Download Franklin Income Fund Update: Our Views on Energy, High Yield

Franklin Income Fund Update:
Our Views on Energy, High Yield
Bonds and Interest Rates
Investment Team
January 4, 2016
WHEN WE EARN OUR KEEP
Markets are challenging. Short-term interest rates have been raised for the first time in over nine
years. Oil prices have dropped to lows not seen since the financial crisis. High yield bonds have
fallen out of favor, tainted by a challenged energy sector. Stock market volatility has picked up after
years of relative quiet.
Edward D. Perks, CFA
Executive Vice President,
Portfolio Manager,
Franklin Advisers, Inc.
As managers of Franklin Income Fund, we’ve seen this all before. Knee-jerk reactions are to pull out
of troubled markets and let it all blow over. But as experienced investment managers, we know this
is the time when opportunities may be greatest to identify investments with the potential to reward
our shareholders over the long-term.
So as we begin 2016, we again have turmoil and opportunity. Following is an update on some of
these key themes as they pertain to Franklin Income Fund.
OIL & ENERGY
And Matthew D. Quinlan and Alex W. Peters, CFA
Market Sentiment: Oil-related companies will suffer for years as overwhelming supply
drives prices lower.
Our View: Supply is being curtailed in the US, and demand estimates are rising. Our focus is
on those companies with the operational and financial wherewithal to withstand a prolonged
period of oil price weakness, in our view, and which we believe have the ability to perform
well in a recovery.
Strong production growth over the past several years contributed to over-supply in oil markets. The
energy complex broadly has been swift to respond, cutting spending on new production efforts over
the course of 2015. We expect this trend to continue into 2016. Current estimates show US
production has declined by approximately 400-500k barrels per day since peaking in June 2015.1
We expect to see production declines in other areas of the world as well over the course of the next
12 months.
Importantly, although inventories remain at elevated levels, demand also continues to be high. The
International Energy Agency (IEA) and the US Energy Information Administration (EIA) increased
their demand estimates for 2015 by 50% from earlier in the year. While we don’t anticipate that oil
will recover to previous highs in the short-term, we also don’t believe it needs to in order to achieve
compelling returns in the securities we hold in Franklin Income Fund.
The majority of energy exposure in the portfolio is in equities. Our focus has largely been on
multinational conglomerates, which entered the current period of weaker oil with some of the
strongest balance sheets on record. In addition, members of this group generally have the ability to
reduce significant production-related costs, while also engaging in five- to ten-year investment
planning processes. As a result, these firms have more levers to adjust to a prolonged low oil-price
environment and can be somewhat opportunistic in taking advantage of other sector participants
who might be experiencing heightened business impairments and financial distress. In addition,
many offer very attractive dividend yields, comparable in some cases to yields one might find in the
high yield bond market, yet with the added benefit of potential long-term capital appreciation when
commodity prices stabilize.
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Franklin Income Fund Update: Our Views on Energy, High Yield Bonds and Interest Rates
January 4, 2016
HIGH YIELD BONDS
Market Sentiment: Lack of liquidity in the high yield market makes it an area to avoid.
Our View: Challenges for some companies in the energy sector of the high yield market has
led to opportunities in other sectors as all high yield has been painted with the same
negative brush.
In recent weeks we’ve seen media attention placed on liquidity in the high yield market, and have
often received questions regarding the impact of longer term regulatory changes on market makers
and dealers of securities within high yield markets. We’ve found that over the past several years,
high yield markets have broadened out significantly and our ability to trade in these markets has not
been challenged.
Though much has been made of the energy sector within the high yield market, volatility has
extended to other sectors as well, including industrials, health care and technology, creating
potential investment prospects over a broadening opportunity set.
We entered this recent period of high yield market volatility with the lowest high yield bond exposure
in the fund over the past decade (roughly 26% of total fund assets as of November 30, 2015). We
have taken a dynamic approach to managing the high yield exposure, and there have been cases
where we repositioned into different bonds to attain a more favorable position in the corporate capital
structure. There have also been cases where valuations (and corresponding yields) became more
compelling during various points of increased market volatility creating attractive entry points.
