Trading places: favoring defensive equity when bond yields go too low

While defensive equity may strike some as an oxymoron, the phrase isn’t as absurd as it sounds in an age of government bonds that yield little, nothing, or less.

The 10-year U.S. Treasury note yields a nominal 1.8%, and that’s about as good as it gets in high-quality government bonds these days: Comparable issues from the United Kingdom, yielding 0.7%, and Germany, yielding negative 0.4%, appear even less likely to live up to their traditional roles as defensive return drivers—those expected to perform during bear markets or economic recessions.¹

The premium compensating investors for assuming government bond duration, or interest-rate risk, has paid off in the past, particularly in periods of market stress. However, today’s already low yields leave bonds with little room for capital appreciation potential—and lots of room for losses. That makes those of us on Nordea’s multi-asset investment team more reluctant to count on the interest-rate risk premium prospectively. Any investment can lose its most attractive risk/return and diversification characteristics when it becomes overvalued, and even the highest-quality government bonds are no exception. In our view, the current market environment calls for investors to get more imaginative to fortify the defensive parts of their portfolios.

Balancing both aggressive and defensive return drivers allows a portfolio to pursue capital preservation and return generation without needing to make bold macroeconomic calls.

Shifting the focus from asset classes to risk premia

To that end, it helps to think less in terms of traditional asset classes and more in terms of their underlying return drivers, or risk premia. Looking at the investment world primarily through a risk premium lens offers a number of advantages. We’ve found that the risk in multi-asset portfolios is easier to identify, isolate, and diversify when it’s viewed in terms of specific return drivers.

Recall risk and return are two sides of the same coin. While a risk factor is an underlying driver of the asset’s risk, a risk premium is an underlying driver of the asset’s expected return. At the most fundamental level, there are two types:

  • Aggressive risk premia, or risk-on return drivers: those expected to perform during bull markets or economic recoveries
  • Defensive risk premia, or risk-off return drivers: those expected to perform during bear markets or economic recessions

We view an appropriate balance of both types of these return drivers as essential, and we've in effect split each portfolio into two portions: one holding defensive risk premia and the other aggressive risk premia. This risk balancing approach allows a portfolio to pursue capital preservation and return generation simultaneously throughout the course of the market cycle without needing to make bold macroeconomic calls.

Defensive equity: the low-risk anomaly premium

It’s easy to see how maintaining sufficient exposure to risk-off return drivers could become much more difficult when prospects dim for duration. Fortunately, the investment idea that’s earned our highest levels of conviction in the current market environment is itself a risk-off return driver, hidden in plain sight within certain segments of the equity markets.

Defensive equity represents the largest allocation among the defensive risk premia in the multi-asset portfolios we manage today. While we keep equity market beta as an individual driver in the aggressive part of our portfolio, we think equities can also play a role in defensive positions. Equities can, in fact, contribute more defensive elements into the portfolio that can protect against drawdowns by isolating what’s called the low-risk anomaly premium.

How do we identify and isolate this low-risk anomaly to construct a defensive equity allocation? We start with a global universe of roughly 8,000 stocks, filtering out those that don’t pass our data integrity, liquidity, and five-year stability screens. We continue to narrow the list of candidates through valuation screens and stability analysis of company fundamentals, including price, earnings, dividends, and cash flow. That results in a relatively short list of stocks from which we select to create a basket of comparatively stable equities.

We have high conviction in defensive equity today

At that point, the basket would still include both the equity beta risk premium and the low-risk anomaly premium, but we can isolate the low-risk anomaly by shorting the beta exposure with equity futures, which removes most of the risk tied to the broader market. If all goes well, the residual exposure—the low-risk anomaly alone—results in exposure with a capture ratio that’s higher on up-market days than it is on down-market days. The basket has a lower expected return than the market as a whole, but it has a better risk/return profile, which is what’s most needed in the defensive parts of the portfolio.

Equity investing always entails risks, and as with any investment the low-risk anomaly can face challenging periods. Nonetheless, our way of harvesting this particular defensive equity premium is an approach that has stood the test of time, more than 15 years. Together with other proprietary risk premia, the low-risk anomaly underscores our team's capabilities to identify and exploit alternative sources of risk and return. We stand firm in our belief that, in this persistent low-yielding environment, with low expected returns and muted risk absorption from government bonds, an attractive alternative source of protection during distressed markets can be found in defensive equity. 

 

 

 

 

1 Wall Street Journal, 10/25/19.

Duration measures the sensitivity of the price of a bond to a change in interest rates.