What’s going on with ‘defensive’ investments

The long-accepted wisdom in investing is to spread your investments across various sectors and approaches. This, it is said, should allow you to benefit from returns of the portfolio, and mitigate some of the risk that exists and can impact on sectors or economies in time.

At Wren Sterling, this is the approach we recommend to our clients, and it has stood the test of time across differing market cycles and events.

That is not to say that it comes without some challenging times. Periods when some or all of a portfolio can seems to move in tandem, and usually downwards, placing stress on your plans, and making for an uncomfortable experience.

So far, 2022 has been one of those times, driven largely through the challenges in the bond markets, which are meant to provide some solace against the more “volatile” equity markets.

So why is this happening?

Governments across the Western world are battling to keep inflation under control. We’ve seen the US Federal Reserve, the Bank of England and the European Central Bank all raise interest rates, which has caused bond markets to fall.

In the UK, we are seeing inflation at 40-year highs, with predictions of even higher levels in the coming months. With the most recent figures (August) showing the Consumer Price Index (CPI) being up by 10.1% over the previous year.

The Bank of England has an inflation target of 2% and we’ve seen them raise the base interest rate five times since February. With it now sitting at 1.75%, the highest level since 2009, but still a low level historically.

Generally, Central Banks have one tool to try and dampen rising prices – raise the interest rate. It is a fairly blunt tool all told; trying to incentivise people and businesses into saving (or at least not borrow) money rather than spending it, cutting demand, and hopefully leading to a fall in increasing prices.

This is not to say things will get cheaper, just that prices won’t rise quite as fast.

The challenge however is that a significant proportion of the current inflation levels are global – the increasing cost of energy, which then has a knock-on effect to food prices too. This leads to a situation where interest rates are raised to try and cool inflation, but the reason behind the increasing inflation levels are largely outside of its control.

What does this mean for the bond market?

Bond investing is a little like lending money to someone.

You lend a company or a government a sum of money and in return they will pay you a pre-agreed amount of “interest” each year, which you can think of as your return. The level of that return is set at the beginning of the loan and is fixed for term – which for some government bonds (Gilts in the UK) can be for 20- or 30-years.

For a long time now, we have been in a period of low interest rates, meaning it has been quite cheap for governments and companies to borrow money. As inflation rises, and central banks raise the interest rate, this is bad news for bond investors as the level of return they get from their investment is fixed, and so in real terms is falling.

As a bond investor, you can sell on your bond to someone else. The general relationship between the price of a bond, and its yield (the income it pays relative to that price) is like a seesaw. As one increases, the other will fall. The longer the term of the bond, then the more pronounced this change is.

What we’ve seen over the year so far is a combination of the interest rate rises, both current and expected, pushing down the price of the bonds.Portfolios where the manager is buying a broad spread of investments across the market will likely see greater changes in value in situations such as this, than one who can be more selective about what they buy and hold.

We’re currently seeing central banks trying to walk the tightrope between tackling inflation and avoiding a recession. Compared to the past decade, we are seeing more volatile markets across and within a range of assets.

We still believe that diversification is the best defence an investor can have against the ups and downs of the markets in general. This diversification should not only be through holding different asset classes, but also using different investment styles.IMPORTANT: The value of your investments can fall as well as rise and is not guaranteed. Past performance is not a guide to future performance.