Looking back, the investment landscape 12 months ago was quite different. Investors were searching for yield across all asset classes, turning to equities. Entering 2023, the tide has turned and bonds are back in play, says Franklin Income Investors (FII).

“A year ago, yields on high-quality credit did not seem attractive to us, prospects for total returns were poor, and bonds were not acting as a diversifier,” writes Ed Perks, CIO of Franklin Income Investors. “Today, we believe the same assets offer better total return potential than equities, while the positive correlation with stocks is also breaking down, allowing fixed income to offset equity market volatility.”

Perks is making the case for investment-grade (IG) credit. “In a positive economic scenario, we believe these assets have the potential to make double-digit returns as rates move lower and spreads narrow, while they should also outperform other risk assets should fundamentals deteriorate.”

FII suggests that investors increase exposure to IG corporate bonds if yields move back toward 6%, lowering exposure to either equities, high-yield (HY) bonds or US Treasuries.

However, Perks points out that the outlook on US Treasuries has also improved as interest rates have risen, “given they currently offer attractive yields and downside protection should a recession increase equity market volatility”.

Furthermore, FII sees HY bonds resillient with most HY issues not needing to be refinanced in the next few years. “As a result, while the investment community focuses on whether spreads are wide enough to justify a move into credit, we see opportunities at current yields, which have shot up to levels not seen for 15 years,” declares Perks.

That said, FII still believes that a broad equity exposure remains important – should an improvement in economic sentiment trigger an equity market rally. For this to happen, FII believes it would take “a favorable trajectory around inflation and economic growth, while earnings would also need to remain relatively robust”. Also, the Fed would have to pause rate hikes and get back to a neutral setting.

Downsides for equities , however, linger. Equity-linked notes (ELNs), according to FII, could provide a way to manage this uncertainty, while expanding the universe of stocks available for investment.

Read the full insight here.