(July 17): Like many things in life, “defensive” assets do not always behave as promised. But these are particularly unusual times. The Covid-19 crisis has triggered the fastest bear market in history, followed by the fastest initial rebound. Traditional defensive assets provided some protection during the March sell-off, but to a lesser degree than in past crashes. This raises the question as to what constitutes a genuinely defensive asset in the era of coronavirus and beyond.
To answer this, we briefly examine asset class performance during the recent market collapse and correlations between security types. We then consider likely market scenarios, what makes an asset truly “defensive” asset, and how investors can diversify portfolios to better withstand future market evolution.
Traditional assets offered protection through Covid-19 crisis, but not enough
Defensive assets should typically have a negative correlation to risk assets. But the success rate for traditional defensive assets during the March sell-off was mixed.
High quality government bonds (e.g. US Treasuries) did correlate negatively to risk during the sell-off. But compared to previous crises, their capacity to protect was somewhat handicapped by the starting level of government bond yields. With yields now at record lows, we would expect the size of any protection from government bonds to disappoint even more should there be another leg down in markets — unless the Federal Reserve decides to introduce negative interest rates, which looks unlikely at present.
Investment grade (IG) bonds, unlike in previous episodes such as the Global Financial Crisis, did not provide a negative correlation to risk. IG bonds have two main drivers of returns: interest rate duration and spread duration. Historically, the interest rate duration impact (i.e. the fall in the risk-free rate) has more than offset the impact from widening spreads, resulting in the asset class posting a positive return in market crises. This time around, however, given the lower starting level of government bond yields, the interest duration impact was insufficient to offset widening spreads.
Currencies generally behaved as expected during the crisis. If we look at the whole of March, the yen had a negative correlation to risk, though intra-month it was volatile until dollar swap lines were put in place. In terms of the size of the move, the yen worked well as it benefited from attractive starting valuations.
Alternatives presented a mixed picture. Real estate, which often takes time to reflect broader economic troubles, was hardest hit by the lockdown as retail tenants struggled to cover rents. Select volatility-driven strategies, however, did provide a negative correlation.
Possible scenarios: Japanification, some growth or stagflation
While traditional defensive assets such as government and investment grade bonds may continue to offer some protection, it is clear that they will not always prevent capital loss. Instead, investors may need to think more laterally about what “defensiveness” means, and consider other ways of introducing defensive exposure.
A helpful way to think about diversification in the current environment is to consider a range of possible scenarios and then combine elements of protection for each. Here are three we believe could unfold over the medium term:
1) Japanification of US and European markets
Going underweight or short Japanese government bonds in the past two decades is sometimes referred to as the “widow-maker trade” as it was the bet that never paid off: yields have not rebounded. If this type of “Japanification” occurs in the US and Europe, then government bonds should play a more defensive role in portfolios, as the risk of persistently rising bond yields would be remote. In this scenario, interest rate volatility should be kept low, and investors can move further along the yield curve and embrace duration.
Yield curves may have flattened already across many major bond markets, but compared to Japan they have further to go. The Japanese government bond (JGB) yield curve is flatter than the US curve (Chart 1), while absolute yield levels are lower in Japan across the curve, including at the very long end (for example 30- year Treasuries are at 1.5% compared to 0.6% for JGBs). Finally, any rise in yields should be viewed as a buying opportunity, if one subscribes to the Japanification scenario.
2) Low interest rate volatility, with improving US growth and gradually rising bond yields
If growth prospects improve, the need for defensive assets will diminish. That does not necessarily mean, however, that government bonds would be a negative contributor to investors’ portfolios. If the move higher in yields takes place in a gradual manner, with well-telegraphed guidance from central banks, then returns from government bonds will not necessarily be negative as their coupons will offset some of the negative duration impact.
US Treasuries should fare better in this instance as starting yields are higher in the US than in Europe. The higher government bonds yields move, driven by better growth prospects, the higher their ability to provide better downside protection; as such, their defensive role should be reinforced for every upwards move.
3) Stagflation — rising inflation with no growth
Stagflation (a period of high inflation and stagnant demand) is most likely to be driven by “bad inflation”, via a weakening currency or supply shortages. This is because “good inflation” (i.e. wage growth) usually occurs when the economy is expanding. Stagflation is the worst outcome for government bonds, as correlations between government bonds and equities could rise and diversification benefits would disappear. Central banks would be forced to raise rates as inflation targeting is typically their foremost objective. If they had to lift rates rapidly, government bond returns would be negative.
Central banks may try to avoid raising rates due to fears that higher rates could push corporates and governments into default, given record debt levels. If rates do not rise, there would be a limited negative impact on performance from a duration perspective (as yields will not rise); but investors would still be worse off in real terms as the value of their assets would depreciate every day that inflation ticked higher. While nominal government bonds could struggle in this scenario, inflation-linked bonds or inflation break-evens should offer some protection.
What constitutes a truly defensive asset?
Finding a truly defensive asset that works in any scenario is no easy task. Recent months have demonstrated that, while asset classes exhibit a range of different risk characteristics, it is perhaps insufficient bluntly to label any asset “defensive” without context. Indeed, asset classes may exhibit defensive characteristics at different times, under different conditions and to different degrees. Some offer stronger elements of absolute defensiveness (i.e. the avoidance of capital loss), while others offer relative mitigation (i.e. less pronounced drawdown versus other asset classes).
To build a strategy that can meet objectives over multiple market cycles, we need to look beyond the simplistic “risky/defensive” dichotomy to understand the drivers of individual asset class behaviour, and the effects created by combining them in a portfolio. Combining assets with different triggers for defensiveness, such as moves in rates, liquidity and correlations, can help to increase overall portfolio resilience.
