euro) Fund
FTIF - Templeton Global Bond Fund
FTIF - Templeton Global High Yield Fund
FTIF - Templeton Global Total Return Fund

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