Why Australian Fixed-Income Is Always on the Agenda

recipients. It should not be forwarded to any other person. Contents herein should be treated as conﬁdential and proprietary information. This material may not be reproduced or used

in any form or medium without express written permission.

September 2018

by Jonathan Baird, Client Service Executive

Investors in Australia retain one of the lowest allocations to the ﬁxed-income asset class in the de-

veloped world. While this is a concerning fact, what is more alarming is that these assets have been

allocated to cash and term deposits.

There is undoubtedly a structural element to this allocation based on investor biases (lack of ﬁxed-

income understanding) and market structure (historically high term deposit rates); however, both

institutional and retail investors have maintained a low allocation relative to international counterparts,

despite watching Australian ﬁxed-income outperform cash over the past decade.

Cash and term deposits play an important role in a client’s overall asset base depending on their

circumstances. But, it’s important to realize that the characteristics of cash and term deposits are very

diﬀerent than those of an Australian ﬁxed-income portfolio and therefore they are not necessarily a

sound replacement in a diversiﬁed portfolio.

The Appeal of Australian Fixed-Income

We have seen a dramatic decrease in the level of domestic interest rates since 2008, with the 10-year

bond yield falling from around 6% to below 2% in August 2016 (Exhibit 1). As we know, a decline in yields

equates to an increase in the capital value of bonds held and when combined with coupons, can result

in attractive total returns. This multi-year rally in bonds has led to numerous market commentators citing

an impending doomsday as the so called “bond bubble” bursts if bonds return to their 10-year average.

An Oversimpliﬁed Scenario

Many who subscribe to an impending doomsday scenario use well understood bond math such as eﬀective

duration to justify their expectations of an extended period of signiﬁcant negative returns for the asset class.

Example:

Change in value (%) = (years of duration) * (interest rate change %)

Portfolio duration = 5 years

Interest rate change = +1%

Portfolio return = -5%

Executive Summary

 Australian investors retain

one of the lowest alloca-

tions to ﬁxed-income, and

many of these investors use

cash and term deposits in

lieu of ﬁxed-income.

 Over a period of rising

yields, ﬁxed-income oﬀers

the beneﬁts of coupon pay-

ments, “roll-down” returns

and a “pull to par.”

 Fixed-income portfolios

offer more advantages

than a single government

bond due to the benefit

of yield curve positioning,

continual reinvestment

of coupon income, credit

spreads (above the risk-free

rate of government bonds)

and active management.

 Australian fixed-income

can play an important role

in diversiﬁed portfolios due

to liquidity, income and

a negative correlation to

equities in risk-oﬀ environ-

ments.

Yield (%)

Source: Bloomberg. As of 31 Jul 18

Exhibit 1: Australian 10-Year Government Bond Yields

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

August 2016 falls below 2%

Why Australian Fixed-Income Is Always on the Agenda

Western Asset September 20182

While eﬀective duration is a reasonable measure of interest rate sensitivity for an instant price shock

to a single government bond, it fails to capture the true total returns of a ﬁxed-income portfolio and

actually gives you the wrong answer.

Time Is Your Friend in Fixed-Income

Simply using duration to measure the total return of a portfolio over a period of rising yields fails to

account for other factors, such as:

 Coupon – The longer it takes yields to rise, the more your coupons oﬀset any mark to market

losses from the increase in yields. For example, a bond portfolio generates income constantly,

so if rates increase over a period of time the income return will partially or completely oﬀset the

negative capital return as coupons are reinvested back in the higher interest rate environment.

 Roll Down – Yield curves generally have a positive slope, as investors see more risk (i.e., inﬂation

and defaults) when lending for longer periods of time than doing so for shorter periods, which

therefore require a higher rate of return. This is exacerbated when investors expect higher interest

rates in the future. This positive slope results in a portfolio of bonds generating capital apprecia-

tion over time, simply by moving closer to maturity and rolling down the curve.

In this example, if an investor buys a 5-year bond with a yield of 2.4% and holds it for one year,

the term risk attributed to the bond is deemed to be lower and therefore the yield required by

an investor falls to 2.3%. This change in yield has a positive price impact, as the bond’s market

price increases from its initial issue price of 100 to 100.38, all else being equal.

If at this point the investor sells the bond, their total return would be the 2.4% coupon received

and the 0.38% capital return.

 Pull to Par – Fixed-income securities can trade below their face values, which commonly occurs

when investors require a return greater than that of the coupon yield on a security. This results

in capital appreciation over time that compensates the investor for the shortfall in coupon yield

to achieve the required total return.

