SPECIALIST AUSTRALIAN BOND STRAIGHT TALK ON FRANKLIN AUSTRALIAN ABSOLUTE RETURN BOND FUND

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Bernadette Little
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1 SPECIALIST AUSTRALIAN BOND STRAIGHT TALK ON FRANKLIN AUSTRALIAN ABSOLUTE RETURN BOND FUND

2 CHRIS SINIAKOV Managing Director, Australian Fixed Income Franklin Templeton Investments an absolute return approach to investing can help restore the defensive characteristics Taking of the fixed income asset class.

3 A SHIFTING FIXED INCOME LANDSCAPE The Australian bond market is now best understood by looking at the domestic market through a global lens. In fact, over 50% of Australia s non-government debt now originates from offshore entities 1 providing opportunities to build portfolios that blend local investments with alternative global exposure to maximise return outcomes and provide for better risk management. We strongly believe investors need to rethink their fixed income approach and remain focused on three main areas of investment potential: 1) the bias for global yields in the short-term is higher, 2) the Australian economy continues to face significant pressures, and 3) we remain cautious about credit. First, we see global yields moving moderately higher, led by the US, as markets adjust to Fed tightening and a potentially expansionary White House fiscal agenda. Alternatively, we see the potential for declining yields in Australia and New Zealand, which historically have been generous. We continue to use tactical duration management to harvest excess return. Second, Australian economic data has revealed persistent low inflation and weak domestic demand, in line with our view that the Australian economy is weaker than headline GDP has been suggesting. We remain positioned for a steepening of the Australian yield curve as the combination of weak domestic fundamentals and rising global bond yields exerts divergent pressures across the domestic curve. Straight Talk on Franklin Australian Absolute Return Bond Fund is designed to help strengthen your understanding of the Fund and its strategy. On the following pages we ll review: Macro Outlook 2 Investment Approach 4 Fund positioning 6 Results 8 Third, we believe credit valuations have entered extra time and the final whistle is imminent. Therefore we are selectively reducing credit risk, rebalancing our portfolios away from several higher beta securities towards higher quality government-related securities. Ultimately, an absolute return approach can help investors continue to hold bond positions that can deliver attractive returns, including consistent income streams, while reducing some of the risks now accumulated in a more traditional approach. 1. Source: UBS. As of 31 December franklintempleton.com.au Franklin Australian Absolute Return Bond Fund 1

4 MACRO OUTLOOK December 2017 Below are key regional themes that have been identified through our investment team s analysis of global macro dynamics as well as countryspecific research. AUSTRALIA UNITED STATES Australian Economy neither Hot nor Cold but Vulnerable to Chills Australian employment has bounced back strongly but household balance sheets remain under pressure with heavy debt loads and low income growth. Housing price growth appears to be topping as macro prudential measures tighten financial conditions. Non-mining business investment remains subdued. Consistent with global economies, inflation in Australia is benign. We expect the Australian cash rate to remain unchanged at 1.50% as the RBA balances inflation, financial stability risk and a higher AUD. A weaker USD, some improvement in the domestic economy and stronger commodity prices have driven AUD higher. At around the 80 cent level (last seen in May 2015), AUD strength is a risk for the domestic economy. We have found a sweet spot in select high-quality, investmentgrade corporate bonds offering better return potential than domestic government bonds without much additional risk. In particular, we prefer sectors like utilities and infrastructure, where there is government support and regular cash flows. US Economic Conditions Remain Constructive US consumers have been benefitting from an economy that appears close to full employment and a stock market at record levels. Tax changes expected to provide a moderate boost. Though a modest cyclical rebound in inflation might occur, at this point it still seems hard to foresee pricing pressures building enough in coming months. The US Federal Reserve (Fed) will undergo leadership change but, for now, the official projected policy path remains relatively unchanged with three rate hikes in 2018 followed by three rate hikes in Markets, however, remain unconvinced. Source: Franklin Templeton Investments. Opinions expressed are as of 31 December 2017, and are subject to change without prior notice. This is not investment advice, and is not a complete analysis of every material fact regarding any security, sector, portfolio, strategy or market. 2 Franklin Australian Absolute Return Bond Fund franklintempleton.com.au

