Franklin Managed Income Fund Q2 2024 Commentary

Performance evaluation

During the second quarter of 2024, all three major U.S. indices reached new all-time highs. While the Dow Jones Industrial Average (DJIA) ended the period with losses, the fervor for artificial intelligence propelled the S&P 500 Index (SP500, SPX) and the NASDAQ Composite Index (COMP:IND) to solid quarterly gains. Optimism that the U.S. Federal Reserve (“Fed”) could begin cutting interest rates in September also boosted stocks. Of the 11 S&P 500 sectors, information technology (“IT”) and communication services performed well, while materials and industrials were among the six sectors that experienced negative results. Large-cap stocks in aggregate rose and outperformed mid- and small-cap stocks, which generally fell. The Fed kept the federal funds target rate unchanged at a 23-year high during its May and June meetings and reduced its projected number of rate cuts through 2024 from three to one. The Fed’s preferred gauge of inflation, the core personal consumption expenditures price index, rose in May at the slowest pace since March 2021 but remained above the Fed’s target. In addition, the U.S. labor market remained strong during the quarter; while the unemployment rate rose in April and May, jobs and average hourly earnings grew at a faster pace in May after softening in April. Meanwhile, U.S. gross domestic product expanded in the first quarter of 2024 at a significantly slower annual pace than in the previous quarter as consumer spending, exports, and state and local government spending grew at slower rates and federal government spending declined; in contrast, residential fixed investment accelerated.

Quarterly Key Performance Factors

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The US 10-year Treasury bond (US10Y) yield increased 20 basis points during the quarter, reaching 4.40% at the end of the period. The fund's fixed-income allocation decreased to less than 58% of the portfolio at the end of the quarter and contributed to absolute returns. Financials, industrials, and consumer staples sectors led fixed-income absolute returns during the quarter. In terms of individual issuers, JBS (OTCQX:JBSAY) was the largest contributor within the consumer staples sector, while Community Health Systems (CYH) and Vistra (VST) added value within the healthcare and utilities sectors, respectively. US Treasuries were the only material detractor within the fund's fixed-income allocation. The fund's equity allocation increased to more than 41% of the portfolio at the end of the period. Equities contributed to absolute returns during the quarter, led by the IT, utilities, and financials sectors. Texas Instruments (TXN) and Analog Devices (ADI) helped returns within IT, while NextEra Energy (NEE) added value within utilities. In contrast, the healthcare, consumer discretionary and materials sectors dragged down equity returns over the period. Bristol-Myers Squibb (BMY), Home Depot (HD) and Albemarle (ALB) detracted value within these sectors, respectively.

Perspectives and strategy

Economy: The outlook for economic growth has been a major area of ​​focus for the fund as central banks around the world have raised interest rates over the past two years to combat elevated inflation. Central bankers around the world have shifted their stance, moving away from a solely targeted fight against inflation in favor of a more balanced approach to monetary policy. The U.S. economy remains resilient despite some cooling in early 2024, largely driven by a strong labor market and robust consumption in goods and services, despite the federal funds target rate being raised by 525 basis points over the past two years. We continue to monitor financial conditions as a leading indicator of future economic performance and Fed policy. The lagged effect of Fed policy has resulted in a broad tightening of financial conditions; nominal yields and mortgage rates have risen, while loan growth in several categories has slowed as banks reported higher lending standards.

Equity: We remain selective in investing in equities, given current valuations, as markets digest the lagged effect of monetary policy tightening, the shape of the yield curve, cost of capital implications as rates remain higher for longer, and geopolitical risks. We have found select opportunities in the consumer discretionary, industrials, and materials sectors. Market breadth has been limited over the past year, but opportunities are starting to present themselves below index levels, which we believe favors active management. As income-focused investors, our asset allocation mix is ​​primarily driven by bottom-up stock selection, with a focus on company fundamentals rather than the direction of the broader equity market. While the story of capital returns differs by sector, our holdings are focused on companies that show an ability to support attractive dividend yields and grow them over time.

Treasury bonds/government-backed bonds: Deficit spending, combined with demand dynamics from the Fed's quantitative tightening and increased supply of US Treasury bonds, has resulted in a broad rise in the 10-year US Treasury bond yield so far in 2024. Recent higher inflation readings relative to consensus expectations, coupled with a resilient labor market, have led the market to now expect a later start to Fed easing, as well as fewer rate cuts in 2024. We continue to believe that the Fed will remain vigilant to ensure inflation does not return, and we continue to expect the lack of fiscal restraint to weigh on balanced budgets. We believe these factors should provide attractive returns, while exposures can help protect the portfolio against volatility should we see a drawdown in risk assets.

Investment grade corporate bonds: We maintain a balanced view of the investment grade corporate bond sector as the attractiveness of higher quality assets has increased over the past 18 months. While absolute yield levels remain attractive for an income generating strategy, credit spreads have materially contracted over the past year, which has marginally reduced the attractiveness of investment grade corporate bonds, in our view.

High Yield Corporate Bonds: While the high yield market offers attractive yields, we remain balanced and selective due to the potential for higher refinancing costs to impact corporate fundamentals. The possibility of slowing growth requires a vigilant approach to stock selection within our high yield portfolio, so our preference remains for companies that have a greater degree of flexibility to meet upcoming maturities.

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