Yield (%)

Source: Bloomberg. As of 31 Jul 18

Exhibit 2: Roll Down Eﬀect

1.50

1.98

2.07

2.08

2.18

2.27

0.0

0.5

1.0

1.5

2.0

2.5

Cash Rate 1Y 2Y 3Y 4Y 5Y

Tenor

Yield Curve

12-Month Roll-Down and Coupon Year 5 Year 4 Return (%)

Market Yield 2.40% 2.30%

Bond Price–Roll Down 100.00 100.38 0.38%

Coupon Return 2.40%

Total 2.78%

Why Australian Fixed-Income Is Always on the Agenda

Western Asset September 20183

Fixed-Income Portfolios Are More Than Just a Single Government Bond

Yield Curve Positioning – While eﬀective duration is a reasonable measure for the price impact on a

single bond for a point-in-time interest rate movement, it is less accurate on the impact of a portfolio

of bonds, as a portfolio is made up of numerous bonds spanning across the yield curve. When interest

rates move, they rarely move in a perfectly linear fashion across diﬀerent bond maturities; the yield

curve may steepen, ﬂatten or change shape based on the fundamental or technical drivers supporting

the change in interest rate expectations.

This results in bonds of diﬀering maturities experiencing very diﬀerent mark-to-market price move-

ments. While some may depreciate signiﬁcantly, others could remain ﬂat or even appreciate in value.

Diﬀerent drivers impact diﬀerent sections of the yield curve bonds with short maturities, which are

often inﬂuenced by expectations of future moves by the Reserve Bank of Australia (RBA), and the

longer-dated bonds are inﬂuenced by global factors such as inﬂation, debt loads or demographics.

Consistently Re-investing – The fundamental structure of a portfolio of bonds requires it to be

regularly re-invested as it receives coupons and as the bonds mature. In this context, despite the

initial price decline stemming from a rise in rates, over the medium- to long-term it is better for a

bond portfolio’s total return to be re-investing at the higher interest rate level.

Credit Spreads – Credit spreads refer to the additional return above the risk free rate (that of a gov-

ernment bond) that is required by investors to hold riskier debt, such as that issued by corporations.

This spread diﬀers from sector to sector and company to company and is heavily inﬂuenced by the

prevailing and expected economic conditions. Credit spreads generally decrease in periods of rising

interest rates as conditions in the economy are viewed to be strong or improving.

Active Management – Skilled active ﬁxed-income managers not only have the ability to lower

portfolio duration in the face of rising rates, but also to adjust the portfolio’s exposure to any of the

factors listed above. Furthermore, there are other tools such as inﬂation-linked securities or deriva-

tives that can be employed to implement conditional strategies that may dampen or negate the

negative mark-to-market returns from rising rates.

Each of these factors can help complement the pure return of interest rates in a ﬁxed-income portfolio.

A Historical Perspective

We have seen a multi-decade decline in bond rates in Australia, from the excessive inﬂationary condi-

tions of the 1980s through to the more recent environment where inﬂation has regularly undershot

the RBA’s target (Exhibit 3).

While rates have fallen over the long-term, Exhibit 3 highlights the bear market periods during this

time, where interest rates levels have increased by 2% or more.

In Exhibit 4, we have tracked the yield change (dark blue) and performance (blue) of the 5-year

Australian Government Bond (ACGB 5-year) during the highlighted bear market periods. This provides

an example of the power of coupons and roll-down, with the running yield over the 1988-1989

bear market being suﬃcient to negate a negative capital return—with the bond generating a ﬂat

total return.

Why Australian Fixed-Income Is Always on the Agenda

Western Asset September 20184

To highlight the impact of the other factors mentioned above such as a credit allocation and the

beneﬁt of active management, we have also included the return on both the Bloomberg AusBond

Composite* 0+ Index (green) and the Western Asset Australian Bond representative account (yel-

low). Note that the Western Asset strategy has managed to generate a positive total return in three

of the four bear market periods for bonds.

Velocity of Change

What the above chart also highlights is that the velocity of a rise in interest rates is just as important

as the destination. For example, a protracted grind higher over an extended period has less of an

impact on the total return of a bond portfolio (over the speciﬁc period) than an instantaneous shift,

as coupons and reinvestment proceeds help to compensate the investor.

Given the investment time horizon for a core Australian bond portfolio should be ﬁve years or lon-

ger—if the period of rising interest rates is meaningfully shorter, the reinvestment of coupons and

maturing bonds in the portfolio will likely result in higher total returns for a long-term investor.

Why Do We Include Australian Fixed-Income in a Diversiﬁed Portfolio?

