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Bondz 'n' the hood: Franklin Templeton's Takaha on income's best bets

Bondz 'n' the hood: Franklin Templeton's Takaha on income's best bets

Eric Takaha has come a long way since joining Franklin Templeton as an analyst 25 years ago.

Having made the transition from analyst to portfolio manager in the intervening years, the laid back North Californian has also crossed the asset class divide by switching from being an equities analyst earlier in his career to cover bonds at Franklin Templeton.

In his role Takaha has access to the investment arsenal available at a company that runs $390 billion (€283 billion) of fixed income assets.

Today he is director of the firm’s corporates and high yield bond group, overseeing a team of 24 analysts spread between London, New York, Singapore and the company’s headquarters in San Mateo, some 25 miles south of San Francisco.

A proud born and bred local, Takaha manages six funds at the group, totalling around $20 billion in assets.

Following a degree at the University of California, Berkeley and an MBA from Stanford University, he had a brief stint as an equity analyst in Morgan Stanley’s New York office.

He joined Franklin Templeton in a similar role upon returning to the West Coast and found himself drawn to the forensic approach required for poring over company balance sheets and analysing reports.

‘I really enjoyed digging around to find out what was driving a company’s fundamentals,’ he says.

Casting the net wide

The $1.36 billion Franklin Strategic Income fund has become an ever increasing focus for Takaha, as fixed income markets continue to evolve away from the more pure beta plays of the last 30 years.

The fund has posted solid gains since launch and over the five years to the end of March 2014, has returned 58.4% versus 34.5% from its average peer.

The fund, which Takaha runs alongside Franklin Templeton Fixed Income Group CIO Chris Molumphy and Kent Burns, has a flexible go-anywhere mandate which is becoming increasingly popular with investors concerned by the diminishing returns from more conventional areas of the fixed income market, for more on this see Buyers’ Market, pages 8-10.

Takaha is happy to invest in more niche parts of the asset class such as bank loans, asset-backed securities and US municipal bonds.

‘I can leverage off anyone and everyone at the firm and we have a team of 115 in fixed income.

The fixed income policy committee (FIPC) meets every Tuesday to discuss market fundamentals, and links Franklin Templeton’s San Mateo base with its offices in London, New York and Singapore via video conference call.

Along with Takaha, the committee includes such illustrious names as Templeton Global Bond manager Michael Hasenstab, and fixed income CIO Chris Molumphy.

As well as the FIPC, the risk group also meets with CIOs and individual fund managers on a regular basis to provide analysis on recent performance and examine where the major sources of volatility are within respective portfolios.

Takaha currently has 15% of the Strategic Income fund in bank loans and more unusually, a further 7% in US municipal bonds – a much maligned sector over the past year.

‘It’s important to have a big team to do the research to invest in these more niche areas, and we certainly have that.

‘Bank loans are a very interesting asset class. They have the features of a corporate credit bond and at the same time they are floating rate instruments.

‘While their yield doesn’t change automatically they are tied to short-term rates so when we start to see the Fed increase fund rates in the next couple of years we will see the income rise.

‘You can pick up some yield, and can also benefit from a rise in rates,’ he says.

Franklin Templeton’s fixed income capabilities

Corporates & high yield group

Takaha oversees a team of 24 credit research analysts located in San Mateo, London, New York and Singapore. Organised along sectoral lines, credit analysts cover specific industries. The fixed income corporate credit analysts also frequently consult with their equity research counterparts. Although not formally a part of the fixed income process, the firm’s equity analysts offer a perspective on the global credit markets that deepens the research team’s understanding of activity in the credit sector.

Municipal bonds

In terms of municipal bond exposure, Takaha started to grow interested around a year ago after a spate of bad news stories that followed the revelation that the city of Detroit was in default.

‘Detroit, parts of Illinois and places like Puerto Rico were under the gun in 2013 but we have one of the biggest in-house teams looking at this area. Their feeling was that a lot of the headlines and technicals, which precipitated the outflows, had caused too much pressure and didn’t reflect the long-term fundamentals of these types of bonds,’ he says.

Takaha has just less than 1% of the fund in a Puerto Rican municipal bond, and the remainder in a mix of Californian and Illinois-based ones.

‘Municipal bonds are not traditionally followed by fixed income investors. It is a longer-duration asset class and while you have to be aware of that when you invest, you can pick up a fair amount of spread relative to government bonds.

‘Again, you do need to have a specialised research team because this is a whole spectrum of individual cities across a range of counties and states.

‘These are longer maturity bonds with typically 4-6% yields. Often they are tax free and we think that over time, most of them will stabilise.’

By contrast, Takaha has been reducing his exposure to mortgage-backed securities, and increasing commercial real estate to around 5% of the fund, as sentiment and fundamentals improve for the sector.

