How Australian is your Australian fixed income benchmark? The answer may surprise you!

Often investors debate the merits of including global exposures within Australian fixed-income portfolios. Those that oppose these allocations often do so on the basis that the benchmark is ‘Australian’. But how ‘Australian’ is an Australian benchmark?

What does ‘Australian’ really mean?

Determining how ‘Australian’ an Australian Benchmark (Benchmark) revolves around defining what the term ‘Australian’ means. Attempting to define what constitutes ‘Australian’ in reference to the Benchmark can often make matters more complex not less. Let’s consider the two relevant construction rules which need to be followed for the inclusion of securities within a typical Australian Benchmark*. For inclusion within the Benchmark an issue must be:

• issued in AUD and
• legally domiciled in Australia.

The key point to note is that the issue, not the issuer, must be legally domiciled in Australia for inclusion in the Benchmark. For example, AUD bonds issued by the Neder Watershapsbank or the Svenska Handelsbanken AB (Dutch specialist financial institution and a Swedish bank respectively) qualify for inclusion in the Benchmark however, Commonwealth Bank of Australia USD bonds do not. But which is the ‘Australian’ issuer? This highlights that care needs to be exercised when referring to the Benchmark as only including ‘Australian’ exposures.

What can be said with certainty is that the Benchmark represents a subset of AUD bonds issued under the Australian legal/regulatory system. 

But should Australian mean that the issues themselves are legally considered ‘Australian’ or that the economic exposures associated with them are ‘Australian’? Rephrasing the question this way shifts the debate to whether the legal domicile of the issue or the issuer is the more important risk factor when determining the underlying economic exposure. 

Given this distinction, it is reasonable to assume that when considering the economic exposures represented by the Benchmark, the domicile of the issuer is the more relevant measure of regional risk rather than the currency or the domicile of the issue itself.

Your Australian benchmark isn’t necessarily Australian after all?

What may surprise investors is that when one considers the domicile of issuers as the relevant risk factor then an Australian benchmark may not be as Australian as initially thought. Classifying bonds by the legal domicile of the issuer highlights that currently around 13% of the Benchmark comprises non-Australian (‘Global’) issuers from a broad range of countries of which some are classified as Emerging Markets. 

It is worth noting that the proportion of ‘global’ issuers will depend on the nature of new issuance and at times has comprised more than 20% of the benchmark. Importantly investors utilising the Benchmark are implicitly accepting that their portfolio will incorporate a material economic exposure to ‘global’ issuers.

Holding global exposures directly can improve outcomes

With the Benchmark being recognised as holding ‘global’ economic exposures, the next question investors need to ask themselves is whether it is more efficient to access such global economic exposures via 

• (a) the securities within the Benchmark or 
• (b) global markets directly and hedge back the exposure into AUD. 

When weighing up these two alternatives investors need to consider the pros and cons of incorporating global exposures directly which include:

Pros:

• Access to greater issuer diversification given the relative concentration of issuers in the domestic Benchmark.
• Globally, markets can behave differently based on variations in a range of factors. These pricing variations provide greater opportunities for investors to exploit such differences to increase returns though active security selection.
• Access to superior returns as global exposures within a local benchmark may not be optimal priced.

Cons:

• Inclusion of ex-benchmark exposures can add to the tracking error of a portfolio.
• Hedging the currency exposures back to AUD has the potential to increase the volatility in distributions.

Pricing of global exposures within a local benchmark may not be optimal

While many of the Pros and Cons listed above are self-explanatory it is worth going into a bit more detail on the idea that pricing of global exposures within a local benchmark may not be optimal. Though investors may accept that local-global exposures may be less optimal due to increased concentration, it may be less evident that such exposures may be sub optimal due to pricing. 

To better understand what may drive such pricing distortions, it is important to keep in mind that there are several reasons why an offshore entity may want to issue bonds into a smaller market such as Australia. One of the more common rationales is the ability to access lower funding costs. Driving such a distortion is that in smaller markets, where new supply and issuer diversification may be more limited, local investors may be prepared to bid more aggressively for new issuance especially if it is being included in the local benchmark. 

Such a demand dynamic may often mean that for a small market such as Australia, there is a greater potential that offshore corporates are only accessing the market because the relative pricing, compared to the larger more liquid global markets, is more attractive. 

Unfortunately, it follows that what is a gain to a corporate issuer in terms of lower funding costs is also a loss to local investors in terms of lower returns. While the local investor may be prepared to accept the lower return to access an additional diversifying name, the fact remains that they would have been able to earn a higher return by accessing the issuer's bonds directly via the offshore market. This raises the obvious issue of whether, from a relative pricing perspective, such global exposures are best accessed via the local benchmark sub-set or directly via the global market.

Not too hot, not too cold, finding what is just right

Though there are pros and cons associated with including global ex-benchmark exposures, the key constraint is ultimately the return profile of the Benchmark. Separate from the debate over portfolio composition is the general overarching constraint that the Benchmark represents the overall return/risk profile desired by the investor. With this being the case, the introduction of ex-benchmark exposures increases the extent returns will deviate from the benchmark (referred to as tracking error). Adding global ex-benchmark exposures can assist in generating higher returns but caution still needs to be exercised to ensure that the returns of the portfolio are not excessively distorted from the Benchmark; i.e. returns still exhibit similar behaviour to the benchmark. Given these impacts, investors need to find the right balance between factors when determining which mix is most appropriate for their needs.

Investors often dismiss the inclusion of ex-benchmark global exposures within their Australian bond portfolios on the grounds that global exposures are not consistent with the Benchmark. However, they may be surprised to learn that their Australian benchmark may be incorporating material amounts of global exposures. 

Though this provides the justification to access such exposures via ex-benchmark holdings, care must be taken in managing the size and type of exposures. 

The key to managing the magnitude of these exposures is to ensure they are introduced selectively to enhance returns while at the same time ensuring that the overall behaviour of returns remains consistent with the Benchmark. Admittedly, achieving this balance is a mix of science and art but when done properly the result can be the best of both worlds in providing a similar but higher return profile to the Benchmark.

* For the purposes of this discussion, the representative ‘Benchmark’ utilised is the Bloomberg Ausbond Composite 0+ Index. Note that inclusion rules will vary from index to index so understanding such rules is important for investors.