Rethinking defensive income: Diversification no longer just a buzzword

In a world of heightened macroeconomic uncertainty and volatile markets, the role of defensive income in portfolios is once again in the spotlight. Traditionally, government bonds have anchored this segment, offering a reliable source of income and capital preservation. However, structural shifts in interest rates, inflation dynamics, and market correlations are challenging their effectiveness. Investors must now broaden their defensive toolkits, exploring a more diversified and nuanced set of income-generating strategies that can better navigate today’s risks.

The government bond dilemma

Government bonds, particularly in developed markets, have long been the go-to asset class for capital protection and income during periods of economic slowdown. Yet their risk-return profile has weakened for several reasons:

• Low and volatile real yields: Despite nominal rate increases, real yields remain low or even negative in some regions, once inflation is accounted for. This undermines their long-term purchasing power. Central bank financial repression is in the cards.
• Duration risk: With longer-dated bonds still forming a significant portion of core defensive allocations, portfolios are exposed to substantial interest-rate sensitivity. As 2022-2023 demonstrated, sharp yield spikes can lead to deep drawdowns, calling into question their reliability in stressed environments.
• High correlation with growth risk: In recent years, bonds have shown increasing correlation with risk assets, particularly in periods of inflationary stress or policy tightening. Their diversification benefit is no longer guaranteed, especially when central banks are both fighting inflation and slowing growth.
• Sovereign risk – Record debt levels, necessity to roll and expand debt levels call into question the roll of government debt, fiat currency and risk. Simply relying upon historical relationships between bonds and equities is not robust risk management.

Credit: Not a free lunch

Investors have naturally looked to corporate credit to enhance yield. While investment-grade and high-yield credit offer improved income potential over sovereign bonds, they carry important caveats:

• Tight spreads: Credit has historically traded near the tight end of spread ranges, leaving little cushion for risk repricing. Valuations are vulnerable in a downturn, especially if defaults or downgrades rise.
• Growth sensitivity: Corporate credit remains fundamentally tied to the economic cycle. Slower growth or recessionary conditions can widen spreads and impair returns.
• Private credit caution: The rapid institutionalisation of private credit has created exciting opportunities – offering attractive illiquidity and complexity premia – but also challenges. Accessing these benefits requires skilled manager selection, rigorous due diligence, and an understanding of structural protections in private-loan portfolios. Not all strategies are created equal, and investor protections vary widely.

Alternatives for a modern defensive toolkit

To build more resilient income portfolios, investors should look beyond traditional fixed income and corporate credit. A diversified approach to defensive income can draw from a broader spectrum of alternatives, each with distinct risk-return drivers:

• Infrastructure debt: Offers long-dated, stable cash flows with lower default rates and higher recovery than corporate debt. The physical asset backing and essential-service nature of many projects support their defensiveness.
• Insurance-linked securities (ILS): These instruments provide returns that are generally uncorrelated with economic cycles, driven instead by actuarial risk. While complex, they offer true diversification benefits when used appropriately.
• Market-neutral strategies: Equity market-neutral, relative value credit, and arbitrage strategies can deliver uncorrelated returns with minimal market beta. Their alpha potential depends on manager skill and strategy discipline.
• Private defensive income: This includes asset-backed lending, royalty streams, litigation finance, and other niche income-generating strategies. These often sit in the “uncorrelated income” bucket but require robust underwriting and governance.
• Volatility and derivative strategies: Increased use of derivatives for portfolio defence can not only re-shape portfolio return distribution, but can enable portfolios to maintain or increase growth allocations. As real rates approach zero or negative, bonds’ defensive convexity weakens; volatility and options offer more robust defensive solutions. Equity derivatives do not rely on expected negative bond-equity correlation.

Building a Multi-Asset Defensive Income Solution

A well-constructed multi-asset defensive income solution balances liquidity, diversification, return, and downside protection. Key principles include:

• Diversification by risk driver: Move beyond just sector or asset class diversification. Understand what is driving return – credit risk, duration, illiquidity, insurance risk, etc. – and diversify across these dimensions.
• Active management and manager selection: With alternatives and private markets, access to experienced, aligned, and capable managers is critical. The dispersion between top-quartile and bottom-quartile managers is wide.
• Role clarity in the portfolio: Each strategy should be clearly mapped to its purpose – whether income, capital preservation, or diversification – to ensure alignment with portfolio objectives.

Conclusion

In a regime where traditional playbooks are being rewritten, relying solely on government bonds or conventional credit for defensive income is increasingly risky. Investors must expand their approach, incorporating a broader set of alternative income streams that can withstand different market conditions. By doing so, portfolios can achieve more stable, diversified, and resilient income – a cornerstone of success in the next era of investing.

Michael Armitage is principal at Fundlab Strategic Consulting Pty. Ltd.