Legg Mason Western Asset Australian Bond Fund Q4, 2020 Performance Update

Anthony Kirkham, Portfolio Manager gives an update and discusses the outlook for the Fund.

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Peter Cook, Senior Investment Writer, Franklin Templeton: Hello and thank you for joining us. I'm Peter Cook, Senior Investment Writer at Franklin Templeton. Today, we'll be speaking with Anthony Kirkham, Portfolio Manager for the Legg Mason Western Asset Australian Bond Fund, for a review of the Fund's recent performance and outlook.

Please note that all performance figures discuss our net of fees and as of 31st March 2021 unless otherwise noted.

Peter Cook: Anthony, thank you for joining us. How did the Fund perform over the last quarter?

Anthony Kirkham, Portfolio Manager, Legg Mason Western Asset Australian Bond Fund: The Australian bond market saw yields move sharply higher over the March quarter, with yields rising from the start of January moving dramatically higher in February before consolidating in March. It was quite a mixed quarter in that way. But the move in February was the largest move we've seen in a single month and the Australian 10-year bonds since 1994. So, it was quite momentous.

Thanks to the yield curve control and quantitative buying by the Reserve Bank of Australia, most of the action in bond markets was seen in the mid to back end of the yield curve, but this was enough to drive large negative returns for the quarter. This move was part of a global sell off in bonds driven by the reflation trade, with the vaccination programme in full swing, particularly in the UK and the US, really through necessity due to the poor management of the virus, global markets have been very quick to price in high growth and inflation expectations as the global economies opened up.

Despite the wild swings in the markets and the volatile outcomes across the sectors, the outcome for the portfolio was very much in line with the benchmark. And that's despite our very active positioning relative to the said benchmark. Duration positioning was a marginal add, as we move to slightly overweight position after the large selloff in February, which worked but curve positioning was a mild detractor to the steep move in that yield curve. Sector and stock selection positioning was a positive, thanks mainly to our opportunistic overweight in the mortgage backed sector through late last year that saw that reprice on the positive recovery trade over the quarter.

Peter Cook What is your outlook for the economy and markets for the rest of 2021? Do you see this continuing?

Anthony Kirkham: Despite that sharp move higher in the yield curve, which as we know is a traditional signal that the market believes that we're in a period of recovery, the RBA and the Federal Reserve, in fact, most of the central banks continue to scream "patience". The incredibly strong recovery in employment outcomes, locally, have continued to beat the RBA's most recent updated forecasts but still not enough to change the rhetoric coming out of the RBA, even the fact that the Q4 GDP in Australia beat all forecasts and meant that Australia only declined 1.1% In 2020 beating nearly all developed countries and putting us in a much stronger position than we thought. That's also not been enough for them to change their stance around their forward guidance for interest rates.

The RBA are adamant that they are not moving any time soon and the cash rate will be held at just 10 basis points for the next three years at least. And they stand by the position of not moving the cash rate until they actually see both inflation comfortably back in their target band of 2-3% and unemployment at a low that is driving wages higher. It's not going to be at that point to do so until somewhere below 5% and possibly as low as 4.8%, so it's a place where we haven't seen unemployment since 2009.

At Western Asset, we believe the super easy monetary policy stance, the QE programme, the support for the banks, and tax incentives for investment, and the fiscal programme that saw us through the pandemic was super supportive and this will drive growth in 2021, and into 2022.

However, the headwinds that existed here and more strongly offshore, just got bigger through the pandemic, the largest of those really being government debt levels, which ultimately have to be brought down. That is going to happen through taxation. And as a result, this will act as a brake on growth at some point before we see solid growth as the economies open up and as monetary and fiscal policy support generates that growth and therefore jobs lowering that unemployment rate and ultimately leading to a growth in wages. But this doesn't lead us to a runaway inflation story and therefore sharply higher rates.

When you factor in that the cash rate is going to be held at 10 basis points for at least the next two years and possibly three, and that when they do start tightening monetary policy, you consider the level of indebtedness at a personal level in Australia, and the lack of real wages growth, the tightening cycle is going to be slow and measured to ensure the economy does not lose momentum.

