The one thing investors should be paying most attention to in the next 12-24 months

Note: This interview was recorded on 22 October 2024.

In the not-so-distant past, interest rates were ridiculously low.

In some parts of the world – Japan, for instance – rates were so low that the economy also saw negative bond yields. It’s been quite extraordinary. But Western Asset Management’s Anthony Kirkham is warning of a nasty hangover from those old low-rate days that could hit us in the next 12-24 months.

“It meant that people were forced to do or make investments that probably weren’t valued properly because you had that super low interest rate.

People were leveraging into different asset classes, almost creating new asset classes in terms of crypto and other components where these were built because of where markets were, because of what investors wanted to get out of their investments,” says Kirkham.

He is concerned that some of these investments are getting challenged, particularly as interest rates normalise and wants investments to consider that in light of their asset allocation going forward.

In this episode of The Pitch, Kirkham discusses the nuts and bolts of bond investing, and how he is using duration at the moment based on market conditions. He also discusses why investors need to monitor those challenged assets that they may have used for returns in the days of ultra-low interest rates.

Edited transcript

The portfolio focuses on adding value to investors through three components: duration, yield curve positioning, and sector and stock selection. Can you take us through each of those elements in relation to the portfolio?

We like to use all those levers wherever possible and the market is in a position where we can. For many years, we had interest rates at crazy low levels, and because it has been manipulated there, it was much more difficult to actually use some of those tools. But now that yield codes have normalised, interest rates are a big part of how we add value.

Duration is a key one obviously, because that can make a big difference to the added value within the portfolio moving that around. At the moment, we broadly have an overweight position on [duration], particularly in the idea that we expected yields to start to decline as inflation came down, and that's worked well for us.

We still see an opportunity with our duration positioning because there is some volatility in the world. 

We are trying to capture that movement by moving our duration around and being opportunistic, capturing those moves within markets with that, and similarly with the yield curve in terms of how is it shaped, what are the expectations with regards to that.

The yield curve certainly has been a tool that we've been using to provide a bit of a diversified strategy to the portfolio because of back-end yields, so the 20-year and 30-year bond in Australia is still relatively steep versus a 10-year bond, for example. Often, we've used that as a form of ballast within the fund. What I mean there is that we've got an overweight to credit, it's adding good value, we see that the fundamentals are strong so that we're capturing that yield there, but we do have an overweight, and so therefore, we want to have a strategy that's going to offset that if a soft landing doesn't come about and we see more of a hard landing.

Having a bit more exposure to that 20-year and 10-year part of the yield curve means that if things did go a little pear-shaped, then we'd actually see that yield curve moving downwards, and offsetting some of the other positions that we have in the fund. That's where the yield curve and certainly duration can play a part, sector-wise. Once again, it is pretty obvious that if you are worried about the economy, then you're probably going to be more leaning into government bonds, semi-government bonds (SSAS) because they're typically AAA rated, so they're very high-quality assets, and therefore we're definitely holding reasonable weights within those sectors. 

Semi is a little bit underweight because we're just worried that the amount of bonds that they're issuing push that spread wider because of greater supply. But otherwise, we are finding a nice balance between those high-grade sectors. But it's a very important part of the portfolio to have that diversity within it.

What's the average duration of the portfolio at the moment? How does that compare to about a year ago?

It's all driven by issuance, and we've seen quite a bit of issuance by both federal and state governments, less so on the federal side, in the last 12 months because we've been running surpluses, which is fantastic. But on the semi-government side, they have been issuing a lot more than federal, which is an unusual situation, and they've been definitely on the longer side as well. That has pushed the duration of the index that we're managing to become a little bit longer. But we're certainly happy to hold, as I said, a little bit of duration just to offset a bit of a surprise in terms of the economy. 

At the moment everything looks reasonably good globally, people are thinking the US is in a soft landing or possibly even a no landing. Therefore we are just sort of having a position there that could play an offset too if something that surprised us on the geopolitical side, just general elections that are going on and really those factors that could certainly shock the portfolio. It's important to have that ballast.

There's a lot of active management involved in this. What's the objective for investors from all that active management?

This fund is meant to be a defensive part of your portfolio, so it's really important to make sure that it's capturing that side so that it can play offset to riskier assets. And definitely, where yields are now, bonds can actually play that part, which is really important. 

It couldn't do it before when yields were super low, but now it can because we've basically got fair value for bond yields based on growth and really inflation. So that is important.

Then having a portfolio that provides that balance between having income for investors, but also making sure that the overarching position within the fund is going to provide what you want during times of risk-off is that defensive component. We think we can add just through that rotation of sectors, stock selection, duration and the yield curve, we can add around 75 basis points of alpha over the benchmark. And the pleasing thing is that, over the long term, we've been able to do that. 

In fact, out of 22 out of 26 years, we've been able to outperform the benchmark. So, it says something about our investment philosophy and providing the balance between the sectors that we can invest in and providing an outright added value for clients,

We might draw back into that performance. I think it's worth highlighting. So what are you targeting specifically as a return, and what has the fund been able to deliver investors over the journey?

It's a difficult one with bonds clearly because we've had a pretty big rollercoaster over time, not driven by us necessarily, really driven by central bank action pushing yields to crazy levels. What we experienced in 2022 was the worst year for bonds on record, much worse than 1994, which I experienced in the early part of my career. 

That obviously has impacted outright returns, but interestingly, with yields sitting around 4.85% in the fund over the last 12 months, we've been able to produce something much higher than that, around 8%+, partly because you've had credit spreads tightening, you've had our positioning in terms of duration working for us, and so therefore, we want to achieve something like 75 (basis points). It's been a lot more than that over the last 12 months, but those are factors that certainly came together within the portfolio and within markets that allowed us to be able to do that.

What should investors be paying the most attention to over the next 12 to 24 months?

I think the most interesting thing about what's happened over the last few years is that by having interest rates being moved down to close to zero - in fact, yields got to negative positions, which I still can't get my head around in many countries. 

It meant that people were forced to do or make investments that weren't necessarily valued properly because they had that super low interest rate. People were leveraging different asset classes, almost creating new asset classes in terms of crypto and other components. These were built because of where markets were and because of what investors wanted to get out of their investments. And therefore, it became somewhat challenging.

Now we're in a position where interest rates have normalised, as I said before, definitely closer to fair value. Some of these sectors are certainly getting challenged, and I would say that what we saw in the US around the regional bank crisis that we had back in early 2023 was somewhat of a result of some of those moves. 

There are a number of asset classes that are still just hanging on because they've been shocked by interest rates normalising. 

And I think you need to be mindful of those impacts as we move forward. And so that's something that people need to consider in terms of their asset allocation, moving into more of a normalised environment.

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 Franklin Templeton website for more information.

Managed Fund

Western Asset Australian Bond Fund

Australian Fixed Income

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