Building income from credit, not the rate cycle

For many clients approaching or living in retirement, fixed income carries a simple promise of a reliable stream of income. Yet the route to that income often runs through a quiet bet on where interest rates head next.

Damon Shinnick, portfolio manager at Western Asset Management, prefers to take that bet off the table, using short-duration credit to earn income without relying on rate calls.

“The fund is built for investors whose priority is income,” Shinnick says.

Two sources of return in short-duration credit

A bond portfolio earns its keep in two broad ways. Duration measures how sensitive a bond’s price is to changes in interest rates, so a long-duration portfolio rises and falls with the rate cycle. Credit exposure pays investors a margin, known as a spread, for lending to companies and other borrowers rather than to governments. Shinnick’s approach leans heavily on the second.

“We aim to keep interest rate risk deliberately low and focus instead on where investors are paid for taking credit risk, rotating across sectors and selecting securities across the capital structure,” he explains.

The Western Asset Enhanced Income Fund puts that thinking into practice as an actively managed, short-duration credit strategy. It invests across Australian and global investment grade corporate credit and structured credit, with a modest allocation to high yield.

All global exposures are hedged to Australian dollars, which removes currency swings from the income equation.

The fund targets returns of 1.5 to 2 per cent per annum above the Bloomberg AusBond Bank Bill Index, before fees, over rolling three-year periods. It pays distributions monthly, a feature that suits clients who draw on their portfolios for regular living costs.

“That allows the portfolio to generate income from running yield rather than relying on the direction of interest rates,” Shinnick notes.

The research lens

Research house ratings play a central role in how advice practices build income portfolios. They often determine which products appear on a licensee’s approved product list, and they give advisers an independent check on a manager, its team and its process.

Lonsec rates the managed fund version of the strategy Highly Recommended, its highest rating and a step up from the Recommended rating it previously held.

Lonsec considers the rating “supported by a highly experienced and stable investment team, overseen by Damon Shinnick”. It adds that the manager’s research, portfolio construction and risk management systems “combine to deliver an effective means of accessing an Australian and global credit portfolio targeting higher income returns.”

Within a peer group of 34 rated Fixed Interest Specialised Income funds, Lonsec scores the fund above its peers on all seven factors it assesses. These cover business, team, process, ESG, product, fees and performance. The fund’s annual fees and costs of 0.50 per cent come in just below the peer median of 0.52 per cent.

Lonsec also observes that the fund outperforms both its benchmark and peer median across all rolling periods, with lower volatility than the peer median.

Felicity Walsh, managing director of Franklin Templeton Australia and New Zealand, sees the rating as a signal for the advice community.

“This acknowledgment is an important independent endorsement of the Fund and the experienced team behind it, and one that matters to the advisers who rely on research to build income portfolios for their clients,” Walsh says.

The strategy also trades on the ASX as the Western Asset Enhanced Income Fund – Active ETF (FEIF), which gives investors a choice between the managed fund and a listed structure. The Lonsec rating applies to the managed fund.

Local team, global reach

Western Asset is a global fixed income specialist and a wholly owned subsidiary of Franklin Templeton, and its Australian business dates back to 1998. Shinnick credits the strategy’s results to the way the local and global teams work together.

“Our Melbourne-based team works closely with Western Asset’s global credit research and investment teams, to build a portfolio that provides a diversity of alpha sources, without sacrificing liquidity,” he says.

The credit backdrop

Australian fixed income markets have seen their share of volatility, as domestic inflation concerns and higher global bond yields push yields higher. Shinnick still finds plenty to like in credit.

“Global credit markets remain supported by healthy corporate balance sheets, resilient earnings and strong demand for income,” he observes. “Domestic credit markets continue to go from strength to strength, absorbing record levels of supply, particularly from kangaroo (non-Australian) issuers such as Alphabet.”

Kangaroo bonds are Australian dollar bonds that offshore companies issue in the local market. Their growth gives domestic investors access to large global names without taking on currency risk. Shinnick also points to a shift in who is buying.

“An evolving investor base, with increased global and retail participation, is underpinning strong and ongoing demand,” he adds.

There is, of course, another side to any strategy built on credit. Short duration softens the impact of rate moves, but credit spreads can widen quickly when risk appetite fades, as they did during the lockdowns.

High yield and structured credit usually feel that pressure first. A deep pipeline of new issuance also relies on demand holding up through tougher conditions.

For income-focused clients, the reliability of their income ultimately rests on the health of the borrowers behind it.

That makes the source of income a worthwhile part of every client conversation. For advisers weighing up their options, a short-duration credit strategy that earns its return from credit rather than rate calls, backed by an experienced team and an independent research view, offers a considered way to deliver the steady income many clients value most.