Leveraging short-term bonds amid economic uncertainty

In a volatile market as observed in recent times, cash is often reallocated into more strategic investments. Holding onto cash may seem prudent in periods of uncertainty, but it can impede long-term financial goals for investors.

Currently, money market funds hold an unprecedented amount of assets, with US money market funds alone amassing nearly $6 trillion as of mid-December 2023, according to the Federal Reserve. This figure represents a 60% increase since December 2019. While keeping cash reserves is important for emergencies, an overabundance can hinder the achievement of long-term objectives. Unlike many other risk assets, cash does not benefit from falling yields, making it less advantageous in the long term. For example, fixed-rate bonds appreciate in price when yields decline.

In a discussion led by Alex Lee, head of Canada ETF Product Strategy at Franklin Templeton, portfolio managers Naveed Sunderji and Adrienne Young from Franklin Fixed Income outlined the benefits of shifting cash into shorter-term bonds. They emphasized that in a high cash yield environment, moving money from money market funds to short-term fixed income strategies could be beneficial for risk-averse investors.

Inflation and economic trends

Sunderji highlighted a significant decline in inflation metrics since their peak in 2022, with notable differences between Canada and the US. In Canada, discretionary goods such as clothing and household equipment have seen a decline. In contrast, US inflation remains broad-based, driven by shelter, medical care services, and transportation.

Economic growth patterns in Canada and the US have also diverged. In the US, growth is driven by government spending on infrastructure, the Inflation Reduction Act, and robust consumer spending supported by excess savings and a strong labor market. Business investment and net exports further bolster US growth.

In Canada, growth initially stemmed from government spending and a strong housing market. However, higher interest rates have dampened home purchases, despite some relief from recent interest rate cuts. Canadian consumers, although more leveraged, are spending less. Significant immigration has masked underlying economic issues, resulting in softer GDP growth.

Opportunities in short-term bonds

Young added insights into the labor market’s impact on inflation and economic growth. In the US, unemployment is slightly up at 3.9%, with wage inflation around 4%, complicating the Federal Reserve’s efforts to reach a 2% inflation target. In Canada, unemployment has risen to 6.1%, with wage inflation at 3.5%, prompting a recent rate cut by the Bank of Canada.

Given the economic divergence between Canada and the US, active management in fixed income is crucial for mitigating risks and capitalizing on opportunities. Franklin Fixed Income focuses on short-term fixed income strategies, such as the Franklin Canadian Ultra Short Term Bond Strategy (TSX: FHIS) and the Franklin Canadian Short Duration Bond Strategy (TSX: FLSD).

Investment strategies and advantages

Sunderji emphasized the benefits of the Franklin Canadian Ultra Short Term Bond Strategy, which comprises high-quality commercial paper, bankers’ acceptance notes, and provincial bills. These assets provide low volatility, stability, and liquidity, enabling the fund to seize opportunities without being forced into selling in challenging market conditions.

Young highlighted the advantages of the Franklin Canadian Short Duration Bond Strategy, particularly in the current environment of an inverted yield curve. This strategy leverages high-quality secured bonds, corporate bonds, and diversification into US markets to manage risks and capture potential upside.