Roger Bayston, CFA
Senior Vice President and Director, Fixed Income

Zero yields in money market funds have been driving fixed income investors further out the maturity spectrum and down the credit-quality range in a bid to find income opportunities. Such a development is exactly what the loose monetary policy put in place by the Federal Reserve (Fed) was designed to accomplish. Encouraging investors to take more risk has reduced the cost of borrowing for individuals and corporations, allowing the overall system to delever. And I think investors can expect the zero money-fund yield scenario to have some further legs. The basic reason for this is that it represents the easiest way for the banking system to continue recapitalizing itself. As Fed Chairman Ben Bernanke warned in mid-December, the banking system in the U.S. still faces many headwinds in the months ahead. But borrowing at no cost from the Fed to buy higher-quality fixed income instruments can potentially help banks replenish capital.

Additionally, excess capacity in labor and product markets may prevent cost-push inflation from rearing its head in 2010, so the Fed has more latitude to keep short-term rates very low. However, as we move further into 2010, economic conditions may warrant some adjustment to monetary policy.

Credit markets have improved since March 2009-in some cases quite dramatically. In turn, the revival of credit markets has allowed the U.S. economy to improve. This improvement in economic conditions is having the biggest impact on the way we are allocating assets in the Franklin Templeton Fixed Income Group. Twelve months ago, there was a great deal of uncertainty about whether some of our investments would actually pay back their principal. Expectations for defaults were increasing, sometimes by the day. By contrast, credit defaults are now expected to decline in the period ahead, leading us to embrace more credit exposure in some of our multi-sector fixed income funds. In addition, in our global fixed income funds, the size of the fiscal deficits in developed countries has driven greater non-U.S.-dollar diversification into countries with sound fundamentals.

U.S. Treasury Yield Curve Comparison

Quarter-End Yields of Various U.S. Treasury Constant Maturity Securities
Quarters Ended 12/31/2008, 3/31/2009, 6/30/2009, 9/30/2009, 12/31/2009

Source: U.S. Treasury, Federal Reserve, as of 21 January 2010

Please click for more information on the following funds:
FTIF - Franklin U.S. Government Fund
FTIF - Franklin U.S. Total Return Fund
FTIF - Franklin U.S. Ultra Short Bond Fund