As a result, we think current levels of bonds are reasonably fair. We suspect that due to all the moving parts and the sporadic nature of the recovery globally, the volatility in rates will continue. And thus, we'll be staying very active on the duration and curve front. I think selecting the right part of the curve to capture roll down will be a very real way of adding value whilst the curve is so incredibly steep.

Peter Cook: Some people have said that this rise in yields is the start of a longer-term trend. And in such a trend, long duration bonds no longer offer the defensive characteristics they once did.

Could you give us your thoughts on this kind of view? And also, what role does a core bond fund like the Western Australian Bond Fund play in the broader portfolio, given that view?

Anthony Kirkham: Yeah, it's sort of interesting. I mean, the argument for or against bonds is a constant discussion, which surprises us because the value is most clearly there. It's sad how quickly people forget, although amazingly investors have a habit of doing that.

Importantly, the Australian bond market is one of the highest quality, and unusually, also offers the highest yields in global markets. The steepness in the curve, as I mentioned before, is the largest it has been in multiple decades, and once again, one of the steepest in developed markets. We are not looking at negative yields like so many other bond markets so the starting point is very different. And the bond market here is also actually closest to the fundamentals. That means that should we run into challenges (and we're seeing a little bit of that at the moment with the vaccines) and risk markets fall, then critically, bonds in Australia have that ability to cushion that fall, remembering that the goal of proper portfolio construction is really finding negatively correlated assets. Australian bonds have proven time and time again that they can be that sector.

With the current pricing after the selloff in February, the sector is really primed to provide this ballast, as they did last year during the pandemic, when the starting point in yields was much lower than we currently have (in the 10-year, at least). At the same time, through active management, we can use tools like duration and yield curve positioning to further enhance or protect the portfolio. And, once again, sector and stock selection in what is a very solid investment grade corporate market here, also enables us to provide that extra yield in the fund without taking undue credit risk.

We see that active core bond funds can definitely provide the defensive characteristics that investors are looking for in their overall investment portfolio and argue against some of those naysayers, if you will.

Peter Cook: With that positive outlook in mind, could you talk just a little bit about what segments or sectors of the bond market you're finding particularly attractive at this time?

Anthony Kirkham: We still feel very comfortable with the credit sector. It continues to offer a healthy yield pickup and in fact, a little more so, just the way markets moved over the last month or so. And that is very much commensurate with the risk being taken across the industry sectors. The fundamentals really remain solid thanks to management's conservative balance sheet approach that we saw last year with them reaching to equity to protect ratings. And thanks also to the incredibly generous fiscal support, whether it was through JobKeeper payments or through tax incentives for business, that the backdrop will remain solid. And of course, super easy monetary policy for the next two to three years will also assist businesses in terms of their costs for debt.

At the same time, due to the low base yields, that chase for yield in what is a solid investment grade market should remain strong. From technical backdrop, we should see a healthy yield pickup from credit and some further spread contraction over the year as growth continues to improve in the local and global economies as a vaccine programme takes hold.

Sector wise, we think the banks will continue to do well. Although, thanks to the term funding facility, most domestic banks won't need to come to the bond market. As a result, their bonds remain, relatively expensive. Thus, it's really the other sectors, like the REITs, infrastructure, utilities and the staples that looked relatively attractive. You'll see overweights in most of those sectors in our portfolio that will continue to benefit from the economy opening up and as consumer gains greater confidence.

I think, within semi government bonds, they definitely benefited from the RBA buying programme. We're a bit more judicious in terms of our selection within that sector. But we have found different parts of the curve within semi's have provided greater value, just partly due to the select nature of the QE programme.

And similarly, supranationals do look rather cheap as they haven't been part of that buying programme, and they've stood out relative to major banks at times, so we'll continue to be very active in this high grade, but very liquid sectors, to add value within the portfolio.

Peter Cook: Sounds like there's some interesting opportunities out there today.

Anthony Kirkham: Yeah.

Peter Cook: Thank you for taking the time. I look forward to our next conversation.

Anthony Kirkham: Fantastic. Thanks so much, Peter.