5 EUROPE ASIA Europe Mix of Robust Growth and Weak Inflation Unlikely to Persuade ECB to Change Course Data for the eurozone continued to suggest strong economic growth, at a level much more robust than generally considered to be sustainable for the region over the long term. The sentiment indicators underline strength and breadth of the current expansion. Business conditions in many member countries improved faster than that of their global peers over much of The temptation to assume that the strength of the economy could unduly influence ECB policymakers should be resisted. The central bank s mandate is centered on inflation. Inflation figures remain subdued, and are predicted to drift lower during early 2018, as the impact of a previous rebound in energy prices falls out of the annual calculations. Synchronised Global Expansion Benefit Asia Asia continues to account for over half of world growth. The uplift in economic activity in Japan surprised in External demand and domestic surveys support a continuation of that momentum in the new year. In China, the rotation of growth from heavy industry which is commodity intensive to services and higher-end manufacturing will be a key emphasis for 2018 and beyond. Financial deleveraging is also a key priority for the Administration. India and the ASEAN-5 have performed well, supported by policy easings from central banks who appear to be nearing the end of their rate cutting cycle. franklintempleton.com.au Franklin Australian Absolute Return Bond Fund 3

6 WHY AN ABSOLUTE RETURN APPROACH There are many absolute return strategies in the market. Some in their desire to move away from traditional approaches have either moved to the other end of the spectrum adopting significant risk positions making them behave more like hedge funds or diversified credit funds. The Franklin Australian Absolute Return Bond Fund seeks to preserve the defensive characteristics of a traditional bond allocation, approached in a different way: Maintaining a high-quality portfolio Seeking to diversify sources of return Seeking to distribute on a monthly basis We believe it s important to reconstruct bond portfolios from the ground up and begin with a riskfree benchmark, cash, and then select the specific opportunities that make sense for Australian investors still looking for defensive returns with lower capital volatility. The majority of bottom-up security and sector positioning is targeted towards high quality, liquid bond issuers from the government and corporate sectors. This core portfolio provides yield, liquidity and quality. Tactically, we seek to add incremental value from select sectors and security selection when the value is compelling primarily from the domestic market but also selectively from international markets. PLAN YOUR INCOME Franklin Australian Absolute Return Bond Fund Monthly Income Distribution Return FY 2016/ % 0.60% TOTAL YIELD 3.8% pa 0.40% 0.20% 0.00% Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Monthly Income Distribution Return Past performance is not an indicator of future performance. Monthly income distributions may change due to market movements. 4 Franklin Australian Absolute Return Bond Fund franklintempleton.com.au

7 ISOLATING DESIRED RISK MACRO POSITIONING Complementing the bottom-up company research and analysis, we conduct macro-economic (Macro) research on multiple countries around the globe. Macro research helps determine whether an economy, including Australia, is improving or deteriorating. This assessment of individual countries and the relative performance between countries provides a framework that helps identify opportunities to further diversify portfolio risk through positioning the portfolio for expected changes in interest rates and foreign exchange rate levels. Risk management is integral to the portfolio construction process and includes the careful consideration of each best idea and how different ideas combine and interact to influence portfolio outcomes. The illustration below shows three macro positioning examples. RATES RELATIVE VALUE CURRENCY New Zealand Canada Australia Hypothetical Situation and Country Analysis Economic activity in New Zealand remains mixed and disinflationary forces considerable. We expect the RBNZ will need to ease rates more than currently expected by the market. Implied increases in official rates in Canada are unlikely to be realised and reflect short-term market positioning. Equally, no increases in U.S. rates by the Federal Reserve for 18 months is overly pessimistic relative to our investment conclusions. The Australian dollar is overvalued as a result of shorter-term weakness in the USD and commodity price strength. We expect it to decline over the coming period as these shorter-term factors decline. Proposed Course of Action Take advantage of attractive interest rates in New Zealand given our investment view. Take advantage of attractive yield differential between Canadian and U.S. short-term interest rates. Take advantage of the recent strength of the AUD against fundamental value. Hypothetical Portfolio Decision Hypothetical Portfolio Decision Buy (go long) short-term New Zealand interest rates via interest rate swaps Hypothetical Portfolio Decision Buy (go long) 2-year Canadian interest rates Sell (go short) 2-year U.S. interest rates in equal size Hypothetical Portfolio Decision Sell AUD/Buy USD using forex forward contracts These hypothetical examples are for illustrative purposes only to demonstrate our investment process. They are not intended to reflect any past, current or future holdings of the portfolio and should not be considered as an investment advice or investment recommendation. franklintempleton.com.au Franklin Australian Absolute Return Bond Fund 5

YIELD CURVE POSITIONING We are constantly looking at the shape of the Australian yield curve and currently see value towards the shorter end of the curve.

