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The recent write-down of Credit Suisse’s AT1 bonds and the dreadful performance of government securities last year should reasonably lead investors to question the defensive qualities of their fixed income holdings.
Traditionally, bonds are seen as "safe" and equities as "risky", but this is a rather simplistic view of the world and one which ignores the quality and breadth of securities which make up a company’s capital structure.
As Credit Suisse demonstrated, AT1s, or "Cocos" as they are known, offer potentially the worst of all outcomes – they are bonds when things are going well, but can become worthless equity when things turn sour.
Many bond investors routinely buy these securities and other risky types of bonds, such as High Yield, to generate higher returns. It is worth remembering, however, that in a typical year almost 5% of high yield bonds default on their obligations, and more than 10% will tend to fail in a recession.
Even the most secure bonds issued by highly rated governments such as the United States can lose significant value, as we saw in 2022, in an environment of rising inflation and interest rates, and additionally they may also fail to diversify portfolio risk, amplifying rather than dampening the volatility of returns.
We believe investors should focus less on the generic names used to delineate asset classes, such as "bonds" or "equities", but rather focus on the reliability and predictability of the income streams these securities produce – are they relatively ‘safe’ or pretty "risky"?
We would argue that widening the definition of what can be viewed as relatively "safe" to include some equities, real estate investment trusts and listed infrastructure investments, can help investors achieve better defensive outcomes in terms of both return and risk.
For example, there are a decent number of companies,with strong competitive positions in less cyclical industries, which have shown a capacity to grow the dividends they pay consistently over many decades – Johnson and Johnson, Proctor & Gamble, Nestle are three.
In our minds, the equity of such companies can make sense as components, alongside bonds, in a well-diversified strategy deliverING superior fixed income-like returns. Their rising dividends may also provide some additional help to returns in periods of inflation.
We think it makes sense, therefore, for investors who are looking to achieve a defensive bond-like outcome to cast the net as wide as possible, to ignore simple labels, and focus instead on the quality and resilience of cash flows. Just limiting their choices to fixed income securities is probably suboptimal and may turn out to be riskier than it is perceived.
John Stopford is head of multi-asset income at Ninety One