Asymmetry of risk and return is key, so we believe in taking investment positions which exhibit higher upside potential than downside risk. While it is impossible to predict the future, it is possible to hypothesize how the different asset classes might react and interact in the deflation and stagflation scenarios set out above, based on a variety of factors.
Building defensiveness into portfolios with the aim of protecting capital
There are a number of ways to build defensiveness in a portfolio with the aim of capital protection, using asset classes or strategies which all (in their own way) have defensive elements.
- Government bonds: Look beyond US Treasuries
For example, if we assume a risk-off Japan-style scenario, government bonds in developed markets such as the US may continue to behave defensively. And if the Fed changes its mind on negative rates or moves to yield curve control, then the diversification role of Treasuries may become more meaningful than it is now.
But to capture the magnitude of the negative correlation nearer-term, consider other developed markets or Chinese government bonds. Yields for the latter remain attractive compared to US Treasuries and have different drivers.
- Leverage: Not just about adding risk
Another way to achieve greater magnitude is to use leverage. Historically, leverage has typically been dialled up to enhance return or yield characteristics, adding degrees of risk to a portfolio overall. But, in future, more investors may consider using leverage to boost the potential defensiveness of traditional asset classes such as Treasuries during an equity and credit sell-off. This type of strategy is not new, though more leverage may be required than before to achieve the desired result, increasing the potential risks if yields spike. Nonetheless, it may allow investors who are comfortable with Treasuries to hold onto them, while increasing the potential for a defensive response.
- Pair trades: Asymmetry of risk/returns
Investors can also use techniques such as pair trades. These aim to capture relative value and can provide attractive risk/return characteristics. One example might be going long on a less risky government bond, while going short on a more vulnerable government bond, perhaps in an emerging market. However, this only makes sense where the risk/reward ratio is asymmetric — heavily skewed in favour of the potential upside, but simultaneously limiting the downside.
- Currency: Depends on the base
Currency hedging can be a quick and easy way to manage exposures in a risk-off environment. Being long the US dollar worked well during the crisis, given the dash for dollars early on. But for investors who believe it may now be over-stretched, it could make sense to go long areas such as the yen and the Swiss franc, depending on a portfolio’s base currency. Currency markets can move swiftly, however, and are often first to react to major events; so this is a risk that has to be actively managed.
- Commodities and alternatives: Look for non-conformers
Gold may have a role to play in steadying the ship; it has recovered well since it was hit by the dollar liquidity squeeze in March. It could prove equally useful as a store of value if there is stagflation.
Where investors can access alternatives, it is worth finding those that do not conform to risk asset patterns directly or in combination with other assets, but also being selective as each may have different defensive properties. Being long volatility and out-of-the-money put options (the right to sell a stock or bond at a given price) would have helped during the sell-off, but it is important to consider the cost/benefit ratio of these types of hedges — they can be expensive.
Building relative defensiveness through the use of risk assets
Not all defensiveness is about protecting capital in absolute terms; sometimes it can be relative. Long-term investors often prefer to maintain risk exposures during temporary periods of stress, so defensiveness for them may be less about absolute drawdown prevention, and more about defensiveness across their portfolio and through time.
This may include an allocation to defensive equities such as those with lower beta or good cash flows, which typically fall less than cyclical stocks when markets plunge. In the latest crash, there was a clear bias towards quality, and companies with higher environmental, social and governance (ESG) scores outperformed those with lower ones. Riskier assets may also outperform one another on a relative basis. So while neither equities nor high yield bonds are classed as defensive, combined in a particular fashion, they can offer defensive characteristics.
From Feb 14 to March 23, during which the sharpest sell-off took place, high yield bonds fell 63% of the drop in equities. During the shorter sell-off on June 11, high yield captured just 25% of the downside. While this is a very short time period for comparison, it demonstrates that liquidity is good for both equities and credit on the way up, but a lot more beneficial for credit on the way down, as this time the Fed is buying corporate bonds and providing a backstop.
So securities with asymmetrical risk profiles can also reduce risk, even if long/short positions are taken in asset classes that are not themselves low-risk or defensive. For example, an investor could go long a defensive equity sector, and short a cyclical one. “Defensiveness” does not always come from exposure to nominally defensive asset classes, and pair trades can offer defensive opportunities across the risk spectrum.
Conclusion
Diversification is as important within a defensive allocation as it is across the whole portfolio. No asset is absolutely defensive all of the time, and investors may need to hold more than just the couple of traditional defensive assets they would have had in the past, to achieve the type of negative correlation they need.
In the current era of low rates, investment grade is unlikely to offer the magnitude of protection it has previously and parts of it may be exposed to defaults in sectors worst hit by the pandemic. So while higher quality corporate bonds can offer some defensive risk in a portfolio, they are unlikely to merit the same weighting as before.
Instead Chinese government bonds, safe haven currencies, select alternatives, defensive equities and long volatility plays all have a role in increasing the defensive nature of portfolios over the medium term. Much will depend on individual requirements, and whether investors are seeking absolute defensiveness (e.g. via an absolute return product) or defensiveness relative to other asset classes, benchmarks or long-term investment parameters.
As the economic data hardens over the coming months, and perhaps some emergency stimulus is rolled back, markets may lose some of their enthusiasm for risk. At the same time, some economies are re-opening and managing the threat of further outbreaks much more effectively than others. Having an all-weather portfolio can help navigate this unprecedented time. That may mean holding some traditional assets, but also thinking laterally about which other assets are truly behaving defensively, to what degree and when.
George Efstathopoulos is a portfolio manager with Fidelity International.
