A flexible approach to income and managing risk

James: [00:00:04] Hello, everyone, and welcome to the latest edition of WP Talk. I'm your host, James Burton, managing editor of Wealth Professional Canada. For this episode, I was delighted to welcome Kent Shepherd, SVP, Senior Institutional Portfolio Manager at Franklin Templeton Income Strategies. Kent has more than 30 years of industry experience behind him, so it was a privilege to be able to pick his brains on some hot topics with tricky market conditions in mind, we delved into why income might be a challenge right now and where the opportunities are. We also talked about how the Franklin US Monthly Income Fund is positioned, the tug of war between value and growth and what advisors should be considering right now for their clients portfolios. Okay. Hi there, Kent. Thanks so much for joining us on WP Talk. Let's dive straight in to our first question. As you well know, current market environment and conditions pretty challenging for investors. As Franklin income investors, where do you seek income opportunities in today's market? 

Kent: [00:01:14] James, you couldn't be more right. It's been quite an interesting and volatile period on many fronts, including monetary policy movements and in different financial markets, whether the equity or fixed income. Now, we also have some recently developed issues around global banking and some confidence shuddering there. So, there are certainly a lot of different dynamics to navigate right now. And in that effort, we take great pride in our 74-year-old Franklin Income strategy – a multi-asset, flexible, nimble, tactical approach, able to shift over time to where we think the opportunity set is greatest. And you know, if you look back over the past year and a half, we were quite cautious on things related to interest rate movement and bonds, fixed income and the duration risk. Well, fast forward to the current environment, and we now see much improved opportunities in the interest rate arena. You know, you've seen Treasury bond yields on the US 10-year maturity bounce off multi-decade lows of roughly ½ of 1% to recently exceed 4%. You've seen US investment grade corporate bond yields bounce from roughly 2% percent yield range to roughly 6% percent yield range, and below investment grade corporates that were yielding the 4.5% to 5% percent just a year and change ago now bouncing around the 10% yield range. And there are certainly some select opportunities in the equity market as well. And we take every opportunity to harness the volatility of equity markets to create covered call-write strategy equivalents, where we utilize the volatility to our benefit by getting more yield out of out of equities. So that's really the big picture where we're gravitating. You know, I would tell you that just as of year-end calendar 2021, roughly 63% of the Franklin Income Fund portfolio was in equities and only 34% was in fixed income. Well, now that's almost completely flip flopped. And now we're looking at about 62% of the portfolio in fixed income and the total equity components fallen from 63% to 37%. So that's a rather meaningful shift between the equity fixed income categories that kind of reflects how unique and dynamic this past year or two has been in the real economy and markets. 

James: [00:03:20] Yeah I mean dynamic that's definitely that's definitely one way to put it. I mean, just honing in on just the last few weeks, you know, we're recording this on March 24th for the benefit of our listeners, but we've had obviously the banking issues and the Silicon Valley Bank. And then just this week, the Fed raised rates again. What's your perspective on recent developments, especially around monetary policy and where do you think the Fed goes from here? 