8 YIELD CURVE POSITIONING We are constantly looking at the shape of the Australian yield curve and currently see value towards the shorter end of the curve. We are concerned that the longer end of the curve could be subject to forces of rising interest rates globally, and therefore can easily see a scenario where the curve steepens. Our core views remain consistent and we continue to invest for the themes of potentially rising global yields and declining yields in Australia and New Zealand. We also actively seek duration opportunities that may offer positive real yields without undue interest-rate risk, such as curve exposures with compelling levels of yield, healthy underlying fundamentals and prudent monetary policies. THE FUND S AVERAGE DURATION WAS LOWER THAN THE BENCHMARK, WHILE THE YIELD TO MATURITY WAS HIGHER Franklin Australian Absolute Return Bond Fund Average Duration and Yield to Maturity vs. Bloomberg AusBond Bank Bill Index (%) As of 31 December 2017 Average duration 3 Yield to maturity 4 Franklin Australian Absolute Return Bond Fund years 3.25% Bloomberg AusBond Bank Bill Index (%) 0.12 years 1.71% We are patient and targeted in our approach, taking advantage of the market environment to be well positioned for market volatility and the next opportunity to increase exposures at attractive pricing levels. ANDREW CANOBI, CFA Director, Australian Fixed Income, Franklin Templeton Investments 2. As of 31/12/17. Portfolio holdings are subject to change. For the fund s most recent portfolio information, please visit franklintempleton.com.au. 3. Duration shown is the option-adjusted duration. Duration is an indication of a fund s sensitivity to changes in interest rates. The option-adjusted duration formula takes into account embedded call options and redemption features that impact a bond s expected cash flow, and thus its interest rate sensitivity. Figure reflects certain derivatives held in the portfolio (or their underlying reference assets). 4. Not representative of the amount of income investors can expect to receive from the fund. Yield to maturity (YTM) is the rate of return anticipated on a bond if it is held until the maturity date. The calculation of YTM takes into account the current market price, par value, coupon interest rate and time to maturity. For a fund, this represents the weighted average yield to maturity of the portfolio s holdings. 6 Franklin Australian Absolute Return Bond Fund franklintempleton.com.au

9 CREDIT POSITIONING We do adopt positions in non-government sectors such as corporate credit, but importantly, we generally stay at the high quality, liquid end of the spectrum. We avoid higher risk and less liquid sectors such as listed hybrids and RMBS. We also actively hedge credit risk with risk management strategies to help protect our client s capital should market volatility spike higher. While credit securities can provide additional yield to portfolios it is important not to fall into the trap of putting all your eggs in one basket. Historically credit cycles through time show that portfolios are likely to be exposed to similar risks by having a high correlation to equities during inevitable periods of cyclical downturns and market distress. In addition to credit s high correlation with equities, credit spreads or, the incremental yield paid for the additional risk of investing in credit appear to be approaching relatively expensive valuations. As can be seen in the chart below, credit spread levels have returned to pre-gfc levels, begging the question, are investors being rewarded enough for the additional level of risk? Credit Markets: High Yield Risk/Reward Is Poor Bloomberg US High Yield Credit Spread % ? Source: Franklin Templeton Investments, Bloomberg. franklintempleton.com.au Franklin Australian Absolute Return Bond Fund 7

