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Bond fund looks globally to dampen impact of rising rates

INVESTMENT REPORTER

Funds holding government and corporate debt have reaped a steady flow of new cash from shell-shocked investors still suffering the aftermath of the stock crash in 2008.

But with interest rates left with nowhere to go but up, some market forecasters have been warning since the start of the year that bond funds are increasingly less attractive. The concern is that when interest rates and inflation finally begin to rise again, existing bonds will be worth less because new issues will have to pay higher rates.

Michael Reed, vice-president and institutional portfolio manager with Franklin Templeton Investments, says such fears are premature. He suggests that his firm's Global Bond Fund has implemented a strategy to dampen the effect of rising rates, and that Canadian fixed-income investors are missing out by not looking globally.

In the United States, the economy is 85 per cent service driven, which means that the cost of labour drives inflation. With the jobless rate stubbornly stuck above 9 per cent, however, there is plenty of room for employment growth before inflation begins to emerge, he says.

"The fund aims for positive returns and limited volatility in any environment," says Mr. Reed, who works in San Mateo, Calif., with Michael Hasenstab, lead manager of the Templeton Global Bond Fund.

The fund, which has a management expense ratio of 2.07 per cent for Canadians, is one of the largest and most successful in its class. It delivered a one-year return of 3.7 per cent, compared with 2.5 per cent for the group average and negative 5.7 per cent for the benchmark, Citigroup World Government Bond index.

For two years, the fund boasts a 13.3 per cent return, compared with 7 per cent for the average and 6 per cent for the index. And over the decade, it produced returns of 5.5 per cent, compared with 3.2 per cent for the group average and 3.0 per cent for the index, according to GlobeInvestor data.

For Canadian investors, it's important to realize that fixed-income funds are evolving along the same path as equity funds did, building products that offer a means to get broader, international exposure. (Canada comprises only about 2 per cent of the global market for fixed-income.)

"Canadians are very overweight in Canada. People need to look abroad because there are tremendous pockets of value," Mr. Reed says.

Templeton uses three main levers to try to maximize its investments in government debt: durations, currencies and sovereign risk. The firm is being very selective, with durations chosen on an issuer-specific basis. Currencies of developing nations, including Brazil's real, India's rupee and China's yuan, offer far more value than the U.S. dollar and the euro. And sovereign risk is assessed on a piecemeal basis, he says.

One way to dampen the effect of rising rates in North America is to look to countries that have already priced in rate hikes, such as Brazil and Australia.

The Templeton Global Bond Fund favours developing nations such as China and Brazil and is rejecting investments in countries marred by massive debt. The U.S., Western Europe and Japan face tax hikes and spending cuts in the years ahead, which will likely translate into weak growth and currencies, he says. On the other hand, a lot of developing countries have made smart infrastructure investments and have significantly less debt than advanced Western economies, meaning they should benefit from greater efficiencies and less drag in the coming cycle.

The fund had only 1.2 per cent exposure to North America, compared with 25.8 per cent exposure in Asia and 17.3 per cent in Latin America, according to a filing for the first quarter. Top holdings by nationality are South Korea, Indonesia, Poland, Mexico and Brazil. Templeton's Global Bond Fund doesn't hold any Canadian government debt, preferring Australian because of the symbiotic ties to China versus the U.S. The fund eschews U.S. Treasury debt. Australia and other commodity-exporting nations also offer some protection against inflation because their currencies will rise with commodities, Mr. Reed says.

The Templeton Global Bond Fund for Canadian investors had assets of $825-million at the end of June. Worldwide, Templeton's global bond portfolio had assets of about $69-billion (U.S.).

***

The breakdown

The Templeton Global Bond Fund for Canadian investors has $825-million as of June 30. The overall Global Bond strategy worldwide for Franklin Templeton (that includes the Canadian version of Templeton Global Bond) is $69-billion (U.S.).

Top 10 countries in the Canadian version of Templeton Global Bond Fund (with percentage of portfolio in brackets):

South Korea (9.11)

Indonesia (8.70)

Poland (6.17)

Mexico (6.02)

Brazil (5.73)

Australia (4.94)

Russia (4.07)

Venezuela (3.14)

Argentina (2.53)

Malaysia (2.21)

Source: Franklin Templeton

© 2007 The Globe and Mail. All rights reserved.

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