Kent: [00:03:50] Sure. Yes. And you're right. Just this week, the Fed, the US Federal Reserve, raised that Fed-Funds rate target by another 25 basis points, getting it to the 4.75 to 5% range. And we do see the Fed staying honed-in, in a very disciplined, devoted manner to their dual-mandate of achieving price stability & full employment, meaning you try to reduce inflation to an acceptable level while also pursuing healthy employment levels. And their third, less-frequently discussed mandate is stability in the financial system. And we do feel like perhaps the developments of the last week or two, starting with Silicon Valley Bank, Credit Swiss and some other financial institutions, has arguably done some of the Fed's work for it. It is conceivable that these strains in the financial and banking systems may tap the brakes a bit on access to capital, financial conditions, liquidity, lending activity. So, these developments actually could be construed as an ally to the Fed's desire to slow the economy a bit, in their effort to get inflation down closer to the 2% range or so. We're not necessarily finding ourselves in agreement with folks and market indicators suggesting Fed might be cutting rates beginning before the end of this year. Nothing's impossible - if they considered it absolutely necessary the Fed could possibly pivot to a rate-cutting stance before the end of this year, but that wouldn't be our base-case assumption at this point in time. One other thing I think is important to highlight about rates: we of course know the Fed funds rate is discussed endlessly by different commentators and venues around the financial community, and it is, of course, the rate at which US banks lend money to one another US bank overnight. An important factor to consider here is that before this recent Fed rate hike cycle that commenced a year or so ago, we were at 0.25% Fed funds for nine of the last 13 years, which spans through the GFC of 2007, 08, 09, plus the unprecedented COVID Pandemic period. I'm not second guessing the wisdom or judgment of the Fed, but I'm just saying rates were so low for so long that they arguably catalyzed some somewhat unusual behaviors in financial markets. One could even argue that an abundance of capital from venture capital firms flowing into small companies was elevated when interest rates were so low, access to capital was so inexpensive, and the opportunity cost of making such investments was thus historically low. One might argue that, as we reflect upon recent market events, some of them may have been the unintended consequences of having abnormally low Fed policy rates for such an extended period of time.  Metaphorically speaking, one might make a case that these historically low borrowing costs seeped into the groundwater of the way investors and market participants started to behave. So now we're seeing sort of a normalization or recalibration of things like the cost of borrowing money – to levels more typical of historical levels - and that normalization has had profound impacts on the fair market value of a wide range of investments. 

James: [00:06:49] I'm just curious, Kent, you know, when the SVB, sorry, story broke or it was happening, did it have a sort of material impact on your strategy? I mean, was it something that you expected to sort of just wondering what it looked like from your perspective? 

Kent: [00:07:06] Yes, great question. I would say first and foremost, no, it did not impact us because we had no exposure to the company and likewise no exposure to some of their siblings, or banks of similar characteristics – such as regional banks that that had concentrated exposures to particular types of markets, depositors and borrowers, and/or large quantities of deposits that were not FDIC-insured. So, no, we felt pretty much unscathed by that event. I can't say we anticipated the events related to SVB, specifically, but we have spent an enormous amount of time and effort over the past year and a half preparing for an eventual rebound in interest rates. And we took quite extensive action in our portfolios to brace for what we thought would be a rather punishing rebound from abnormally low to structurally higher interest rates. So, my intent is not to throw stones or criticize anyone, but I suppose we were surprised by the magnitude of duration or rate exposure contained in the Silicon Valley Bank's portfolio.  Perhaps they were under great pressure to find something to do with enormous flow of deposits they were receiving from their client base. So, again, I don't wish to judge or criticize anyone, but I can't say their elevated duration exposures  were something we would have expected a sophisticated investment portfolio operation to be exposed to as much as they were. 

James: [00:08:26] Yeah. Okay. Interesting. Kent, some good insights there. Let's hone in a bit on the Franklin income strategy, if we can. Can you tell us a little bit about the history behind the strategy and about the team that are involved in that and the Canadian Franklin Monthly Income Fund? 

