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Zenith’s ultimate guide to rebuilding defensive portfolios

Bonds spent the past few decades earning a reputation as the go-to hedge to equities. Since 2022, that reputation has been tested (see chart below). The negative correlation advisers and investors built portfolios around proved not to be as structural as previously thought, but instead, dependent on inflation, interest rates and geopolitical uncertainty.

So, are bonds broken? Are they still good diversifiers for stocks? Or do advisers need to be looking elsewhere to “diversify their diversifiers”, as one guest on this podcast suggested?

According to Zenith Investment Partners’ Head of Portfolio Solutions, Andrew Yap, bonds are not broken - in fact, today’s environment actually has real uses for bonds.

“[Post-COVID] in Australia, we went from 0.1% to over 3% in a very short time, and that was disastrous for bonds and marked really significant losses,” he says.

We’re in a different environment now, he argues, with the Reserve Bank keeping rates on hold at 4.35%, and Australian bonds now yielding around 5%.

“Most of the market believes we're towards the latter part of the rate-hiking cycle as opposed to the beginning. And as such, with the yields that we have on offer, this is a great time to start reconsidering traditional bonds as an income stream,” Yap says.

Bonds are now “defensive” thanks to the coupon, rather than negative correlation.

"In an environment where you have a big selloff in equities, those risk-off environments, that income that you are getting, that stable coupon, really can help to cushion those drawdowns,” Yap adds.

Cockroaches in credit?

Post-2022, when both stocks and bonds sold off simultaneously, advisers started looking elsewhere for defensive yield. It’s seen private markets, and in particular, private credit, explode in popularity and, with that, some “cockroaches”, as Jamie Dimon suggested, enter the playing field.

According to Zenith’s Head of Alternatives and Global Fixed Income, Rodney Sebire, the noise we are seeing in the media is overblown, though he enjoys Dimon’s creative phrasing.

"The perverseness of Jamie Dimon's comment is that people are concerned about private debt," he says. "But the private lending market is a sponsor-backed market, so it's all private equity. Everyone's sitting there with their private equity exposure thinking everything's absolutely fantastic, and we're worried about private debt."

Zenith has run the numbers on the widely covered risk of a software-led credit crunch. A borrower would need to lose more than 60% of its EBITDA over three years before the equity is wiped out - and only then does it become a debt problem.

"I think we’re pretty well protected. Three years is a lot to wipe out 60% of your business,” Sebire says.

A risk advisers miss

While worries of a systemic cataclysm in credit may be overstated, manager-selection risk should still be on your radar.

Sebire recommends that advisers question returns that sound too good to be true (beyond 10-11% on vanilla corporate lending), be wary of internal trustee structures that offer no investor protection, and be “relentless” in chasing diversification across positions and sectors.

"There's too much time spent on the return side of the equation, and not enough time on the risk side… Just approach it with the lens that there's no upside from this asset class. I’d just be relentless in chasing diversification. I'd much rather have a hundred loans at 1% versus 15 loans at sort of 6.5%,” he says.

Yap frames the same problem from the other end of the portfolio.

"I always think about equities as a risky asset class," he says. "If I think equities through time will give you 8% or 9%, and I'm getting a higher return from a debt instrument, what are the risks inherent in that? Am I getting appropriately compensated? And are these levels of risk appropriate for a particular investor or cohort of investors?"

Spoiled for choice

For all the noise in defensive assets right now, both Yap and Sebire remain optimistic - arguing that investors today are “spoiled for choice”.

"We've got a new interest rate regime where cash rates are far higher and yields on portfolios are at their highest level in over 10 years. That's an exciting environment in which you can start thinking about rebuilding a portfolio, repurposing it so that it does have some of those defensive traditional qualities,” Yap says.

Sebire agrees, and points to how much narrower the toolkit used to be.

"20 years ago, it was just some basic composite bond strategy, and your Aussie versus global split was your only real lever,” he says. “We've had so much innovation that you can almost now pick your return target or your excess return target, and we can build a strategy that achieves that in the most efficient way.”

5 insights on building defensive portfolios

1. Flat unit price ≠ zero risk

Private credit funds don't reprice their loans daily the way a bond fund reprices its holdings. The loans are carried at cost, and the income accrues, so the unit price tends to sit flat, which is a lot of the appeal after 2022, Sebire says. It doesn't mean the risk isn't there. It means losses show up as occasional write-downs rather than as day-to-day movement.

2. The illiquidity premium is about 1%

That's what Sebire says the market pays for not having unfettered access to client money. Above that, the gap has to be explained by leverage, capital structure position, or sector mix. He argues that nothing is mispriced in private credit - borrowers don't pay more than they have to.

3. Platforms force private assets outside of managed accounts

Daily liquidity and daily unit pricing rule out quarterly-redemption vehicles, so advisers often have to run a separate portfolio of private assets alongside their managed accounts. Yap's warning is about reporting - it’s hard to get cut-through and hard to see aggregate listed and unlisted exposures at the same point in time, which is why managed account providers are getting creative with new structures.

4. Currency hedging is the biggest structural challenge in private credit

The AUD is pro-cyclical, so a risk-off selloff hits hedges while the underlying assets are illiquid and the master fund is offshore. Managers roll losses at historical rates or draw on leverage. Often this means that managers will not be able to treat investors equally.

5. Australian duration is particularly attractive right now

With the RBA at 4.35% and the Fed at 3.5–3.75%, Yap says Australian starting yields screen better than the US. It’s a small win for Australian bond investors, and it’s reflected in Zenith’s portfolios.

Join us for the FinFest Exclusive Preview

FinFest is shaping up to be the biggest thing we’ve done at Equity Mates. 2,500 attendees, five stages, food trucks, bars and a full day of content for Australians of all investing levels.

The day before, we’re hosting a preview of financial advisers. You’ll be able to see the full FinFest set-up before anyone else, watch us interview Joe Aston, and hear six fund managers pitch their best ideas to a Shark Tank-style panel of experts.

The event is free for financial advisors to attend.

There are limited spaces, so you do need to reserve your ticket at: https://www.finfestevent.com/Industry26/

Zenith Investment Research: Informing more confident investment decisions

Australian advisers are turning to Zenith’s investment research for its depth, breadth and accessibility. Zenith empowers you to compare funds, track performance, deep dive into different market sectors, model portfolios and keep up to date on market trends - all through one easy-to-use portal.

You’ll have access to broader investment research coverage, tap into trusted insights and feel better equipped to make more informed investment decisions for your clients.

To find out more, visit https://www.zenithpartners.com.au/access-leading-investment-research-today/

In case you missed it

Last week, we explored the undiscovered world of royalties with Partners Group’s Stephen Otter. In this interview, we dive into the opportunity in royalties today, what advisers get wrong about the asset class, and perhaps the most perplexing question of all - why so few investors have exposure.

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