Dampening downside risk during a global economic downturn requires active management and informed decisions, writes Justin Tyler.
Australia is in its first recession for 29 years, and for many investors, this is the first time they have had to navigate this investment environment and construct a defensive portfolio that can weather a bear market.
An added challenge for investors is that finding assets that can both mitigate risk and provide consistent returns is more difficult than ever.
Balanced portfolios have traditionally relied on having a mix of growth and defensive assets, which outperform at various times in the market cycle. However, in recent years the negative correlation between equity and bond prices has been stripped away, as prices often rose in tandem.
Given the current ultra-low interest rate environment, this has created a dilemma for asset allocators, who are concerned about market volatility and declining dividend yields but are having to pay increasingly high prices for low-yielding bonds. When bond yields are low, as they are today, they deliver less income and become inherently less defensive.
One of the key reasons for the current high prices of many bond investments is the dislocation between global economies and markets.
In recent years we have seen a number of market-changing events that have combined to slow growth in developed economies – coronavirus, the US-China trade war, Brexit – the list is long. This has resulted in more cautious behaviour from both consumers and businesses, and low interest rates have failed to stimulate demand.
However, this risk aversion has not been reflected in asset prices and for many it is hard to reconcile the high pricing and resilience of equity and bond markets with the economic damage brought on by the pandemic.
In its Global Financial Stability Report, the International Monetary Fund (IMF) recently noted the gap between the bullish mood among investors and the huge uncertainties about the extent and speed of economic recovery.
The IMF cut its forecast for 2020 global economic growth, saying the pandemic has had a much stronger negative impact than previously thought. This highlights the increasing importance for investors of managing downside risks in their portfolios.
Historically bond duration, a feature of longer-dated bonds such as government bonds, has played a crucial role in portfolio construction and diversification, with long-dated bonds typically performing well in periods of market stress and volatility.
However, unconventional monetary easing programs across the globe have stripped away the supply of duration from US bonds markets, making sovereign bonds historically expensive and lowering yields. In fact, in many cases the returns on offer do not even match inflation and in a few countries around the world investors are now committing to receiving zero interest.
So, if equity markets are risky and traditional ‘safe-haven’ assets are not providing the security they once did, how can asset allocators best manage the risk in the current market?
An active approach
We believe long duration as a mainstay of a balanced portfolio needs a rethink. With yields so low on long-dated bonds, it simply doesn’t make sense to commit to locking up capital for a decade or more.
Instead our analysis shows there is a compelling case for asset allocators to reduce equity allocations in favour of cash and short-term corporate credit. This is particularly relevant for those seeking more reliable income without taking on significantly higher risk, which is possible.
While investors may be tempted to try to build their own portfolios of fixed income securities, the fixed income universe is enormously diverse and, in many cases, trading is done over the counter, making pricing less transparent than in equity markets. Bond investment is about avoiding losers – not picking winners – and therefore holding different types of bonds is critical.
Bond investments also come with interest rate risk and credit risk (or the risk of a borrower defaulting on its debt obligations), so simply investing in the highest-yielding assets at any given time can be a flawed approach which does not justify the risk being taken.
In our view, it is possible to create a defensive bond portfolio in these challenging markets, but this requires an active, diversified approach to assessing and managing risk.
Active managers can not only identify opportunities when markets are volatile but also have the skills and know-how to identify signs of distress that may impact a borrower’s ability to repay debt. As the economic downturn continues, the importance of understanding credit risk will only increase.
In addition, diversification as a means of risk management should be on the mind of all investors. Currently, one of the greatest challenges for bond investors is finding assets with a negative correlation to equities at a reasonable price. Therefore, it is increasingly important for investors to hedge equity exposures with a wider range of defensive asset classes.
A well-diversified bond portfolio should include a number of sectors and regions to mitigate the downside risk if something goes wrong. Investors who do diversify can earn their target yield without risking a sizable portion of their capital.
Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.