Kent: [00:08:46] Absolutely. If ever there were a flagship fund for our firm, this fund is it – globally, within the US, and in Canada.  In total around the world, the Franklin Income Team manages roughly $80 billion USD, and it goes all the way back to 1948. Actually, our prior CEO and his father had a vision literally 74 years ago to create a world class income producing vehicle that also was tactically able to adjust and adapt to changing economic and financial markets conditions. The relative attractiveness of different asset classes can and does change dramatically over time. The last 18 months have certainly reminded investors of this fact, and navigating changing market conditions was core to the mission of the founders of our Franklin Income strategy when they created it. Some 7-plus decades later, this Fund grown into being a very, very important part of our firm. We're very pleased that it was launched in Canada about a decade ago, and has an identical team & investment approach to that of the US version of the Fund.  We just slightly tweaked the name for the Canada market to call it the Franklin US Monthly Income Fund to more explicit reference to its primarily US focused holdings and its monthly distribution policy. We're very pleased that is a five-star Morningstar rated fund. It's in the top quartile of its peer group on a one, three and five year basis and was awarded the highest ranking by the fund grade A+ award organization for the 2022 calendar year. So, we're very pleased with these results. Again, the same exact team of investors that runs the US version of the Fund likewise manages the Canadian version.  And that team is headed up by Ed Perks, the chief investment officer of the Franklin Income Investors team and the lead portfolio manager here. He's been at the helm of this strategy for roughly two decades now, and he's accompanied by two very capable co-managers that I sit alongside on the trading desk every day, Brendan Circle and Todd Brighton. Between the three of them, I know I’m biased, but I personally and quite honestly have never observed a more capable and dedicated team of investors. And that's why the US version of this fund is my largest personal investment, for my own family. So, you can see our enthusiasm gushes over it. It's a very important and very unique strategy for firm. 

James: [00:10:55] I wonder if you could share its sort of current AUM figure and then just maybe provide a bit of insight. I'm curious to know sort of how you manage actively, you know, an active, flexible strategy of this size. 

Kent: [00:11:09] Absolutely. Yes, so, all-in, including the US and the share classes provided to investors around the globe, it's approximately $80 billion USD. And of that, roughly $200 million USD is in Canadian version of the Fund. We're quite optimistic that there's an opportunity now for more Canadian investors to embrace this strategy and enjoy what it's delivered to American investors for seven decades. We find, honestly, that our size is a blessing. It's a blessing because of our aspiration to cast a wide net across so many different asset classes and then execute on those asset class views with individual security selection.  This approach requires a very deep, capable, talented team of over 150 financial analysts covering several categories of fixed income and equity. As I speak, during this trading day, these analysts are actively researching the securities we own, the securities may want to avoid and the securities we might want to own in the future. So, the infrastructure and the resources, the economies of scale of trading and interacting with the Wall Street community, the benefits of our scale, I would humbly suggest, far outweigh any disadvantages of our size. There may be a microcap stock that's so small that we might think it's attractive, but it wouldn't make sense in a in a strategy of this size. But I would propose that the approach that we take would be difficult to do without the scale and the resources that we have behind us. So, is our size our friend, really? Yes, absolutely. 

James: [00:12:58] Now, given everything we've sort of mentioned, how are you positioning the strategy right now? 

Kent: [00:13:04] Well, if you mean in terms of positioning the strategy in the marketplace for investments, it's been embraced by so many different types of investors - certainly those who seek to produce an attractive level of income from their corpus savings find it to be very compelling. I personally reinvest every monthly distribution and use it as a capital accumulation vehicle. We have a lot of investors around the world who do that same thing.  One day when I no longer have an active current salary, the monthly distributions from my corpus of Fund shares owned will be a primary source of income each month for me. So, I would say it's hard to pigeonhole, how it's used or how it should be positioned other than we find that there's a concept that should be considered by investors today allocate to flexibility. You know, the investment community has a general practice of allocating some portion of one’s portfolio to equity, some portion to fixed income, maybe some portion to alternatives, and you might have a 60% - 40% allocation split. You can visualize these allocations in pie charts. Well, we would humbly suggest it's time to carve out a piece of that pie chart for an asset class that we call flexibility; a portfolio allocation that contains the ability to exercise our views and relative value judgements, relative merits and risks of different asset classes at different times. So, we believe that the Franklin Income strategy can be a real core holding for investors to accompany others that are more specific to one asset class or the other.  

James: [00:14:34] Just segwaying from the flexibility, this might kind of touch on a similar vein, the growth versus value topic or argument if you like. How do you think the recent market moves have affected that argument and that those weightings and their long term impact? 

