Fortify your portfolio

PORTFOLIO POINT: Properly constructed, your portfolio can be safe in all weather.

Extreme volatility in markets around the globe will drive many investors to consider adding to the defensive component of their portfolio without first determining whether its construction is as strong and well-built as it can be.

Australia’s equity market-oriented investment culture has empowered many DIY investors and advisers to confidently construct the growth part of their portfolio from shares, listed investment companies and managed funds.

But when it comes to creating truly defensive investment architecture, many lack the understanding of how to do that properly. By relying solely on bank deposits for this exposure, many Australian investors miss out on additional defensive return and become vulnerable to falling interest rate or inflation surprises.

Today I want to present you an outline of an all-weather combination of defensive investments that will help steer your portfolio more safely through tricky periods in financial markets such as those we are in right now. To make things crystal clear the defensive part of your portfolio should:

• Help you sleep at night, diluting the volatility inherent in growth assets such as shares.
• Reward you with a steady and regular income even if interest rates fall.
• Not overly penalise you if interest rates rise.
• Appreciate in value when the prices of equities fall.
• Provide ready reserves to rebalance your portfolio or meet surprise cash flow needs.
• Preserve its purchasing power in a rising cost environment.
• Deliver both a return of capital, not just a return on capital.

As you can probably appreciate, this wish list is never going to be achieved by one single investment including bank deposits. To fulfil these criteria you need to assemble a mix of related defensive assets, as shown in the configuration below.

You will perhaps find it fitting that the diagram is reminiscent of the symbols for peace (as popularised by the anti-war movement) and wealth (the Mercedes-Benz badge). Note that the portfolio incorporates three core and one optional component which I will explain over the following paragraphs.

Floating rate investments

Floating rate investments are needed to: reduce your overall portfolio’s volatility (or fluctuations in value which retiree investors can ill-afford (click here); provide important liquidity; and profit from rate rises. Investments in this part of the portfolio include at-call bank deposits, bank bills, short-term notes, floating-rate high credit quality bonds, or cash or bond funds that buy and sell these instruments.

But what is perhaps more important are the types of investments that I would not include in this list. They include term deposits of more than a year in duration because of the locked-in rate and consequential lack of liquidity. Also, I wouldn’t include floating rate hybrids and other income securities traded on the ASX because of their fluctuating prices or “capital insecurity”.

Because your income varies with changes in interest rates, these investments underperform when interest rates fall. Further, they don’t guarantee to preserve purchasing power, which is why we need to turn to other defensive investments to make sure you have the all-weather protection your finances deserve.

Fixed rate investments

There are at least three reasons for adding fixed interest-rate investments to your defensive portfolio. First, they help stabilise income and lock in a higher yield if interest rates fall. Without doing so defensive investors simply trade “equity risk” for “interest rate setting risk” or the risk that Reserve Bank governor Glenn Stevens and his committee decide that you don’t need the income any more.

Second, they should deliver a higher yield than what is available from short-term investments. Traditionally this has been about 1% or so more, but while banks have been hungry for deposits it can be less.

Third, they can help your overall portfolio during times of distress by increasing in value including if interest rates fall. This dampening effect creates profits to use to buy back shares often at “fire sale” prices. In a previous article (click here) I showed that doing so added an extra 1% to an overall portfolio’s return over recent years through disciplined rebalancing.

The kinds of investments that fit into this category include multi-year term deposits, fixed rate bonds and funds that invest in the latter. In this part of the portfolio I would limit investments to only high credit quality (say A or AA rated and above), otherwise you might find that those investments go down in value rather than up in bad times, owing to fears about default as they did during the GFC.

While term deposits meet our first two criteria, they don’t work to push up your portfolio value in times of falling interest rates – they just hold their value, which admittedly is still pretty good. They also aren’t liquid or accessible (without penalty) to help you profitably buy assets that have declined in value. I would avoid locking into more than a one-year term deposit as the tradeoff for a meagre incremental 0.1–1% increase in yield is too great. Instead, I would invest in bonds or bond funds where you can exit through resale or redemption respectively. A bond fund also allows you trim your position as your needs and opportunities change.

As a starting point you could look at bond funds that seek to mimic the returns from a basket of bonds making up the UBS Australian Composite bond index such as that offered by Vanguard Australia. At the moment the average maturity of bonds held is 3.7 years, which offers you some downside income protection if interest rates fall.

