Update on FTIF Franklin High Yield Funds

Piero Del Monte
Portfolio Manager and High-Yield Bond Research Analyst
Franklin Templeton Fixed Income Group

We maintain a favorable outlook for the U.S. high-yield market, where technical factors are positive due to supply remaining relatively low and cash waiting on the sidelines. High-yield bonds have enjoyed significant spread compression recently, but current spreads are still much wider than their historical average, and therefore a trend of further spread tightening appears to be continuing over the long term.

Nevertheless, we recognize that in the near term some spread widening is possible. Corporate spending remains relatively low. Companies with cash can service their debt, but their immediate focus is on returning to profitability.

Whenever there is volatility, we have found security selection to be paramount in managing FTIF Franklin High Yield and High Yield (Euro) Funds. We are finding opportunities in defensive sectors, such energy, technology, health care and media. We are slowly shifting the average credit rating of our holdings from above that of the benchmark to more market-neutral levels. We are also working to reduce our cash position, which is currently higher than optimal.

We are encouraged by recent re-financings in the U.S. high-yield market, which can reduce defaults. However, we believe defaults are on the rise in the U.S. Depending on the market cycle, defaults tend to lag spread peaks. Consequently, our latest focus is on seeking to avoid securities at risk for default. If a portfolio holding should default, our investment management team would collaborate closely with our legal team to assess latest market prices, estimate ultimate recovery values and project work-out scenarios.

European high-yield bonds have increased in issuance from a year ago. Volume, however, remains modest as the European high-yield market continues to be dwarfed by its U.S. counterpart. Banks and institutional investors have traditionally funded European corporations. Yields are currently high, making it difficult for issuers to tap the market. Decreasing yields should stimulate activity in Europe, and we are already well-prepared to take advantage of such opportunities. Currently, the European default rate remains lower than that in the U.S., but we expect defaults in Europe to rise and eventually peak during the first quarter of 2010. Given the European market's smaller size compared to the U.S. high-yield market, any single default could have a larger impact in Europe than it would in the U.S.

We employ a long-term approach to investing, assessing securities over a three- to five-year time horizon. Under current market conditions, one key aspect of our portfolio management process is our sell discipline, which is also vital to our goal of avoiding defaults. A decision to sell can be triggered by deterioration in the overall financial condition of an issuer and its industry fundamentals, or any indication that a security has reached or exceeded what we believe to be its fair value.

Please click for more information on the following funds:

FTIF - Franklin High Yield (Euro) Fund
FTIF - Franklin High Yield Fund