Kent: [00:14:52] Well, it's a fascinating topic and I think the original crafters of the growth versus value concept were well-intended. But that framework is a little bit simplistic in our humble opinion because frankly, every investment is always about growth prospects, because growth – growth in future earnings, cash flow, dividends, for instance - is typically the core determinant of one’s judgement of worth of the enterprise. It could be slow growth, it could be high growth, could be cyclical growth, could be stable growth. But you start with growth analysis to make an estimation of what you think a franchise or investment is worth. And then the concept and objective of valuation is to be an opportunistic and disciplined acquiror of that investment at an attractive price. So, growth and value probably are more joined at the hip than autonomous concepts, in our humble opinion. That being said, given the Franklin Income strategy’s yield orientation and its very high ranking in yield produced versus our peer group, there are certainly some classic value sectors - as the fund research practitioners typically describe them – within in our portfolio. But we would also point out that there are some areas where we can produce very compelling returns that one might not typically associate with classic value sectors. We do have the ability, for instance, to generate compelling income & total returns from the information technology sector, which currently represents roughly one tenth of the of our portfolio in terms of total assets. And that's in part because of our ability to use structured notes to convert non-yielding or low dividend yielding wonderful, fabulous, financially strong, healthy, innovative companies that lack dividend yield, into securities that do generate attractive yields and total returns. We can construct this yield using a “covered call write” equivalent strategy that we call equity linked notes. So, I would just be reluctant to call us a pure value strategy because our nimbleness, the scope of our investable universe, and our ability to navigate between different sectors and asset classes. We believe this approach does not lend itself to too rigid a categorization.  

In terms of your question about recent market action, when I look back at the past year, calendar 2022, some of our portfolio positioning that contributed positively to our returns was in defensive sectors, sectors like health care and pharmaceuticals, utilities, consumer staples. These are sectors that historically are comprised of companies whose earnings tend to be resilient amidst the onset of an economic slowdown or recession. So, when the Federal Reserve announced a year and change ago that they needed to intentionally slow the economy to subdue inflation, investors naturally gravitated toward those defensive sectors that I listed:  health care, utilities, staples, even energy to a certain degree. The strong performance of our holdings in these sectors certainly benefitted our fund’s performance, but it also gave us an opportunity to gradually shift some of our exposure out of these sectors where the bid was strong and investor demand drove up the valuations. This profit-taking has provided a source of capital for us to embrace and add to those higher yields in the fixed income market that I described earlier in our conversation. So again, we don't tend to believe we're a strategy that lands neatly into the growth versus value box, but rather, one that is more opportunistic and relative value driven. 

James: [00:17:58] Yeah. Okay. Thanks Kent. Great insights into the strategy there. Now, you know, part of what we mentioned a bit earlier in our chat, you know, the with the Fed and the sort of market conditions, there's a lot of talk about recession and about sticky inflation certainly for the rest of the year. What's your economic outlook for the US and Canada for the next 12 to 24 months? 