‘Commercial real estate is moving in the right direction but liquidity is often not that great so you have to be able to hold for the longer term,’ he says.

Takaha is focusing on credit risk across most of his portfolios at present.

‘We are most optimistic on credit, rather than rate risk, from either bank loans or high yield bonds going forward, and we also like selective global bonds in emerging markets.

Takaha has used the sustained sell-off in emerging markets that followed Bernanke’s ‘non-taper’ speech last May, to recently add selectively to both dollar-denominated and local currency-denominated emerging market debt.

‘We have had higher exposure to EM currencies but have been reducing over the past couple of years.’

Takaha has kept a reasonable amount of exposure to Asian currencies, with significant positions in South Korea, Singapore and Malaysia, as over time he expects them to outperform.

Takaha’s best and worst moments

Best

‘During 2001-2002 we saw a large credit crisis unfold after various accounting fraud related issues, recessionary pressure, and an overall deterioration in credit. However, even as valuations cheapened materially, our outlook for both default rates and credit quality trends began to improve. As such, we positioned the fund with a significant weighting in high yield corporate bonds. Having taken this stance to high yield credits prior to the economic recovery, performance in 2003 and 2004 benefited as credit spreads narrowed and the high yield sector delivered strong total returns.’

Worst

‘This was in 2008, when nearly every spread sector of the fixed income market underperformed treasuries, as an overall flight to quality led to a strong rally among US treasuries. Relative to the Barclay’s Aggregate index, our underweight to the government and government agency sectors detracted from performance. However, given tightening valuations we had reduced our high yield corporate weighting prior to the financial crisis, which helped the fund to outperform the average peer fund in the multi-sector income category during that period.’

Key shorts on the euro and yen

However, he has a large short on the Japanese yen even though he admits that during bouts of risk aversion it still has the tendency to strengthen.

Despite recent renewed strength, he expects the Japanese currency to weaken further over the mid-term.

‘We think the yen is still overvalued,’ he says.

Takaha’s other key short currency position is on the euro, which he holds alongside a basket of satellite currencies such as the Polish zloty, the Hungarian forint and the Swedish krona.

‘We think these countries will outperform relative to the eurozone,’ he says.

Takaha is also rebuilding exposure to Latin American currencies after recent dislocations.

He has had a long position on the Mexican peso for some time but in the past few weeks has been building up his exposure to the Brazilian real. There is also a 1% long position in the Indian rupee after significant fiscal and monetary progress in recent months.

He is quietly confident, but not yet ready to say that India has completely left behind its recent currency and economic issues.

‘The recent mood in India has been positive and over the longer term it also looks promising, but things are still at an early stage.’

He is happy to retain his long position in the Mexican peso because, despite recent outperformance, the currency is still down versus the dollar as the country has been hit by the indiscriminate sell-off in all EM currencies.

In terms of Brazil, he says the country ‘took it on the chin’ last year and while the economy is flat year-to-date, recent economic policies have created significant structural improvements.

‘There may still be bumps along the way for commodities and its political set-up this year, but over the longer term we think it is fairly well set.

By contrast, Takaha says that South Korea is already ‘firing on all cylinders’. The fund has a large overweight to the Korean won and in particular to short-dated bonds.

‘We think Korea often gets unfairly lumped in with other emerging markets.

‘The country is doing well in technology, exporting and shipping, and local-denominated bonds have been resilient but are still down compared with dollar bonds.

High yield gains

High yield remains the largest sector in the fund overall.

‘We look at high yield in a similar way to bank loans. These assets still offer a decent yield relative to other areas of fixed income even though they are generally a bit lower quality than most bank loans.

Within high yield, Takaha has been adding to his energy positions in particular.

‘The valuations in the energy sector are at the same level as industrials as a whole, but we think the assets are higher quality. If energy companies run into difficulties in their ground operations they can always sell their assets.’

In terms of rates, Takaha says he remains ‘insensitive to rates overall’, although like many in the sector, he expects to see a gradual rise over the next two years.

‘Inflation remains benign and we see a gradual pull back in QE. We have seen 10-year treasuries move from 150 basis points to 270 and over time they might get to 400 basis points.

‘The point is that the Fed is focused on making sure the markets don’t get out of hand.

‘Right now we think that the rate risk is greater than the credit risk. When you look forward into 2014 and 2015, it is hard to see default rates rising dramatically. Growth has slowed compared with pre 2008 in the US but outside of any major macro event things look relatively benign.’

Despite his liking for high yield, Takaha is realistic enough to admit that returns will be more muted going forward, and will continue to use all the tools at his disposal to try to steer his flexible fund to the best opportunities, wherever they may be.

‘We have dampened our expectations for high yield, and have moved up the credit quality curve over the past 12 months, as valuations have tightened,’ he says.

This article originally appeared in the May issue of Citywire Asia magazine

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