Investing 101: Positioning Portfolios to Invest Defensively

POSITIONING FOR PORTFOLIO DEFENSE

Characterised by generally lower risk and lower drawdowns compared to other asset classes such as equities, fixed income assets can potentially offer reduced risk for the trade off of lower, albeit usually more certain, returns.

We look within the fixed income asset class to highlight which characteristics of fixed income assets can help to make multi-asset portfolios more resilient.

DIVERSIFICATION IS IMPORTANT

Diversification can benefit portfolios as it reduces risk and extends exposure to multiple return drivers. Visually, if we plot the returns possible from investing into differing combinations of two different assets (in the chart: US Equities and Intermediate-term US Bonds), then we can see that by holding a combination of these assets, it’s possible to achieve better risk-adjusted returns than by investing into either asset alone. Indeed, points on the curve of possible portfolios to the left of the 100% allocation to bonds offer both higher returns and lower risk.

DOWNTURNS AND LONGER-TERMS

This effect is amplified for longer-term bonds, which have been shown historically to have lower correlation to equities than shorter term bonds during equity market downturns.

We see this here in the increased curvature of the line showing the possible combinations of US Equities and Long-dated US Bonds below.

Source: CPB Global Investment Lab, Bloomberg. Data: 31 Jan 2000 to 28 June 2024. US Equities is the S&P 500 net total return index. US Intermediate-term Bonds is the Bloomberg US Treasury 5-10 Year Total Return Index. US Long-term Bonds is the Bloomberg US Treasury 20+ Year Total Return Index.

HIGHER CREDIT QUALITY FOR LOWER EQUITY CORRELATIONS

Credit quality is another characteristic to consider for defensive fixed income investing. All else equal, higher credit quality assets tend to be less sensitive to market movements, with lower volatility and lower maximum drawdowns. They tend to have lower correlations to equities, thereby increasing diversification in a multi-asset portfolio.

The chart below shows the historic correlations of US fixed income assets of varying credit quality to US equities.

Source: CPB Global Investment Lab, Bloomberg. Data: 31 Jan 2000 to 28 June 2024. US Equities is the S&P 500 net total return index. US Treasuries is the Bloomberg US Treasury 5-10 Year Total Return Index, US Investment Grade is the Bloomberg US Corporate Bond Index, US High Yield is the Bloomberg US Corporate High Yield Bond index.

US Government debt, or US Treasuries, are the highest credit quality of the assets shown and showed the lowest correlation to US equities – consistently zero or negative. US Investment Grade corporate debt has a higher risk of default than US government debt but is still regarded as high quality with a relatively low risk of default and showed higher, but on average low correlation to US equities. US high yield corporate debt is the lowest credit quality of the three assets, with the highest risk of default and showed consistently high correlation to US equities.

Diversification does not ensure profit or protect against loss.

For all charts: Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary.

Correlation: The extent to which the values of different types of investments move in tandem with one another in response to changing economic and market conditions. Correlation is measured on a scale of -100% to +100%. Investments with a correlation of +50% or more tend to rise and fall in value at the same time, while investments with a negative correlation of -50% to -100% are more likely to gain or lose value in opposing cycles.

Find out more on Diversified Income Strategies (DIS) from your banker.