Showcase: Beyond the benchmark

Fixed income investors are finally getting what they want: higher yields.

After years of near-zero interest rates, Australia's cash rate has risen from 0.1% to 4.3%. On paper, that should be good news for bond investors. Yet despite higher yields, total returns have often disappointed.

The problem may be that we have mistaken a market anomaly for the norm.

Enter Martin Liebowitz.

While Warren Buffett became the face of investing, Liebowitz quietly became one of fixed income's most influential thinkers. The co-author of the 1972 classic Inside the Yield Book spent decades explaining where bond returns really come from.

For much of the past 15 years, his ideas looked outdated. But as yields have normalised and duration has become a headwind rather than a tailwind, Liebowitz's central message is starting to resonate again: understanding where bond returns come from matters more than chasing a benchmark.

The forgotten normal

The Global Financial Crisis (GFC) and the post-pandemic inflation shock that upended bond markets in 2022 both left lasting scars on balanced portfolios.

It was a rude shock to the system when super funds found themselves telling members three years ago that, contrary to the long-held belief that balanced portfolios could cushion market volatility, retirees were staring down losses in both shares and bonds. Whatever happened to diversification?

It is from this lived experience of contradictions and broken conventions that investors can reassess their assumptions about fixed income.

That brings us back to Liebowitz. His insights from the 1970s, largely overlooked during the low-rate era from 2000 to 2020, are beginning to look relevant again today.

"If you look back over a longer period of history, US 10-year Treasury rates have kind of moved back to where, arguably, they were on a long-term average basis," says Andrew Canobi, director of fixed income at Franklin Templeton.

"So it's a bit of a normalisation. Inflation has reappeared and it's not going away as easily as many had thought, so it's hovering at levels that are keeping yields higher.

"And, of course, you've got central banks responding by moving policy rates back to levels that are more consistent with that longer-term average."

Duration as an active choice

That doesn't make life easier for investors.

For much of the decade from 2010 to 2020, fixed income investors enjoyed total returns that exceeded their starting yield as declining interest rates pushed bond prices higher. Duration was a tailwind.

Today's environment is very different. "Investors have moved into the asset class and are experiencing some frustration because their total returns are falling short of that yield," Canobi says.

"Duration has been a drag for investors in the last few years and it's kind of eroded or taken away from the attractive yield."

Duration, which measures a bond portfolio's sensitivity to interest rate movements, can enhance returns when yields fall. But when rates remain elevated or move higher, it can become a headwind.

That has prompted Franklin Templeton to take a markedly different approach from traditional bond benchmarks.

"Our starting position is to be a lot shorter," Canobi says.

"If you look at the average duration on most major benchmarks for the bond market, they're sort of in that five-to-six-year category. We start somewhere between zero and maybe two or two-and-a-half years."

"The main thing for us is we recognise that duration has some value and periodically we see it as an active decision rather than something we just want to neutrally be always positioned in."

For Canobi, duration shouldn't be a permanent allocation simply because a benchmark dictates it. It should be an active choice based on market conditions and the opportunities available.

Credit and sector approach

Another cornerstone of his strategy is investment-grade credit.

While the past several years have been challenging for many bond investors, Canobi believes higher-quality credit continues to offer attractive income while maintaining relatively low default risk.

"It's a high-yielding asset class and you more or less don't get defaults. And if you do, they're extremely rare in investment-grade credit, so it does make sense to have exposure there as a core."

His emphasis remains on higher-quality issuers rather than venturing too far down the risk spectrum.

"In the credit market, we do participate in it primarily in the higher-quality investment-grade part," Canobi says.

"We diversify the portfolio according to not only sector, but coupon type, maturity, et cetera."

As market conditions deteriorate, the strategy also allows for defensive positioning. "As credit markets start to potentially show some periods of underperformance, we can actually incorporate some hedging in our portfolio."

A case for absolute return

The more fundamental question, according to Canobi, is whether traditional fixed income benchmarks still deserve to be the beginning conversation for portfolio construction.

Franklin Templeton invests across many of the same sectors and security types that make up broad bond indices, but it does not anchor portfolios to the benchmark itself.

"We don't see the traditional benchmark as the starting point," he says.

"It is very heavily dominated by government bonds and very heavily dominated by long-term government bonds with lots of duration."

Instead, Canobi prefers an absolute return framework that focuses on outcomes rather than index-relative performance.

"That's kind of the way we would define absolute return, but then beyond that, we want to have a high-quality portfolio. We want to rebalance that return composition to be more around yield income, not just duration."

At present, Franklin Templeton's portfolio has a yield to maturity of around 6%.

"We have a little bit of duration, but not very much. Yes, we have some credit, but it's high quality and we look to other sources of return.

"Across that sort of waterfront, we can achieve those outcomes that investors are looking for."

A more flexible fixed income toolkit is increasingly relevant as Australia ages. More than four million Australians are already retired and another two million or so are expected to reach retirement age over the next decade.

For those investors, the goal is not simply to outperform an index. It's to generate dependable income and meet their spending needs.

In many ways, that brings the industry full circle. More than 50 years ago, Liebowitz argued that bonds should not be viewed solely through the lens of yield or benchmark performance. They should be evaluated in the context of investor objectives, liabilities and risk management.

For bond managers, the question should not be: "Did I beat the benchmark?"

It should be: "Did I achieve the investor's objective?"

In a higher-yield world, that distinction may matter more than ever.

Brought to you by Franklin Templeton.