Some investors and advisers recommend maintaining a laddered like series of different duration term deposits to prefund retiree living expenses over, say, the next three to five years (often called riding the yield curve). This strategy prefunds medium-term expenses allowing other parts of your portfolio to target longer-term growth. If during that time inflation and interest rates rise then new term deposits bought for future years will benefit, albeit in a delayed fashion.

One should always be careful concentrating your funds in any investment or institution, even a bank. Defensive investors should spread their money around, and if they don’t have enough funds, into one or two quality bond funds which in turn invest in 50 bonds. Losing or losing access to one of those bonds in times of distress would only hurt 2% of your capital, not all of it.

Inflation linked investments

While unfamiliar to many, inflation linked defensive investments are a critical component of your defensive strategy. If you think about it, most people invest defensively to preserve the purchasing power of their money, but do so by investing in floating or fixed interest rate investments. However, there is no guarantee that interest rates will compensate you for rising inflation and there are times in our history (click here) and places overseas right now where this doesn’t happen.

A second reason for including inflation-linked investments is that it gives you a safer way of getting higher yield from long-duration investments. I feel much more comfortable locking into a CPI 3.5% annual return than a fixed annual rate of return of 7%. Often the incremental yield from a long-term nominal fixed rate bond is not enough of a reward. How do you feel about locking your money into a 30-year US Treasury paying 4.5%?

Fortunately, there are more and more options available for inflation linked investing today than there have been in the past. You can buy such direct bonds yourself through a bond broker (although mostly in $500,000 lots) or in small lots issued by the Commonwealth from the RBA small investor bond facility (click here). You can also invest in a handful of Australian inflation linked bond funds and even a novel term deposit. Various term annuities which pay a CPI-linked income can also be purchased. Please see my earlier note summarising many of these options (click here).

Putting these three elements together, you can see from the below figure that in the five weeks since July 1, cash held its value (increasing slightly with earned interest) while both nominal fixed interest and inflation linked bonds rose in value by about 4% and 5% respectively. By including bonds in your portfolio you would have counteracted the amazing 15% fall in share prices but I don’t recall seeing any headline in the last few days proclaiming “Bonds Rally 5%” or “Bond Investors Win $100 billion”.

Optional high-yield investments

While most investors should consider using only the above three components, investors prepared to take a “walk on the wild side” could consider including higher yield bonds and income securities. The need for caution is obvious when you realise that “high yield” is just another term for “non-investment grade” in the bond world. High yielding investments are those on issue by companies whose financial strength is now or was suspect, or is constructed so that the investor has less protection in times of default.

Controversially perhaps, I consider hybrid income securities issued by our AA rated banks in this class of investment since: those securities rank just above equity in event of a windup; and their prices fluctuate significantly on the ASX. Previously, I have suggested that investors would be better off “building their own hybrid” by splitting their money between bank deposits and bank shares than by investing in their hybrid security (click here).

I would also include investments in mortgages in this category. Unfortunately for those still in frozen mortgage funds, this higher-risk characteristic was probably not well understood. Sophisticated investors also have access to securitised loans cut up into different tranches of credit quality and maturity, however parts of these look similar to what kicked off the GFC in the first place.

Michael Milken went on to become the junk bond king of the 1980s after citing academic studies that suggested a diversified portfolio of low-quality bonds can reward investors sufficiently for the extra risks taken – most of the time. In my opinion most would be better to get their extra return from having additional exposure to growth assets and enjoy a more rock-solid defence. However others may disagree and in 2009 a lot of smart people made money speculating in unloved income securities. As high-yield investments can come in both floating, fixed and inflation-linked elements, I’ve included this as an optional ring around our first graphic.

Looking forward it is very difficult to work out whether the road ahead includes rising global interest rates to fight inflation, falling Australian interest rates to stimulate the economy, high inflation without rising interest rates or perhaps something else we are yet to consider.

As a consequence, I suspect you can achieve an enhanced degree of peace and harmony from your defensive investments by maintaining an equal one-third combination of floating, fixed and inflation-linked defensive investments. If interest rates rise, your floating rate investments will profit. If they fall, then your fixed-rate investments will perform. If interest rates don’t match inflation, then the latter linked investments should deliver.

Australian investors have enjoyed decades of strong equity returns, which have unfortunately led many to ignore the relative merits of bonds and related investments. Unfortunately in these challenging times, many DIY investors and professionals need to understand how different defensive investments work and how to assemble these to work together in a portfolio. I wish you all peaceful investing!

Doug Turek is managing director of family wealth advisory and money management firm Professional Wealth.