10 RESULTS Taking an active approach to fixed income investing, the Franklin Australian Absolute Return Bond Fund looks to take advantage of opportunities in interest rates, credit cycles and macro-economic themes across the globe aimed at delivering stable, income style returns regardless of general fixed income market performance. Average Annual Total Returns 5 As of 31 December 2017 Quarter 6-Month 1-Year 2-Year Since Inception (22/12/14) Franklin Australian Absolute Return Bond Fund W Class (Net of Fees) 1.10% 1.33% 3.37% 3.02% 3.00% Distribution Return 0.87% 1.77% 4.07% 2.96% 2.94% Bloomberg AusBond Bank Bill Index (%) 0.42% 0.86% 1.75% 2.05% 2.06% Performance data represents past performance, which does not guarantee future results. Periods greater than one year are shown as average annual total returns. Current performance may differ from figures shown. The fund s investment return and principal value will change with market conditions, and you may have a gain or a loss when you sell your shares. Franklin Australian Absolute Return Bond Fund research ratings 6 For more information on Franklin Australian Absolute Return Bond Fund, please contact Franklin Templeton Client Services at or visit 5. All performance data shown is in the Fund currency stated and net of management fees. Sales charges and other commissions, taxes and other relevant costs paid by the investor are not included in the calculations. The value of investments in the Fund and income received from it can go down as well as up, and investors may not get back the full amount invested. Past performance is not an indicator or a guarantee of future performance. Current performance may differ from figures shown. Currency fluctuations may affect the value of overseas investments. When investing in a fund denominated in a foreign currency, performance may also be affected by currency fluctuations. Please visit franklintempleton.com.au for current performance. 6. The ratings and recommendations referred to are only the opinions of the research houses and are provided for information purposes only and are not advice. All ratings and recommendations are subject to change without notice. They do not take into account your circumstances or needs so you should consider your circumstances and seek professional advice before making an investment decision. The research houses accept no liability whatsoever in connection with the ratings and recommendations, subject to law. Contact the relevant research house or their website for additional information, such as their Financial Services Guide. The research houses may receive a fee from Franklin Templeton to review Franklin Templeton funds using comprehensive criteria. The Lonsec ratings (assigned September 2017) presented in this document is published by Lonsec Research Pty Ltd ABN AFSL The rating is a class service (as defined in the Financial Advisers Act 2008 (NZ)) or is limited to General Advice and based solely on consideration of the investment merits of the financial product(s). In New Zealand it must only be provided to wholesale clients (as defined in the Financial Advisers Act 2008 (NZ)). It is not a recommendation to purchase, sell or hold the relevant product(s), and you should seek independent financial advice before investing in this product(s). The rating is subject to change without notice and Lonsec assumes no obligation to update the relevant document(s) following publication. Lonsec receives a fee from the Fund Manager for researching the product(s) using comprehensive and objective criteria. For further information regarding Lonsec s ratings methodology, please refer to our website at: The Zenith Investment Partners ( Zenith ) ABN rating (assigned June 2017) referred to in this document is limited to General Advice (as defined by section 766B of Corporations Act 2001) and based solely on the assessment of the investment merits of the financial product on this basis. It is not a specific recommendation to purchase, sell or hold the relevant product(s), and Zenith advises that individual investors should seek their own independent financial advice before investing in this product. The rating is subject to change without notice and Zenith has no obligation to update this document following publication. Zenith usually receives a fee for rating the fund manager and product against accepted criteria considered comprehensive and objective. The rating contained in this document is issued by SQM Research Pty Ltd ABN SQM Research is an investment research firm that undertakes research on investment products exclusively for its wholesale clients, utilising a proprietary review and star rating system. The SQM Research star rating system is of a general nature and does not take into account the particular circumstances or needs of any specific person. The rating may be subject to change at any time. Only licensed financial advisers may use the SQM Research star rating system in determining whether an investment is appropriate to a person s particular circumstances or needs. You should read the product disclosure statement and consult a licensed financial adviser before making an investment decision in relation to this investment product. SQM Research receives a fee from the Fund Manager for the research and rating of the managed investment scheme. 8 Franklin Australian Absolute Return Bond Fund franklintempleton.com.au

11 WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Currency rates may fluctuate significantly over short periods of time, and can reduce returns. Derivatives, including currency management strategies, involve costs and can create economic leverage in the portfolio which may result in significant volatility and cause the fund to participate in losses (as well as enable gains) on an amount that exceeds the fund s initial investment. The fund may not achieve the anticipated benefits, and may realise losses when a counterparty fails to perform as promised. The markets for particular securities or types of securities are or may become relatively illiquid. Reduced liquidity will have an adverse impact on the security s value and on the fund s ability to sell such securities when necessary to meet the fund s liquidity needs or in response to a specific market event. Foreign securities involve special risks, including currency fluctuations and economic and political uncertainties. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets smaller size and lesser liquidity. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in interest rates will affect the value of the fund s portfolio and its share price and yield. Bond prices generally move in the opposite direction of interest rates. As the prices of bonds in the fund adjust to a rise in interest rates, the fund s share price may decline. Changes in the financial strength of a bond issuer or in a bond s credit rating may affect its value. These and other risks are discussed in the fund s Product Disclosure Statement (PDS).

12 Franklin Templeton Investments Australia Limited (ABN ) (Australian Financial Services Licence Holder No ) issues this publication for information purposes only and not investment or financial product advice. It expresses no views as to the suitability of the services or other matters described herein to the individual circumstances, objectives, financial situation, or needs of any recipient. You should assess whether the information is appropriate for you and consider obtaining independent taxation, legal, financial or other professional advice before making an investment decision. A Product Disclosure Statement (PDS) for any Franklin Templeton funds referred to in this document is available from Franklin Templeton at Level 19, 101 Collins Street, Melbourne, Victoria, 3000 or or by calling The PDS should be considered before making an investment decision. Any research and analysis contained in this presentation has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Any views expressed are the views of the fund manager and do not constitute investment advice. The underlying assumptions and these views are subject to change. Franklin Templeton accepts no liability whatsoever for any direct or indirect consequential loss arising from the use of this commentary or any information, opinion or estimate herein. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not an indicator nor a guarantee of future performance. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Franklin Templeton Investments Australia Limited Level Collins Street Melbourne VIC 3000 Australia Level 30, Aurora Place 88 Phillip Street Sydney NSW 2000 Australia Freecall: ftclientservices@frk.com Franklin Templeton Investments. All rights reserved. FTIFAU STAFI 02/18

RISING RATES WHAT YOU NEED TO KNOW

RISING RATES WHAT YOU NEED TO KNOW Although rising interest rates may primarily challenge those bond investments with the highest sensitivity to interest rates, we believe many parts of the global fixed