Portfolio Strategy-European Bonds

David Zahn, CFA¹, FRM
Senior Vice President and Portfolio Manager
Franklin Templeton Fixed Income Group

Franklin Templeton's fixed income team has a consistent investment strategy that combines top-down views on countries and sectors with diligent, bottom-up analysis of individual securities. In the case of European bonds, such an approach means that we look at interest rate and currency trends when deciding how to position our portfolios. We are also interested in sovereign credit opportunities and valuation discrepancies across the full spectrum of corporate bond issues. Below are details of how we are approaching each strategy in light of near-term conditions.

Currencies. The turmoil that hit financial markets in late 2007 spilled over into currency markets with a number of eastern European currencies outside the eurozone suffering significant losses of value. In anticipation of rising risks, we have not been very active in eastern European currencies for some time, and in the middle of 2008 we reduced our exposure to the Polish zloty, for example. By contrast, we believe the differentials between the euro and the region's non-euro currencies, such as the Swedish krona and Norwegian krone, continue to offer some interesting potential.

Interest rates. Spreads between the yields offered by eurozone government bonds of similar duration remained low and quite stable for a long time after the euro was launched in 1999, thus restricting the opportunities to be had from this sector. The financial crisis, however, has led to significant spread widening, with a considerable spike in yield spreads for many issuers. As a result, we have been looking outside the eurozone government bond market for interest rate opportunities, with the credibility of individual central banks an important element in any investment decision. Thus, appropriate rate positioning in countries that, in our analysis, need to lower short-term interest rates aggressively to deal with economic hardship may prove a significant source of returns.

Sovereign credit. We view any widening of sovereign credit spreads as a chance to build positions in high-quality sovereigns in instances where we believe the markets have overshot and caused valuations to move far beyond our assessment of underlying fundamentals. In addition, widespread, indiscriminate fear has caused financial markets to overprice the likelihood of insolvency in several countries that still have relatively robust fundamentals. For example, there are a lot of bankruptcies among smaller corporate issuers in Russia, but the country's sovereign credit is actually quite strong. Even in corporate credits, the largest Russian companies (Gazprom, for example) benefit from strong sovereign support. We feel that the market's assessment of central and eastern European economies has been indiscriminate.

Corporate credit. Corporate credit is an area of particular interest for our European total return portfolios. The dislocations in credit markets since late 2007 have generated a number of opportunities, especially in the area of investment-grade bonds. We continue to expect the operating environment to be challenging for corporates. Yet we believe such a scenario is more than priced into valuations for investment-grade corporate bonds over the medium term.

We believe that this year will continue to be challenging for the European economy and financial markets. The events that have occurred since the advent of the global economic downturn underscore the dichotomy between the "saver" nations (essentially in northern Europe) and the "spender" nations (southern Europe and the British Isles). As the economic crisis has deepened, this dichotomy has manifested itself in a growing divergence between government bond yields around the continent.

In addition, Europe's deeply ingrained fears of inflation have kept the European Central Bank from cutting key policy rates as low as some of its counterparts, while strict limits on deficits have constrained government action. We believe such factors may ensure that a European recovery lags that in other parts of the industrialized world by at least three to six months.

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Please click for more information on the following funds:

FTIF - Templeton Euroland Bond Fund
FTIF - Templeton European Total Return Fund
FTIF - Templeton Global Bond (Euro) Fund
FTIF - Templeton Global Bond Fund
FTIF - Templeton Global Total Return Fund