Kent: [00:18:24] Yes, excellent point. You know, certainly we look toward the future with the possibility of an economic slowdown and even a recession.  Various factors suggest to us that the probability of a recession seems to have directionally increased. We do see a North American consumer that has experienced some wage growth & income growth, but for many citizens, income growth has not been keeping pace with overall inflation. In other words, I might be getting a 4% or 5% raise in my salary, just as a simple example, but my cost of living might be growing at 8% to 10%. When you think about gasoline and you think about housing costs, you think about food, shelter, borrowing rates on mortgages and credit cards, for instance. So, among other things, the strain on North American households leads us to believe the possibility of a slowing economy has directionally increased. Does it have to be severe? Not necessarily. It's been it's been said by many - and I suppose we don't disagree - that this might be one of the most anticipated upcoming recessions in history. In other words, not like the kind of recession that comes out of left field or out of the blue and catches us off guard. I would say the US and North American, including Canada, both households and corporations, are metaphorically like the individual watching the Weather Channel and observing that the hurricane's on its way and they've made it to Home Depot or the supply store. They've covered the windows, they've bought the water and batteries and they're bracing and preparing. And economic slowing this won't be something that comes out of left field or by total surprise. That said, I think maybe the banking issues of the past couple of weeks were a bit of an unexpected development. And that will probably tighten credit and lending conditions and that would directionally also be a bit of a headwind for the economies of both us and Canada. But I would also point out that when we look at sort of prospective returns on asset classes and we look at, for instance, last year, both equities and stocks had a bit of a rough a rough time of it. But when you look at the returns of common stocks, such as an index like the S&P 500, really last calendar year, 2022 was a year of multiple contraction. Take for instance price/earnings (P/E) ratios based on consensus earnings expectations. The S&P 500 index’s price level was pulled down in calendar 2022 mainly by its P/E falling from roughly the mid 20’s down to the mid-teens level. Of the many different valuation metrics one might employ, this is just one. What didn't happen in 2022 was a decline in US corporate earnings. What we think we might be looking at now for calendar 2023 is the prospect for that metaphorical next shoe to drop may be some decline in U.S corporate earnings, for myriad reasons.  This could turn out to be an incremental headwind for some areas of the US equity market. Now, as that occurs, if that occurs, and if equities become more attractively valued - if they decline to levels we think are good values for long term investors – you will probably see our interest in equities increase.  It is possible we could utilize some of the money that we have recently shifted toward very high grade US corporates and government securities, and redeploy some of that capital back into equities. We do think that with a slowing economy, corporate earnings estimates still have some room for additional downward revision ahead. We've already begun to see that occur to some extent, but we think the odds are pretty good we'll see more of it going forward. 

James: [00:21:38] Yeah. Okay. Thanks, Kent. Just one last one last question for me. And that's just with your income hat on, obviously, what would be your sort of final message takeaway to our advisor listeners? 

Kent: [00:21:52] Yes, you know, one of the things I would emphasize is for many, many years, for almost 50 years leading up to 1990, when you looked at the S&P 500 as a good representative measure of a broad basket of US stocks, almost half of one's total return on equities asset class was from dividend yield. It was 48% to be to be precise - call it almost half. But then, starting in 1991 and through to calendar year 2021, equity market multiple-expansion plus earnings growth really took over as the drivers of total return, and dividend yield fell into the background. Dividends fell to roughly one tenth of the index’s total return over this period. When we take a step back and think, why did that happen? Well, honestly, from 1982 to 2022 - if you take the US 10-year Treasury as a as a benchmark for interest rates and yields – we had 40 years of sawtooth but persistent downward movement in US interest rates. From Treasury yields peaking in the mid-teens in the early 1980’s, all the way down to record-low rates in 2022.  And in that environment of persistently falling interest rates, the primary driver of returns in equity markets became more about PE multiple expansion – higher valuations - and earnings growth, and far less about dividend yield. We think of going forward, we've entered a period in time where a more meaningful part of investors’ total return will indeed once again be from dividend yield, but also from yields available in fixed income – from bond yields that have rebounded from near historic lows just 14 months ago to much more attractive levels today. So, when we when we reflect upon what's going to drive investor returns from here, we think that that income component is going to be a more vital part of the journey and we feel really well-positioned as a provider of the of the most attractive, prudent income available in the markets. 

James: [00:23:47] Kent, it's been fantastic having a chat with you today. Thank you so much for joining us on WP Talk. 

Kent: [00:23:52] Thank you, James. I really enjoyed it. 

James: [00:23:56] Thanks for joining us for this latest episode of WP Talk and thanks also to Kent Shepherd for sharing his insights. Now you can go to franklintempleton.ca/en-ca/products/mutual-funds/US-monthly-income. For more details on everything we talked about in particularly the fund, we will also post that link on the pod page so you have easy access to it. For more WP talk episodes, go to wealthprofessional.ca. Click on the resources tab and select WP Talk. The site also includes all the latest news and views from the industry. And if you haven't already, feel free to sign up to our daily newsletter. I'm James Burton. 

[00:24:44] Until next time. 

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