As we all know, when it comes to the world of investing, there are investments that are not too risky, and other investments which are terribly risky (and plenty in between). Which definition of "risk" you use will also determine how risky you view an investment opportunity. The benchmark "risk-free" asset in the world has traditionally been US Government securities, but with returns on these not even matching inflation, not to mention the risk of default growing, the way the world see's risk is starting to change, especially when looking at lower risk investments, or defensive assets.
The main types of defensive assets are (ranked somewhat in order of riskiness):
- Cash (Australia) - With the deposit guarantee still in place for deposits under $250,000, and with global economic imbalances still a worry, not to mention Australia's relatively high interest rates, cash is very much king. This includes term deposit rates and other high yield deposit accounts on offer from Australian banks. However, lower rates may start to cause greater concern, especially if inflation was to start running up.
- Sovereign Bonds (Developed World) - Just 4 or 5 years ago, developed world Government debt was seen as risk-free with no chance of default. Enter Europe. Without the easy escape chute of money printing Greek debtholders were forced into haircuts, and Spain and other European nations are getting closer to the default precipice as well. Of course, even with the option to turn on the printing presses (e.g. US, Japan and now Europe), and though default may be averted, currency devaluation may end up eating away any real return and capital. Australian Government Bonds may be one of the only exceptions to this, even though yields have fallen considerably over the past few years.
- Other Investment Grade Bonds - Both highly rated corporate debt (including some hybrid securities), sub-Government debt, emerging market sovereign bonds and asset-backed securities fit into this area. With balance sheets being fixed over the past few years (corporates) and the further deregulation and transparency taking place (emerging markets), this has been a growing focus for bond funds and pension accounts. Also, post-GFC, asset-backed securities, including residential mortgage-backed securities (RMBS - one of the main catalysts for the GFC) have recovered and are being structured, rated and priced much more prudently. However, not all is rosy in this sector, with some local and state Governments moving towards bankruptcy (particularly in the US).
- Junk Bonds - This mainly includes non-rated or less secure debt issued by corporates. This would also still include Greek Government debt. Even though things have settled down somewhat in the world following the credit crunch, these bonds still have a relatively high probability of default and loss of capital, with high yields to entice (especially with recessionary pressures increasing and sovereign debt crisis in Europe still ongoing).
- Property - This is not a defensive asset. Even though we have all witnessed massive property crashes in the US, Spain, Ireland many Australian investors would still bet on property to not go down. This may be a delusion (probably due largely to the infrequency of price data), and in the long run house prices are expected to moderate to be closer in line with disposable incomes. Also, considering most gear up to 80-100% to invest in property, the risk of this type of investment is large and should definitely not be considered an asset that cannot lose value.
- Gold - Seen by some as a defensive asset, especially considering its propensity to increase in value in times of credit distress and currency devaluations (or inflation).
- Defensive Shares - Though seen to be more defensive than other equities, defensive stocks will still move in line with general market conditions, though with somewhat less volatility. These shares include for the most part consumer staples (food, supermarkets), infrastructure, telecoms, healthcare, alcohol and tobacco industries (i.e. businesses whose profits tend not to decrease in recessionary environments).
Overall, defensive assets ideally have the following traits:
- Low risk of permanent capital loss
- Positive returns when shares go down (i.e. negative correlation to shares)
- Stable and moderate level of income/capital growth
So you'd want these types of assets to give you some sort of gain, with no real chance of making a loss and also to give your portfolio an extra boost when times are bad (e.g. equity bear market). And a combination of these (particularly the top 3 - cash, bonds, investment grade debt) is likely to provide your portfolio with a robust defense for when times get rough. Cash meets 2 of the above traits, but has zero correlation with equities, in that cash does not go up or down in price. Government bonds have traditionally been the main asset class portraying all 3 of these defensive qualities, and investment grade debt has also shown all 3 of these qualities at times (though correlations tend to be slightly positive).
However, in today's environment, it is becoming increasingly more important to analyse which types of defensive assets to include in your portfolio. One outcome of the current quantitative easing that is taking place in most developed nations is the extremely low yield on Government bonds which has led to a strong rally in the price of short and long-dated bond issues over the past few years. The result of all this is the dampening of negative correlations with equities, meaning that should we suffer another macroeconomic shock, Government bonds may not be able to help much to offset losses. Worse yet, bond prices may even fall.
Consequently, cash (incl. term deposits) and investment grade bonds have become of much greater importance to those both seeking yield and low correlation with equities. In the US, UK, Europe and Japan, where cash rates are basically 0%, AA-to-BBB rated corporate bonds are in particular high demand (along with Australian and emerging nation sovereign bonds). The only benefit of putting money in the bank in these countries (as opposed to under the mattress) is really for security. But in Australia, where banks are still offering attractive rates for deposits, portfolios, and not mattresses, will continue to be stuffed with plenty of cash.