In a diversiﬁed portfolio there are three primary roles that Australian ﬁxed-income plays: liquidity,

Total Return (%)

Source: Bloomberg, Western Asset. As at 20 April 17

Periods are inclusive using nearest month-end data to Australian Govt 5-yr Bond Index yield peak and trough. ACGB 5-yr return calculaton assumes constant yield

from beginning of period. WARA is the Western Asset Core Australian Bond strategy representative account return gross of management fee net of trust expenses.

Exhibit 4: Composite Returns During Bear Markets

-14

-10

-6

-2

Apr 1988 - Feb 1989 Jan 1993 - Jan 1994 Oct 1998 - Jan 2000 Feb 2009 - Aug 2009

ACGB 5-yr Yield Change ACGB 5-yr Return AusBond Composite WARA

3.25

0.00

4.50

2.35

0.08

2.05

3.60

-4.25

-1.40

4.25

-3.60

1.85

0.90

-10.90

-3.55

-6.95

Yield (%)

Source: Bloomberg. As of 31 Jul 18

Exhibit 3: Historic Bond Bear Markets

1984 1989 1994 1999 2004 2009 2014

Bear Markets Australian Govt 5-Year Australian Govt 10-Year

Why Australian Fixed-Income Is Always on the Agenda

Western Asset September 20185

income and negative correlation to equities in risk-oﬀ environments. It is important to note that

despite the historically low yields in recent times, Australian ﬁxed-income has continued to provide

these characteristics.

In ﬁve out of the six most recent equity market sell-oﬀs, Australian bonds have provided strong posi-

tive returns to help dampen total portfolio volatility.

When comparing Australian ﬁxed-income to cash or term deposits, cash only generates a modest

level of income—though it does provide daily liquidity. While term deposits provide a slightly higher

income level, this comes at the cost of lower liquidity. While some consider both to be slightly safer

than Australian ﬁxed-income, given they sit higher within the bank’s capital structure (relative to bank

senior debt) and do not face the same mark-to-market volatility as that of government bonds (given

that there is no market price on term deposits), there is a clear cost attributed to such an allocation

and in this case it is long-term underperformance.

In four of the past ﬁve calendar years, the Australian ﬁxed-income market (as represented by the

Bloomberg AusBond Composite 0+ Index*) has outperformed cash and term deposits, while the

Western Asset Australian Bond strategy has outperformed in all of the past ﬁve years.

Yield (%)

Source: Bloomberg

Exhibit 5: Total Returns During Recent Periods of Volatility

Ausbond Composite - Return S&P/ASX200 Accumulation Index - Return

1.63

3.29

2.42

-1.12

2.97

2.17

-7.51

-9.42

-7.34

-6.27

-1.26

-7.54

-10

-8

-6

-4

-2

May 2010

(Eurozone

Concerns)

Aug/Sep 2011

(US

Downgrade)

May 2012

(Eurozone

Concerns)

May/June 2013

(Taper

Tantrum)

Nov/Dec 2014

(Oil

Collapse)

Q3 2015

(Global Grow

Fears)

16.05

-43.59

-50

-40

-30

-20

-10

Nov 2007

until Mar 2009

(GFC)

Return (%)

Source: Bloomberg, Western Asset. As of 31 Jan 18

Gross of management fees net of trust expenses. Past Performance is not an indicator of future returns.

Exhibit 6: The Western Asset Australian Bond Strategy Has Outperformed In the Past Five Years

2012 2013 2014 2015 2016 2017 2018

Calendar Year

Western Asset Core Australian Bond Representative Account Bloomberg AusBond Composite Index

Bloomberg AusBond Bank Bill Index RBA Cash Rate

10.27

3.56

9.92

2.96

3.54

4.58

2.02

7.49

1.99

9.41

2.60

2.93

3.62

1.84

3.90

2.83

2.66

2.31

2.05

1.73

1.11

4.25

3.00

2.50

2.00

1.50

Why Australian Fixed-Income Is Always on the Agenda

Western Asset

September 2018

Past results are not indicative of future investment results. This publication is for informational purposes only and reﬂects the current opinions of Western Asset. Information contained

herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an oﬀer or solicitation with respect to the purchase or sale of any security and are

subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset may have a position in the securities

mentioned. This publication has been prepared without taking into account your objectives, ﬁnancial situation or needs. Before acting on this information, you should consider its appro-

priateness having regard to your objectives, ﬁnancial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence.

Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorised and regulated by Comissão de Valores Mobiliários and Banco Central do

Brasil. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte.

Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Manage-

ment Company Ltd is a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan. Western Asset Management Company Limited is

authorised and regulated by the Financial Conduct Authority (“FCA”). This communication is intended for distribution to Professional Clients only if deemed to be a ﬁnancial promotion

in the UK and EEA countries as deﬁned by the FCA or MiFID II rules.

Conclusion

While many investment commentators fear the initial capital price impact to bond markets due to

their expectation of a sharp interest rate rise, factors such as the velocity of interest rate change, re-

ceiving coupons and roll-down over time dampen the drawdown. Further, through the eﬀective use

of the broad investment tool set available to bond managers, highly skilled active managers such as

Western Asset have a proven track record of reducing risk and enhancing returns for investors. Finally,

by merely holding a bond to maturity (assuming no default) we receive par value and coupons—the

same as what is oﬀered by term deposits, only with the added beneﬁt of liquidity.

Overall, a period of rising interest rates represents a more challenging period for Australian ﬁxed-

income markets; however, the reality of a rising interest rate environment on the back of improving

economic conditions is a far cry from the dooms day expectations of some market commentators.

When we assess the low overall impairment to an investor’s portfolio of an Australian “bond bubble”

scenario, relative to the impact of an equity bear market scenario, we believe it is prudent for investors

to include an allocation to Australian ﬁxed-income in their portfolios.

This strategy is managed by Western Asset. This information is only for use by professional clients, eligible counterparties or qualified investors. It is not

aimed at, or for use by, retail clients.

Western Asset August 2018

Performance and Risk Disclosures

August 31, 2018

Rolling 1-Year Performance Returns Period Ending:

31 Aug 18 31 Aug 17 31 Aug 16 31 Aug 15 31 Aug 14

Western Asset Core Australian Bond Strategy Representative Account

(gross of fees)

4.34% 0.22% 6.79% 6.51% 7.95%

Western Asset Core Australian Bond Strategy Representative Account

(net of fees)

3.95% -0.16% 6.37% 6.09% 7.55%

Bloomberg AusBond Composite 0+ Yr Index

3.84% -0.66% 6.19% 6.29% 6.90%

Base Currency: AUD

Past investment results are not indicative of future investment results. Source for performance figures is Western Asset. Please refer to the Performance

Disclosure for more information. Currency exchange rate fluctuations will impact the value of your investment.

The value of investments and the income from them may go down as well as up and you may not get back the amount you originally invested.

Investment Risks:

The strategy does not offer any capital guarantee or protection and you may not get back the amount invested. The strategy is subject to the following risks

which are materially relevant but may not be adequately captured by the indicator:

Bonds: There is a risk that issuers of bonds held by the strategy may not be able to repay the investment or pay the interest due on it, leading to losses for

the strategy. Bond values are affected by the market’s view of the above risk, and by changes in interest rates and inflation.

Credit: The risk that an issuer will be unable to pay principal and interest when due.

Interest Rates: Changes in interest rates may negatively affect the value of the strategy. Typically as interest rates rise, bond values fall.

Australia Core Composite

Composite Inception Date: 12/01/1994

| Composite Creation Date: 12/01/1994

No. of

Accts

Gross Total

Return

Net Total

Return

Benchmark

Total Return

Gross Total

3-Yr St Dev

Benchmark Total

3-Yr St Dev

Internal

Dispersion

Mkt. Value

AUD Mil

Percentage of

Firm Assets

AUD Mil

2008

12.31%

12.09%

14.95%

2.69%

2.82%

0.80%

2,545

0.35%

725,273

2009

4.50%

4.29%

1.73%

3.03%

3.16%

0.78%

3,276

0.61%

536,185

2010

7.34%

7.13%

6.04%

3.18%

3.42%

0.37%

4,321

0.98%

442,817

2011

10.62%

10.40%

11.37%

2.61%

2.91%

0.12%

6,559

1.52%

432,247

2012

9.02%

8.81%

7.70%

2.42%

2.90%

0.40%

7,219

1.62%

444,896

2013

2.97%

2.76%

1.99%

2.39%

2.80%

0.15%

6,365

1.26%

504,814

2014

10.02%

9.81%

2.39%

2.65%

0.10%

7,692

1.35%

569,482

2015

2.78%

2.58%

2.59%

2.41%

2.55%

0.07%

7,509

1.26%

596,175

2016

3.49%

3.29%

2.92%

2.70%

2.83%

0.07%

6,833

1.18%

578,935

2017

4.54%

4.33%

3.66%

2.63%

2.73%

0.08%

8,227

1.47%

557,833

Description: The Western Asset Australia Core strategy is a broad-market strategy that aims to maximize total return and add value through duration and curve positioning, sector

allocation and security selection, while approximating benchmark risk. The strategy invests in a diversified portfolio using all major Australian investment-grade fixed-income sectors with a

bias toward non-Treasuries.

