John Beck: Lessons from history

Franklin Templeton Investments co-director of international bonds John Beck

22-May-2014

By Wouter Klijn

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For a moment, Franklin Templeton Investments co-director of international bonds John Beck looks like he is contemplating how directly he should answer a question about the negative impact a rising interest rate environment would have on the ability to make money from bonds.

But Beck is not the type of person to dilute his views in order to produce safe and bland responses.

“Bonds are not going to be the stellar asset class,” he finally says.

“It is not that you are going to make a fortune in fixed income; you are not.”

Some areas of the fixed income market are worse than others, and there are certainly areas that, if possible, should be avoided completely, he says in an interview with theinstoreport.

“You have to ask yourself: ‘Why am I lending money to the UK government?’” he says.

“They have an inflation-linked bond: 0.125 per cent coupon, with a maturity at 2068.

“Yes, it is an inflation-linked bond, so you’ve got a tiny bit of inflation protection, so your real return might be higher than that.

“[But] you would need a telescope to see the duration and a microscope to see the coupon.

“Although I’m a fixed income guy, you’ve got to be mad to lend to the UK government for that amount of money.”

But he is unconvinced interest rates will rise quickly in the coming years.

He argues the period of low interest rates is likely to continue for some time, a view that is contrary to that of many fixed income managers, who seem to have piled into short-duration bonds and are waiting until the bond market picks up again.

“The almost ubiquitous wish that death is going to be painful, so bring it on quickly – in other words: interest rates can rise quickly, so let’s get through this cycle – I don’t think that is likely to happen,” he says.

“Is there a new equilibrium of interest rates that is lower than there was before as a result of global competition or an output gap in developed economies? That is plausible.

“Are we likely to return quickly to a 3 or 4 per cent rate in the US? I don’t think we are.”

The dog that hasn’t died

Despite the grim outlook for some areas of the sovereign bond market, investors should also ask themselves what it is they want from fixed income investments, he says.

Fixed income has traditionally functioned as a way to diversify a portfolio and reduce the level of risk.

Shooting the lights out was never the role of bonds, Beck argues, especially when you look at fixed income in a historical context.

“I started in fixed income in the mid-1980s and I often tell a little bit of a joke that I fell out of bed onto my [former Federal Reserve chairman] Paul Volcker prayer mat, and interest rates have fallen ever since,” he says.

“But it will be a different environment where rates will rise and fall.

“Fixed income is possibly going to revert back to what it should have been before the monetaristic experiment that we’ve seen in the late ‘70s and the early ‘80s.”

But the fixed income sector is not a barren wasteland, he says, especially if you operate mandates that are less constrained by indices.

Over the 12 months to 31 March this year, Beck and his team managed to produce an annualised return of 4.8 per cent, net of fees, in the Franklin Templeton Global Aggregate Bond Fund, while year-to-date the fund produced about 4 per cent.

“I’m very pleasantly surprised that in our global aggregate portfolios we returned 4 per cent this year,” Beck says.

“I think a lot of people would have said at the start of the year ‘[negative returns for fixed income] are an absolute certainty’, but that is being questioned.

“Fixed income is the dog that hasn’t died. Despite being kicked, we are still there.”

Besides opportunity in corporate bonds, including bonds of consumer staple companies, he has found attractive yields in peripheral Europe.

“It doesn’t enthuse me to invest in Dutch government bonds, or German government bonds at 1.5 per cent, let’s be honest, but we have been more focused on areas around the periphery,” he says.

“We have, famously, taken quite an aggressive view on Ireland and we still hold in those portfolios a positive gear on Ireland.

“When we looked at some of the peripheral European bonds, you’ve got to ask yourself the question: ‘What is the anomalous yield?’ and in the case of Ireland it was an anomalous yield; it was way too high.

“But if you did the comparison between Spain and Italy and Germany, what was the anomalous yield?

“If you sat here in Australia, you sat here and thought that the eurozone was about to implode. But if you sat in Europe, the anomalous yield was the German yield; it hasn’t traded at 1.5 per cent ever, whereas the Spanish yield at 6 or 7 per cent, well, they have frequently traded there.

“What really happened is that German bond yields went down sharply and Spanish and Italian bond yields widened a little bit against their historical average.

“So again, if you applied a strictly mathematical view – which we don’t because we look at fundamentals – what jumped out at you was the cheapness of the others.

“So you sell one and buy the others.”

The historic perspective

Beck has a passion for financial history and he finds it provides a calming effect in times of stress, such as in the aftermath of the 2009 sovereign debt crisis and the palaver around the potential break-up of the eurozone.

Early on in the process, he and his team made the call that the eurozone was not going to break up and although Greece could perceivably leave the pact, the speculation surrounding Italy’s departure was just that, speculation.

“Could you envisage Greece leaving the euro? Absolutely,” he says.

“But it was the discussions about the fall-over effect that started the repricing of Spain and Italy, because people saw that Greece in some way could be like a Trojan horse.

“Greece could leave because it has deep structural problems and arguably should never have been in the euro and wasn’t an initial eurozone member.

“But then to extrapolate that to the fifth largest bond market in the world?”

He says the political commitment to the euro is far greater than most people give credence to and the effects of Italy pulling out of the eurozone on the financial markets, not only in Europe, but also globally, would be catastrophic.

“If the euro would have imploded, I would not have liked to see what would have happened to the Malaysian ringgit, I would not like to have seen what would have been the ramifications for Chinese growth or what might have happened to commodity exports out of Australia and the valuation of the Australian dollar,” he says.

Beck was, therefore, convinced Italian bonds, which were priced at a level that implied a return of the lira, offered good opportunities.

“You would think to yourself: why would an Italian with big savings, Italy is a big savings market, invest in anything other than their domestic bond market? They are not going to buy German bonds,” he says.

“What you have seen is the short-term flow of overseas money go out and the next-term flow will be what the Italian bond market was always like in the 1980s, which is a largely domestically funded market, funded by Italian savings.

“But what we have seen is not only that domestics have bought their own market, but also a return of confidence from all the ambassadors who sold it when it was 5 or 6 per cent and now buying it while it is yielding 3.5 per cent.

“That is their choice, but we prefer to do it slightly the other way around.”

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