Deciding how to position the defensive assets within your portfolio

Diversification is the foundation of portfolio construction. It’s otherwise known as ‘not putting all your eggs in one basket’.

To achieve this, we build multi-asset portfolios for our clients. We combine appropriate proportions of high growth, riskier assets with lower growth, less risky assets. It is equally important to consider how to diversify within each segment. In this article, we consider how to structure the defensive portion of the portfolio to provide maximum benefit.

Introducing Bonds, fixed income Bonds

Our key tool in this role is fixed income, otherwise known as bonds. The term ‘defensive’ in this context means that typically – over a long investment time horizon – fixed income offsets the volatility of equity markets and produces a more stable outcome overall for the portfolio. In times when equity markets fall, fixed income tends to retain its capital value to a greater degree, therefore a proportion of the portfolio held in fixed income provides some downside protection.

You need to be aware, however, that there are certain market conditions, such as unexpected interest rate movements, which can cause fixed income assets to experience significant declines in capital value. Different sub-classes of fixed income have differing sensitivities to these conditions, so we further diversify the portfolio by investing across these sub-classes.

Some studies have shown that longer term bonds have high levels of volatility which are not adequately compensated for by returns. Having a longer time to maturity means a bond is more sensitive to changes in interest rates. The bond is locked into a fixed rate, so if interest rates go up it might look less attractive, while if rates fall it will look more attractive.

However, longer term bonds do provide attractive diversification benefits. They offer an increased degree of certainty of outcomes relative to shorter term bonds. As a result, they sometimes do well in periods of market volatility caused by uncertainty, dependent on the underlying cause of the uncertainty. Therefore, longer term fixed income can provide stronger downside protection in weak periods of equity market cycles.

Examining the evidence

In the chart below, you can see that the UK equity market produced a negative return in 2000, 2002, 2008 and 2011. In those years, 7-10 year gilts produced higher returns than their 5-7 and 3-5 year counterparts.

Source: FE Analytics

In the last 20 years, there have been exceptions to this pattern. In 2001 and 2015 when the equity market was negative, shorter term bonds did better than longer term. In 2015 we suspect this was due to the expectation of interest rate increases.

It has also been observed that longer term gilts tend to outperform shorter term gilts when gilts overall are doing well. Conversely, longer-term gilts underperform when gilts, in general, are producing negative returns. In terms of holding gilts as a defensive asset, this characteristic means that longer term gilts can offer even more protection when it is required – they produce higher returns in periods when bonds do well, i.e. the periods when we would expect equities to do less well.

Dependent on market expectations for certain economic factors, e.g. interest rates, longer term bonds can provide strong diversification benefits for multi-asset portfolios.

Jargonbuster

Our defensive holdings include bonds of all terms in the following categories:

UK Gilts: Typically, the most defensive segment of the fixed income universe for a UK investor is UK government bonds, known as gilts. These tend to hold up well when equity markets are in decline. Being backed by the government, they are considered a ‘safe haven’.

UK Index-Linked Gilts: These bonds have their interest rate linked to inflation. In periods of uncertainty, the correlation between the movement of index-linked bonds and bonds with a fixed coupon rate tends to fall, so they provide downside protection in weak markets. They are also a useful tool in sustaining good portfolio performance relative to inflation and protecting clients’ future spending power.

Overseas Bonds (hedged): Global diversification offers protection from localised interest rate movements. This argues for the inclusion of fixed income across diversified markets despite the currency risk that is introduced, particularly given the wide availability of funds that manage currencies by hedging to Sterling, i.e. removing the exposure to currency movements. The UK bond market tends to be longer term than global markets overall, meaning that it also tends to have higher yields and higher interest rate risk. Relative to the global market, the UK market typically has more government debt in issue and consequently lower credit risk. Global diversification is a useful tool for managing these risk factors.

UK Corporate Investment Grade: This refers to bonds issued by companies that have been rated as Investment Grade by the key rating agencies, such as Moody’s, Standard & Poors and Fitch. This rating means the issuers are judged to have lower levels of credit risk. Given there is always some credit risk compared to governments, these bonds typically offer better returns to compensate. The bonds are issued by companies in any location, but they are all issued in Sterling so there is no currency risk.

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