Searching for Income From the Bottom Up

Jeff Holt: Hi, I'm Jeff Holt, analyst with Morningstar Manager Research. Today I'm joined by Ed Perks, portfolio manager of [Bronze-rated] Franklin Income. Today we're going to dive into some of the distinguishing features of that fund.

Ed, as its name implies, Franklin Income has an income objective, but it doesn't just focus on fixed-income securities. It also invests in stocks. Can you highlight the benefits and risks of having a diversified multi-asset income portfolio to meet your income needs?

Ed Perks: As we approach investing for income, we do have a secondary objective in the Franklin Income Fund of also maintaining prospects for capital appreciation. So our orientation is really to look across a very broad range of asset classes and security types to identify the unique opportunities that will help us meet that objective.

We do think there are a lot of benefits. First, it's an interesting question around what might the risks be of a diversified income approach. Clearly something that we're facing today in financial markets is the prospect and potential for interest rates to rise over time. So I think one of the potential pitfalls or risks of a diversified income approach could be that that factor--the potential for rising interest rates to be damaging to the portfolio's performance--is something that actually can affect multiple asset classes and not just fixed-income securities.

The example would be, if you're an income investor and you've strayed away from fixed income into very yield-oriented equities that are sensitive to potentially a rise in rates, that actually can be highly correlated to other parts of the portfolio.

Our approach is really, and will certainly benefit from, having a very flexible mandate as we pursue our objective. Our orientation, and we think the real benefit, is being able to tap the resources that we have through our equity research, through our credit research, and insights into all the fixed-income markets to have a diversified portfolio that can respond and deliver on our objective for our investors in a range of financial market conditions.

Holt: You mentioned you have a lot of flexibility to move between the asset classes. What drives when you have a higher position in equity? I know your traditional equity position has ranged between 50% and 20% of the portfolio over the last 10 years. What drives the allocation differences?

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Perks: I think it's somewhat common and typical for these strategies, and investors at some level, to think these strategies are very top-down allocation driven. Our process really starts from the bottom up. We're continually looking across all of the markets, engaging our research team to look for unique opportunities, and we really want the characteristics of the security: How attractive is the income on a relative basis to other income opportunities? How do we feel about the long-term value and the prospects that this investment can appreciate over time for our investors? We really let that process drive where we go in terms of shifts in asset allocation.

It's a pretty dynamic process. It really reacts to what kinds of opportunities we're seeing in the market, and it quite frankly makes my day generally pretty interesting.

Holt: Over the past few years, high-yield bonds have made up a majority of your overall fixed-income portfolio. Where are you finding opportunities within high-yield bonds, in particular?

Perks: You're right. If I step back and think about what's happened to our overall fixed-income allocation over the last five years, it has declined substantially. A lot of that was driven by quantitative easing and the Fed's efforts to really bring down the long end of the curve, in particular. As yields plummeted to all-time low levels in many segments of the fixed-income asset class, we continually reduced our weighting, and we were more attracted to opportunities on the equity side and convertible securities.

And on the fixed-income side, yes, you are correct. We continued to move away from what we felt like were securities that would be driven over time more by the interest rate dynamics in the market. As a result, we have a core portfolio on the fixed-income side today of credit risk. So, identifying opportunities--particularly within the high-yield market, within floating-rate term loans--where we feel confident that the company's prospects are improving going forward and thus their credit quality improvement can be a major driver of the security's performance as opposed to just solely the movement in rates.

Holt: You mentioned convertibles. You hold convertibles and equity-linked structures in the portfolio in addition to stocks and bonds. What role do those more unique areas have in meeting the income objective of the fund?

Perks: I really am quite interested in convertible securities. It's an asset class that I think has, at some level, the best of both worlds. It has the potential to give you a nice income component, oftentimes in excess of what the underlying stock might offer investors, if at all. So it broadens our opportunity set. It lets us invest in companies that may not have dividend yields, and I really like that profile.

There is a very broad range of convertible-type structures out there, so it's difficult at some level to talk about it in general terms, but we really look at it as: A security, or an investment opportunity, that can deliver on income generally has lower volatility or lower beta than the underlying stock and also can at some level be asymmetric in terms of its risk/reward profile for the investor. So, we really think it fits.

It is a smaller market; it is more of a niche. When you look at Franklin Income Fund's asset allocation, the more traditional segments of fixed income tend to be our larger bucket. Dividend-paying common stocks on the equity side, and then convertibles play a nice supporting role in the portfolio.

Holt: You mentioned getting the portfolio into the niche markets. The fund has grown over the years, and assets in the fund are over $90 billion. How does that affect how you're able to deploy the assets and execute your strategy?

Perks: We have experienced substantial growth over the last decade, but we think the asset size of the portfolio continues to be a real strength and asset for us in terms of opening up opportunities. I think what really enables the strategy to work is the flexible mandate and the ability for the fund not only to invest across such a wide range of asset classes and segments of the financial markets, but also historically our approach of being a little contrarian at times, focusing on markets that are out of favor in something like high-yield bonds, an area of concern for many people in terms of liquidity in that market.

Given that we approach that market oftentimes in a contrarian way, we've seen instances just in the last several years where there have been large outflows from that market, from investors in that market--traditional or maybe high-yield only investors whether it's high yield ETFs or traditional asset managers. And at times we've seen that create some volatility in credit spreads. That's been a great opportunity for us to think about relative value to other parts of the portfolio that we may have and maybe reallocate. So, a lot of our decision-making around engaging in an asset class like that happens in a contrarian fashion looking for opportunities when maybe other investors are selling.

Now the flip side of that as well--we have seen periods when there have been substantial inflows into a given asset class that bids up prices and may encourage us to actually sell into that movement up in prices and reallocate.

Our process is really driven by that analysis and working with our research team, the value of the underlying securities, the prospects for those securities, and then having that move and impact the portfolio.

Holt: In terms of gauging success of the fund, you have a lot of flexibility, are diversified across asset classes, which complicates the ability to benchmark the fund. How should investors gauge the success of Franklin Income?

Perks: I think it's part of our history. The fund's inception was in 1948. This fund has been all about generating attractive income for investors since Day 1--well before funds were compared to a benchmark. So when we show our investors the performance of our portfolio, what we really focus on is an attractive level of income, but consistent and stable monthly income, and that's a big part of investors' interest, particularly those that are seeking retirement income. I think that's a lot of their interest in Franklin Income Fund.

We certainly then show them the performance relative to the broader asset classes, the S&P 500 or the Barclays Agg Index in fixed income. But we really think that a longer-term view, consistent attractive stable income and maintaining prospects for capital appreciation is really what we're trying to deliver to our investors, and that's how we should be gauged.

Holt: Ed, thanks for joining us today.

Perks: It's good to be with you.

Holt: I'm Jeff Holt with Morningstar. Thanks for watching.