INTEREST RATES AND THE FED
Market Sentiment: Rising rates may kill a slow, post-financial-crisis economic recovery that
has never fully taken hold.
Our View: Rising rates signal the Fed’s belief that the economy is no longer in a vulnerable
post-crisis state, which we view positively.
Ultimately, we think rising US interest rates will be a “normalization” event off an unusually long
period of easy monetary policy.
The Fed’s 25 basis-point increase in the federal funds rate at the December Federal Open Market
Committee (FOMC) meeting was the first hike since 2006, before the financial crisis hit. In our view,
the central bank’s historically accommodative monetary policy during the financial crisis of 20082009 amounted to an emergency response to emergency conditions. That emergency is now long
past, so monetary policy needed to adjust. We think the Fed’s move to raise interest rates confirms
its confidence that the US economy and financial system are no longer in a vulnerable post-crisis
state. As investors, we view that positively.
As we enter 2016, a key area of focus in the US economy is the robustness of job growth, with the
national unemployment rate having fallen to 5% (often considered the “full employment” level) and
wages rising at the fastest pace in roughly five years. Additionally, consumer spending—including
auto and home sales—has been resilient and even strengthened in recent months. But we would
point to language from the Fed accompanying its decision that suggests the pace of any future
moves is likely to be gradual and measured.
We recognize that rising interest rates may have some near-term negative consequences for
interest-rate-sensitive equities such as utilities, banks and real estate investment trusts (REITs).
Overall, however, we would expect many companies to successfully navigate a Fed rate-hike cycle,
as the benefits from a continued US economic expansion and earnings gains should outweigh the
potentially negative implications.
Franklin Income Fund Update: Our Views on Energy, High Yield Bonds and Interest Rates
January 4, 2016
WHAT ARE THE RISKS?
IMPORTANT LEGAL INFORMATION
All investments involve risks, including possible loss of principal. The
fund’s share price and yield will be affected by interest rate movements.
Bond prices generally move in the opposite direction of interest rates.
Thus, as the prices of bonds in the fund adjust to a rise in interest rates,
the fund’s share price may decline. Changes in the financial strength of a
bond issuer or in a bond’s credit rating may affect its value. The fund’s
portfolio includes a substantial portion of higher-yielding, lower-rated
corporate bonds because of the relatively higher yields they offer.
Floating-rate loans are lower-rated, higher-yielding instruments, which
are subject to increased risk of default and can potentially result in loss of
principal. These securities carry a greater degree of credit risk relative to
investment-grade securities. Stock prices fluctuate, sometimes rapidly
and dramatically, due to factors affecting individual companies, particular
industries or sectors, or general market conditions. These and other risk
considerations are discussed in the fund’s prospectus.
This commentary reflects the analysis and opinions of the author as of
January 4, 2016, and may differ from the opinions of other portfolio
managers, investment teams or platforms at Franklin Templeton
Investments.
Because market and economic conditions are subject to rapid change, the
analysis and opinions provided are valid only as of January 4, 2016, and
may change without notice. The commentary does not provide a complete
analysis of every material fact regarding any country, market, strategy,
industry, asset class or security. An assessment of a particular country,
market, security, investment, asset class or strategy may change without
notice and is not intended as an investment recommendation nor does it
constitute investment advice. Statements about holdings are subject to
change. Statements of fact are from sources considered reliable, but no
representation or warranty is made as to their completeness or accuracy.
Investors should carefully consider a fund’s investment goals, risks,
charges and expenses before investing. To obtain a summary
prospectus and/or prospectus, which contains this and other
information, talk to your financial advisor, call us at (800) DIAL
BEN/342-5236 or visit franklintempleton.com. Please carefully read
the prospectus before you invest or send money.
CFA® and Chartered Financial Analyst® are trademarks owned by
CFA Institute.
Franklin Income Fund Symbols:
Class A: FKINX
Class C: FCISX
Class R: FISRX
Class R6: FNCFX
Advisor: FRIAX
1.
Source: U.S. Energy Information Administration, as of 12/16/15.
Franklin Templeton Distributors, Inc.
One Franklin Parkway
San Mateo, CA 94403-1906
(800) 342-5236
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