22 Dec 2015
In any decent sports team, you’re likely to find a mix of attackers and defenders. The world of investments has many similarities. On the investment playing field, attackers are growth assets: more aggressive and likely to ‘score’; whereas defenders are defensive assets: safer but less likely to get big runs on the board.
When considering defensive investments, it’s natural—and correct—to assume they carry lower levels of risk than growth assets. But it’s important to be aware that they’re not risk-free.
Market volatility is generally associated with share markets. But you might be surprised to learn that global bond and credit markets can also experience volatility—directly impacting investments normally considered defensive.
UniSuper offers three single-sector defensive options: Cash, Australian Bond and, the recently introduced, Diversified Credit Income (DCI).
Our Cash option predominantly invests in deposits with banks—so it’s as close to ‘risk-free’ as you can find. The trade-off is that cash returns are low.
Generating higher returns within defensive asset classes means taking on more risk—typically in the form of bonds.
A bond, in its simplest form, is a debt security generally issued by a government or company to raise money. Essentially, an investor loans money to a government (as is the case with our Australian Bond option) or company (the strategy of our DCI option) that borrows the funds for a defined period of time at a specific interest rate. While there are some variations, in most cases bonds pay investors a fixed annual income (known as the coupon) and can be bought or sold. While the coupon stream is fixed, the price of a bond can vary with credit margins or interest rates, so they can experience capital gains or loses.
Why bonds are considered defensive
Bonds— along with cash and money-market securities—are considered defensive because the bulk of their return is generated by income rather than capital growth.
And because there’s greater certainty around income generation than capital growth, these assets are generally considered less risky than shares. Plus, if a company collapses, bond investors and lenders get paid out before shareholders.
A closer look at the risks associated with bonds
Coming back to our sports team analogy, it can be helpful to think of bonds and their risks as similar to ‘dependable workhorse’ players. Despite being good, reliable defenders, they sometimes have bad days or seasons. So what are the risks?
Credit risk is the risk that a borrower will default on interest or principal repayments. The term typically applies to a corporate borrower, although banks and some governments also come with credit risk. A recent example of this is the Greek debt crisis.
To compensate for the higher risk of default associated with a corporate bond, investors are paid a credit margin (also known as a ’premium’ or ‘spread’) over and above a government security with an equivalent duration. For example, bonds issued by Woolworths with a term of three and a half years are trading at 3.87%. This compares to 2.11% for an Australian Government bond of the same maturity, representing a credit margin of 1.76%.
Just as share prices move up or down based on the market outlook, credit margins move up and down based on expectations around the probability of default—which can impact the price of the bond. Generally, the price of a bond isn’t as volatile as the share market, but they can certainly be more volatile than you may think.
Consider the movement of credit margins on a basket of bonds issued by Australia’s major banks since January 2000 shown in the graph below.
Past performance isn't an indicator of future performance
Interest rate (duration) risk
A simple way to think about this is, when interest rates rise—or are expected to rise in the future—the capital value of bonds will typically fall (even though the coupon of a bond remains fixed).
For example, while Australian Government bonds are considered free from credit risk, their value can increase or decrease with movements in market rates. This is why our Australian Bond option can fall in value from time to time.
Keen to know more?
Read our latest investment market update (December 2015) for a deeper insight into the recent performance and outlook for our defensive options.
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