Repositioning the Income Strategy

Edward D. Perks, CFA
Senior Vice President
Director of Core/Hybrid Portfolio Management
Franklin Global Advisors

Opportunities in corporate credit last year resulted in a fixed income bias over equities in our income investment strategy. Over the past several months, however, we have started to shift our strategy a bit away from fixed income and more toward equities as the long-term outlook for interest rates appears uncertain and opportunities in bonds, especially those with longer maturities, may not offer the best returns in our opinion.

With market expectations for long-term inflation expectations at about 2% to 2.25%, we anticipate further upward movement in the 10-year U.S. Treasury yield and, hence, interest rates. Our investment-grade corporate exposure has performed well as rates have remained low and spreads have tightened substantially. Given our concerns about rising long-term rates, we have taken profits to diversify the portfolio into other areas. Therefore, we have reduced our corporate bond exposure in recent months.

In repositioning our income strategy toward equity, we found PepsiCo and ExxonMobil to be interesting opportunities and offering compelling valuations. Our view is that high-quality, large-cap, dividend-paying common stocks offer tremendous value potential.

PepsiCo is a global company with about half of its sales outside of the U.S. In addition to being a well-known beverage company, its product line is almost equally split between beverage and food, with strong leverage coming from its Frito-Lay brand and other snacks.

ExxonMobil's pending acquisition of XTO Energy, which was announced late last year, caused a significant downdraft in the company's shares and led to a great value opportunity, in our opinion. We believe it is a very strong company with tremendous cash flow generation and good opportunity for dividend growth as well as share buybacks, which can drive total returns.

Overall, we have been keeping interest rates at the forefront of our income strategy as their movements are likely to impact certain segments of the fixed income market, and fixed income remains our primary strategy at this time. Our current view is that interest rates continue to be abnormally low relative to long-term inflation expectations. With the Federal Reserve having ended its mortgage buyback program in March and the fiscal deficit remaining high, we believe there certainly may be continued pressure to move long-term interest rates to somewhat higher real rates.

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