Bonds are back, baby!

While economic growth is likely to slow, any recession will probably be mild and Australia could avoid a recession altogether, according to Anthony Kirkham, head of investment management and Australian operations for the Western Asset Australian Bond Fund. 

This view is based on the likely buttressing effect that demand for our key exports is likely to have on economic growth rates. 

"The recent Chinese economic reopening and the slow but positive improvement in trade relations are both likely to be supportive of the Australian economy," says Kirham

It's a view worth paying attention to, given Western Asset's investment experience and longevity. Founded in 1971, Western Asset has consistently followed an investment philosophy that is based on two key tenets: 

• Long-term fundamental value, and
• Multiple diversified strategies

In the following interview, Kirkham and I unpack the fund's investment process and overarching philosophy. We also discuss the outlook for Australia and global markets, the recent bond market volatility, and a few key areas where the team sees opportunities in what has been a rapidly changing bond market. 

A wealth of experience and a strategy that has withstood the test of time

Collectively, the Western Asset Australian Bond Fund investment management team averages 26 years of investment experience and has been incredibly stable, working together for an average of 18 years. 

The team boasts a consistent record of outperformance drawing upon Western Asset’s broad global resource base with great success.

The fund’s investment philosophy is the same as that which has stood since 1971 for all of Western’s strategies. 

Kirkham and his team believe that markets often misprice securities and that they can capitalise by identifying that mispricing and emphasising its highest convictions. 

"In doing so, we seek diversified sources of returns seeking to add value across duration, yield curve, sector allocation and security selection, with no one alpha driver dominating portfolio return," he says.

Strategy deep dive

The Western Asset strategy has been constructed so that it maximises the resources of the firm - both local and international. Tapping into the expertise of colleagues that are based in other investment jurisdictions is critical to fully comprehending the unique risks and regulatory framework of each investment opportunity.

As Kirham explains, the team assesses both top-down and bottom-up perspectives, while also applying its top-down macro views. These views are debated on a weekly basis by a panel of Western’s most senior and experienced regional and sector specialists. 

"Synthesising these views and adapting them to the domestic market, these views serve as a valuable input into the intended risk allocation for each of the strategy’s alpha sources," he says. These sources of above-benchmark return are:

• duration, 
• yield curve and 
• security/sector selection.

Home sweet home

"Our base case is for economic growth to slow and for a recession to be mild or avoided altogether in 2023," Kirkham says.

Australia, in particular, is likely to be buoyed by resilient demand for our key exports buttressing economic growth rates, he explains.

"The recent Chinese economic reopening and the slow but positive improvement in trade relations are both likely to be supportive of the Australian economy," Kirkham says.

What about the recent banking crisis?

Kirkham concedes that recent financial stability concerns caused by the banking sector have increased the probability of negative growth outcomes this year. 

"As the lagged impact of aggressive monetary policy tightening programs that have been enacted by central banks over the past 12 months continue to work their way through economies, financial stability issues magnify the downside growth risks," he says. 

"Tighter credit conditions, stricter regulatory oversight and cautious consumers are likely to serve as further constraints on growth."

But he emphasises that the relatively uniform application of Australia’s regulatory framework on the entire banking sector provides some comfort for investors. 

This contrasts with the US, for example, where regulation has allowed looser capital constraints and liquidity requirements to apply to smaller regional banks. Australia's regulation of regional banks has been just as strict as that applied to the majors. 

"Australian banks are very well capitalised and better shielded from a crisis of confidence such as the one which has permeated the US and European banking sectors," says Kirkham.

Navigating volatility

Targeting multiple diversified sources of return has helped the Western Asset Australian Bond Fund navigate recent market volatility well.

"Increased volatility has caused market prices to move away from what we regard as fundamental value quite quickly at times, and we have used our active management tools to emphasise our convictions," Kirkham says.

"We see a renewed opportunity to actively allocate to duration and across the yield curve as fundamentals have played a greater role in market pricing."

Previously, unconventional programs such as quantitative easing and yield curve control changed market dynamics – which prompted the Western Asset team to allocate more risk to sector and security selection. 

"While we still see opportunities there, we envisage a more balanced alpha contribution in the coming period," Kirham says.

The bigger picture

A severe and protracted global economic slowdown, driven by widespread financial stability issues, is the major risk in focus at present. While not Western Asset's base case, it maintains portfolio characteristics that can help offset the potential negative associated effects.

The fund maintains a moderate duration overweight, with its government and semi-government bond exposure predominantly long-dated. This serves as hard duration, whih provides "portfolio ballast" in the event that market conditions deteriorate further.

It also maintains a corporate credit overweight. But as Kirkham explains, the investment team seeks to limit spread risk by maintaining high-quality exposure that is primarily short-dated in nature. The portfolio is also constructed so that:

• more than 50% of corporate exposure is scheduled to mature within three years, and
• 75-80% is scheduled to mature within five years.

"If a major recession were to eventuate, we’d expect investors to demand greater compensation for default risk which would result in credit spreads widening," Kirkham says.

"In that environment, we’d continue to maintain high-quality exposure and potentially increase longer-dated government bond exposure through the reinvestment of shorter-dated corporate bond maturities as they occur."

How is the fund currently positioned?

The fund currently has a moderate duration overweight of 0.15 years versus the benchmark. This has been reduced from an overweight of approximately 0.45 years at the beginning of 2023 as yields have moved lower and in line with our expectations.

Kirhkham also highlights the fund's emphasis on high-quality credit assets. Versus the benchmark’s average rating of AA+, the fund has an average credit rating of AA-, a rating that Kirkham notes would be highly sought by many sovereigns globally. 

"While a duration overweight has been maintained, duration positioning is now driven more by a motivation for defensive attributes in case of a major economic slowdown rather than prior positioning being mainly driven on valuation grounds," Kirkham says.

"We maintain high confidence that all securities will 'run home' without issue and we continue to identify securities with attractive fundamentals."

Bonds are back!

The market has experienced a material reset through 2022, as yields and the risk premium demanded by investors above the risk-free rate have moved higher. 

"While painful for investors, the market reset presents fixed income investors with a much more compelling investment opportunity with correlation benefits and higher income returning to the fore," Kirkham says.

He and the team expect market conditions to remain volatile in the short to medium term. While this may be unnerving for some investors, it's also likely to present numerous opportunities to capture value. And in the eyes of Kirkham, this environment will favour an approach that is actively managed and has appropriate duration – which helps to provide the correlation benefits that fixed-rated bonds offer.

He emphasises his view that investors no longer need to extend risk profiles to generate attractive risk-adjusted returns. Kirkham also highlights the attractive return prospects, liquidity, and diversification benefits of traditional fixed-income assets, given the dissipation of illiquidity premiums.

"Increased volatility is likely to continue to present greater opportunities for active management," he says.

For investors who have always held bonds, greater economic uncertainty demands the maintenance of a well-diversified portfolio structure. With higher running yields again providing scope to offset further volatility in capital prices, the investment journey in the asset class is likely to be easier, smoother and more rewarding in the period ahead.

Learn more

Anthony's fund is designed to be an active core fixed income allocation with a mandate to provide both defensive exposure and disciplined alpha generation. Learn more via the fund profile below, or visit the Western Asset website for more information. 

Managed Fund

Western Asset Australian Bond Fund

Australian Fixed Income

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