by Edward D. Perks, CFA, Chief Investment Officer, Franklin Income Investors
Impact of interest-rate cuts
In September, the Federal Reserve (Fed) resumed cutting interest rates after a nine-month pause, then cut again in October to bring its target rate below 4%. This move is part of unwinding the restrictive policies implemented in 2022 and 2023 to combat inflation and is guided by the Fed’s dual mandate of maintaining price stability and maximum employment. Recent labor market softness, characterized by a significant slowdown in job creation over the past year, has influenced this decision.
Despite concerns about potential inflationary pressures, particularly from tariffs, US inflation has remained relatively stable. Additionally, evidence suggests that companies are effectively managing these pressures, mitigating the risk of a second wave of inflation. The Fed expects inflation to reach 2.6% in 2026 and 2.1% in 2027, moving toward its long-term target and supporting its shift toward a more neutral monetary policy.1
Markets expect a couple more rate cuts in the next six months, with some observers predicting rates will settle between 3% and 3.25% in the long term.2 However, there has been some divergence among Federal Open Market Committee (FOMC) members regarding future rate cuts. At the October FOMC meeting, there were eight votes calling for just one or fewer cuts remaining until the end of 2026 and nine votes calling for three or more cuts.
While short-term Treasury yields closely follow the fed funds rate, the correlation has tended to weaken for longer-term instruments (i.e., the 10-year Treasury) where other factors have influence. This divergence creates tension in the bond market as we look ahead to the next six months and toward the end of 2026. For now, the 10-year US Treasury yield has stabilized between 4% and 4.25%, a range where the market appears to be more comfortable.
Short rates ease, long yields stay resilient
Source: Bloomberg. Market implied rate as represented by the Bloomberg WIRP. There is no assurance that any estimate, forecast or projection will be realized.
Fixed income diversification
In the United States, credit spreads for both investment-grade and high-yield markets have narrowed significantly, reaching levels close to historical lows. This is a continuation of a trend that started after spreads widened substantially during the COVID-19 pandemic and earlier this year. While tight spreads don't necessarily raise immediate concerns,3 we believe they are an important factor in determining total returns in fixed income investments.
In our analysis, the current yield levels in both investment-grade and high-yield markets look attractive. Over the past few years, average coupons have increased by about 100 basis points from their lows at the end of 2021 to early 2022. As a result, average coupons are now around 4.5% for investment-grade bonds and 6.6% for high-yield bonds, which we consider appealing to investors seeking income.4
Furthermore, we believe the current fixed income market offers a more favorable environment for building a diversified income portfolio compared to the past decade, when yields were very low. With current yields remaining attractive, investors can now achieve broader diversification across the fixed income spectrum.
Attractive yields provide opportunities for diversification
Sources: Bloomberg, S&P Dow Jones Indices, MSCI, Bloomberg Indices. The Bloomberg US Convertible Index is a benchmark that tracks the performance of the US convertible securities market, including convertible bonds and convertible preferred stock. The Bloomberg US Mortgage Backed Securities (MBS) Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). The Bloomberg US Corporate Bond Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers. The Bloomberg US High Yield Very Liquid Index (VLI) is a component of the broad US Corporate High Yield Index that is designed to track a more liquid component of the USD-denominated, high-yield, fixed-rate corporate bond market. Past performance is not an indicator or a guarantee of future performance. Indexes are unmanaged and one cannot invest directly in an index. Important data provider notices and terms available at www.franklintempletondatasources.com.
Broader growth in equity market
In the fourth quarter of 2025, the US stock market has been setting new highs amid improving earnings expectations and a favorable economic backdrop. Earlier this year, concerns about tariffs led to negative earnings revisions and a 20% correction in the S&P 500 Index.5 However, as companies continued to perform well, earnings estimates migrated back up, driving a significant market recovery.
We expect earnings growth to remain a key driver of the market heading into 2026 and beyond. While the dual effect of higher multiples and earnings growth may not continue, we still anticipate a favorable backdrop for equities.
Additionally, while we’ve been seeing broad contribution to expected earnings growth across various sectors, the top six S&P 500 companies now represent about a third of overall market capitalization, highlighting market concentration issues. Thus, we think it is time to emphasize diversification and explore other companies with reasonable valuations that can benefit from economic growth and positive trends.
Selective opportunities persist amid elevated equity valuations
Sources: FactSet, S&P Dow Indices. The S&P 500 Equal Weight Index (EWI) is the equal-weight version of the widely-used S&P 500. The index has the same constituents as the capitalization weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing. Past performance is not an indicator or a guarantee of future performance.
Indexes are unmanaged and one cannot invest directly in an index. Important data provider notices and terms available at www.franklintempletondatasources.com.
Diversified strategy
We maintain a broadly diversified portfolio across fixed income and equity assets. Within fixed income, we emphasize broad opportunities from the lens of an income investor. We favor US Treasury securities, agency mortgage-backed securities, investment-grade bonds, high-yield corporate bonds and leveraged loans. Within equities, in addition to dividend-paying common stocks, we are also currently looking into convertible securities and equity-linked notes for diversification.
We also diversify among a broad range of sectors, including information technology, health care, energy, industrials and consumer staples, given what we consider the high valuations in certain parts of the technology sector and more reasonable valuations in other parts of the market.
Outlook for 2026
As we look ahead to 2026, we are already seeing the broadly diversified nature of the equity market starting to narrow, giving way to a mega-cap, tech-heavy concentration. In response, our strategy will remain focused on diversification and seek to take advantage of periods of volatility. Additionally, with interest rates moving toward their long-term target and a shift toward a more neutral monetary policy, we anticipate a more constructive environment for broad diversification in fixed income investments. This backdrop also underscores the importance of continuing to diversify sources of income with the goal of higher income levels in the coming year.
Endnotes
- There is no assurance that any estimate, forecast or projection will be realized.
- There is no assurance that any estimate, forecast or projection will be realized.
- Tight credit spreads can raise concern because they may signal that investors are underpricing risk and are not being adequately compensated for potential losses. While tight spreads generally indicate a strong economy, they also suggest a lack of caution that can lead to sharp market corrections if conditions change.
- Sources: Bloomberg, Bloomberg Indices. A “coupon” is the annual interest paid on a bond.
- Source: Bloomberg. Past performance is not an indicator or a guarantee of future performance. Indexes are unmanaged and one cannot invest directly in an index. Important data provider notices and terms available at www.franklintempletondatasources.com.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Asset-backed, mortgage-backed or mortgage-related securities are subject to prepayment and extension risks.
Equity securities are subject to price fluctuation and possible loss of principal. Dividends may fluctuate and are not guaranteed, and a company may reduce or eliminate its dividend at any time. Convertible securities are subject to the risks of stocks when the underlying stock price is high relative to the conversion price and debt securities when the underlying stock price is low relative to the conversion price. Investments in equity-linked notes often have risks similar to their underlying securities, which could include management risk, market risk and, as applicable, foreign securities and currency risks.
Investment strategies incorporating the identification of thematic investment opportunities, and their performance, may be negatively impacted if the investment manager does not correctly identify such opportunities or if the theme develops in an unexpected manner. Focusing investments in health care-, technology- and information technology-related industries carries much greater risks of adverse developments and price movements in such industries than investments in a wider variety of industries.
Diversification does not guarantee a profit or protect against a loss.
WF: 7395658
Copyright © Franklin Income Investors