Benchmark Description: The current benchmark is the Bloomberg AusBond Composite 0+ Yr Index. The index is engineered to measure the Australian debt market and is a

composite of Treasury, Semi-Government, Supra/Sovereign, and Credit indices. This index is a subset of the Bloomberg AusBond Master Index.

Base Currency: AUD | Composite Minimum: No minimum asset size requirement.

Current Fee Schedule: .20 of 1% on the first AU$100 million, .125 of 1% on amounts over AU$100 million.

Western Asset claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS

standards. Western Asset has been independently verified for the periods from January 1, 1993 to December 31, 2017.

Verification assesses whether (1) the Firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the Firm's policies and

procedures are designed to calculate and present performance in compliance with the GIPS standards. The Australia Core Composite has been examined for the period from January 1,

2006 to December 31, 2017. The verification and performance examination reports are available upon request.

For GIPS® purposes, the Firm is defined as Western Asset, a primarily fixed-income investment manager comprised of Western Asset Management Company, LLC, Western Asset

Management Company Limited, Western Asset Management Company Pte. Ltd., Western Asset Management Company Ltd, Western Asset Management Company Pty Ltd, and

Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários (DTVM) Limitada, with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São

Paulo, Hong Kong, and Dubai. Each Western Asset company is a wholly owned subsidiary of Legg Mason, Inc. ("Legg Mason") but operates autonomously, and Western Asset, as a

Firm, is held out to the public as a separate entity. Western Asset Management Company was founded in 1971.

The Firm is comprised of several entities as a result of various historical acquisitions made

by W

estern Asset, and their respective performance has been integrated into the Firm in line

with the portability requirements set forth by GIPS.

The Composite is valued monthly. The Composite returns are the asset-weighted average of the performance results of all the accounts in the Composite. Gross-of-fees returns are

presented before management fees, but after all trading expenses. Net of fees results are calculated using a model approach whereby the current highest tier of the appropriate

strategy's fee schedule is used. This model fee does not reflect the deduction of performance-based fees. The portfolios in the Composite are all actual, fee-paying and performance

fee-paying, fully discretionary accounts managed by the Firm for at least one full month. Investment results shown are for taxable and tax-exempt accounts and include the reinvestment of

all earnings. Any possible tax liabilities incurred by the taxable accounts have not been reflected in the net performance. Composite performance results are time-weighted net of

trading commissions and other transaction costs including non-recoverable withholding taxes. Policies for valuing portfolios, calculating performance, and preparing compliant

presentations are available upon request.

The returns for the accounts in the Composite are calculated using a time-weighted rate of return adjusted for weighted cash flows. The returns for the commingled funds in the

Composite are calculated daily using net asset values (NAV), adding back the funds' total expense ratio or equivalent. Trade date accounting is used since inception and market values

include interest income accrued on securities held within the accounts.

Composite returns are measured against a benchmark, when applicable. The benchmark is unmanaged and provided to represent the investment environment in existence during the

time periods shown. For comparison purposes, its performance has been linked in the same manner as the Composite. The benchmark presented was obtained from third party sources

deemed reliable but not guaranteed for accuracy or completeness. Benchmark returns and benchmark three-year annualized ex-post standard deviation are not covered by the report of

independentverifiers.

Internal dispersion is calculated using the asset-weighted standard deviation of annual gross returns of those portfolios that were included in the Composite for the entire year. For each

annual period, accounts with less than 12 months of returns are not represented in the dispersion calculation. Periods with five or fewer accounts are not statistically representative and

are not presented. The three-

year annua

lized ex-post standard deviation measures the variability of the composite and the benchmark returns over the preceding 36-month period. The

three-year annualized ex-post standard deviation is not presented for periods where 36 monthly returns are not available for the composite or the benchmark. Any gross total three-year

annualized ex-post standard deviation measures prior to 2011, included within the "Examination Period" identified above, are not covered by the report of independent verifiers.

Past investment results are not indicative of future investment results.

Western Asset's list of composite descriptions is available upon request. Please contact Derek Fan at 626-844-9465 or de[email protected]. All returns for strategies with

inception prior to January 1, 2008 are available upon request.

For more information on Western Asset visit our website at www.westernasset.com

Western Asset

Performance Disclosure

December 31, 2017