Investors will need to consider a range of strategies to ensure their portfolios remain resilient and able to withstand any changes in the market.

Originally featured in The Australian, published 11 December 20222

Financial experts agree that defensive investment strategies can help to weather difficult economic times such as the one we are currently experiencing. With bond yields restored after the interest rate hikes of 2022, and as the market headwinds shift from soaring inflation to fear of recession in 2023, fixed income could become home for investors looking for a safe haven from risky assets.

Fixed rate bonds are simply a legal IOU where an investor loans money to a government or corporate group in exchange for a predetermined interest rate of return. During the life of the loan, the government or company promises to pay a fixed amount of interest at specified times and return the initial loan amount at maturity. The government or company’s creditworthiness matters: the lower the credit rating, the riskier the investment. A lower-grade/higher-risk bond pays higher interest rates to attract buyers and to compensate for the higher chance of default. But this additional return is not without risk. Should that individual firm encounter financial stress, it may decide not to make good on its obligations. Highly rated governments, in contrast, are positioned to collect taxes from its citizens.

If bonds are held to maturity, all the financial outcomes are known ahead of time – when the cashflows of interest will be paid, known as the coupon, and when the original amount of the bonds will be repaid on maturity date, assuming no credit risk.

While many assets are marketed as being defensive, few actually remain defensive over time in different and difficult market conditions. In times of market stress, many assets can experience less liquidity. Some seize, or a fund’s structure of assets can become gated or frozen for a period, and have a higher chance of default.

High grade bonds, being explicitly backed by the Australian governments, have a low chance of default, and higher levels of investor protection. This is a key distinguishing feature of high grade bonds versus other lower quality corporate bonds with more credit risk which pay a higher return in compensation for the additional credit risk.

While corporate bonds may underperform in periods of stress, once the compensation of additional return – known as credit spread – is sufficient they remain highly investable as part of a diversified portfolio.

The economic and monetary cycle is typically divided into four stages: expansion, peak, contraction, and trough. Understanding which part of the economic and monetary cycle we are in is helpful for asset allocators to set their weightings to each fixed income sub asset class.

Bonds can play a number of roles within a balanced portfolio, providing income, with certainty of outcomes upon the bond’s maturity, while also providing enhanced liquidity. This provides investors with portfolio optionality in moments of peril to make dynamic adjustments to their portfolios. The large equity sell-off in early 2020 on Covid-19 concerns was a great example where high grade bonds held up well, allowing investors to move into deeply discounted equities for great profit as equities recovered.

Over time, high grade bonds earn the majority of their return from compounding income. This design means in different interest rate environments, the asset is self-rebalancing.

Bond prices and interest rates tend to have an inverse relationship to each other. Put simply, they tend to move in opposite directions. So, when interest rates rise, a bond’s price tends to fall (and vice versa). For example, if you held a bond that pays a 4 per cent interest rate, and interest rates rise, that original 4 per cent does not look as attractive when compared to other market offerings available, making the bonds less valuable at that time should you wish to sell it. If held to maturity however, the bond will continue to deliver a 4 per cent return.

A good way to estimate a bond’s potential change in price is its duration, which represents the average time for an investor to regain their funds.

The price of a bond with long-term cashflows will tend to have more interest rate sensitivity than a bond with nearer-term cashflows. A higher duration means an investor needs to wait longer for the bulk of the payments and, consequently, the more its price will drop as interest rates rise, or the more its price will rise if interest rates should fall. It is important to realise that these are not permanent gains or losses, and do not affect the income return of the bond. They are just short-term price volatility.

Investors primarily use duration in three ways. Firstly, duration can play a powerful role in protecting portfolios against cyclical economic downturns – something which has been earmarked as a 2023 possibility. Secondly, duration can diversify against risky asset exposures – shares and property – and cushion more volatile assets. Thirdly, duration can provide a good store of liquid income – an attractive feature given the recent rise in yields.

Duration risk as it’s well-known, has a role to play in portfolios. In a positively sloped yield curve environment – where investors are compensated for the time value of money, and which tends to be most prevalent in markets – investors get paid to take duration risk.

In an environment where interest rates are falling, this also provides a tailwind to performance of long duration assets, as the guaranteed higher coupons become highly sought after in a lower interest rate world.

Bonds also have a flight-to-quality element − in periods of high economic uncertainty and volatility, some investors move capital into higher quality fixed income for the certainty of outcomes.

As we have seen this year, uncertainty has weighed heavily on markets and generated extreme volatility across asset classes. As we enter uncharted territory, investors will need to consider a range of strategies to ensure their portfolios remain resilient and able to withstand any changes in the market. Finally, investors should stay informed and remain vigilant of potential changes in market conditions and adjust their portfolios accordingly.