The classic ‘60/40 portfolio’ allocates a 60% weighting to growth assets, being shares, and 40% to defensive assets, being bonds. Over time, the allocation to bonds has offered two important benefits: a return from both the income the bonds pay as well as capital growth, and a cushion against volatility in the share market.

However, with yields on 10-year Australian government bonds at 1%, many smart investors are questioning whether the case for having such a large allocation to bonds still stacks up.

With the yield well below the medium-term average inflation rate, it’s obvious why the income benefit isn’t particularly attractive.

As for the capital growth, the price of bonds goes up when their yield goes down, and yields follow inflation. Australian bonds have been caught in an almost 40-year bull market with 10-year yields falling from 17% in 1982 as inflation steadily declined. While it’s entirely possible Australian yields could go negative as they have in other parts of the world, it’s not unreasonable to question how much lower they will go, especially when governments appear to have rediscovered the power of fiscal policy, which has stoked the debate about the possible resurgence of inflationary pressures.

That means you run the risk of locking the defensive portion of your portfolio into a paltry yield that could easily be wiped out by falling prices.

What about the second benefit of providing a cushion against share market volatility? Since 1980 bonds have played a wonderful defensive role in portfolios. When Australian shares plunged 40% in 2008, bonds returned 15%, and over February and March this year, while share markets dropped 28%, the Bloomberg Composite index rose by about 0.5%.

However, bonds have not always had the same negative correlation to falling shares. Damien Hennessy of Heuristic Investment Systems points out that, “During the bear markets of the 1970s and early 1980s, bond yields actually rose (prices fell), which suggests they may not provide the same uncorrelated protection against falling shares in an inflationary environment.”

He goes on to add, “To offset a 10% fall in the value of growth assets in a 60/40 portfolio would require bond yields to decline by 200 basis points (2%). In Australia that means going from a yield of +1% to -1%.”

If you don’t use bonds for the defensive portion of your portfolio, what can you use? There is a variety of candidates, but you first need to be clear about what you mean by a ‘defensive’ asset. Do you require it to pay you a yield? Do you want it to just protect capital in a share market decline, or to actually rise when shares fall? Your response to these questions determines what assets best suit your portfolio.

Cash: according to the 2020 SMSF Investor Report from Investment Trends, Australian investors have increased their cash and cash-like holdings to 27% of their portfolio. With the best term deposit rate currently at 1%, having more than a quarter of your portfolio invested like this is creating a tough headwind for portfolio performance in return for the certainty of a government guaranteed reduction in volatility. With such low returns, the best you can say about cash is it gives you optionality to jump on other opportunities as they arise, but there are other investments that provide good liquidity while offering better returns.

Fixed income: Government bonds are only one part of the fixed income market, with others including corporate bonds and loans. Michael Blomfield of Investment Trends suggests the fact Australian SMSF investors have no plans to increase their overall exposure to fixed income investments indicates a lack of understanding of their role in strategic asset allocation.

There are relatively low risk fixed income funds with track records of not reporting a single negative month, that have returned around 3% per year, and others that have never seen a negative 12 month return delivering closer to 4% per year. Because these funds invest in high grade corporate bonds, when shares go down, it’s very unlikely their funds would go up, but it’s also very unlikely they will lose a  lot of capital.

I also recently wrote about the hidden gem of private debt (loans) which can pay interest of between 7-9%, backed by strong levels of security. Since these loans are not traded on a market, the value of the asset doesn’t change, meaning the capital value is stable.

Gold: has rocketed toward its all time high recently, but exactly what’s driving it is a matter of debate. It used to be argued gold is a hedge against inflation, but that’s clearly been debunked, and now gold bugs will tell you it’s hedge against deflation.

Obviously gold pays no yield, in fact it costs you to hold and store it, and it appears to be uncorrelated to everything. But in terms of preserving your capital, historically it is even more volatile than shares. Rather than set and forget, it’s more of a hold and hope.

Currency: the Australian dollar has a good record of weakening when share markets drop, which is usually more of a function of a rush to the safety of the US dollar. Whether the average investor has the stomach to trade currencies is quite another thing.

Other alternatives for defensive investments include option strategies, hedge funds and unlisted trusts, or you might decide to stick with bonds. They all have their advantages and disadvantages, the key is to have a diversified portfolio that matches your risk appetite.