We currently have the ironic situation where, the asset class which is supposed to be our safe option, designed to protect our capital, is a risk.

Bonds, which are the most common defensive asset (along with cash), are in a very precarious position both domestically and internationally. Given that Bonds are used to offset the risk associated with growth assets such as shares and property, it is making us reconsider our investment portfolios.

The risk associated with current Bonds is to do with the possibility of interest rates rising. When interest rates rise, the capital value of bonds decrease. The reason for this is that, why would someone buy a Bond that is paying 1.5% when they can buy one that is paying 1.75%?  Therefore, the value of the Bond with the lower interest rate falls.

While this is not a new issue with Bonds, it is exaggerated due to very low interest rates. A rise of 0.25% actually represents quite a large portion of the overall return, resulting in a sharp fall in the value of a Bond.

Worsening the situation, as the overall interest rate is so low, the reduction in capital value takes longer to recoup. Furthermore, the risk of interest rates rising isn’t just likely, it is virtually inevitable.

A best-case scenario is that interest rates stay the same or fall over the medium-term. But again, this then results in perpetually low returns from Bonds, well below expectations. This is still a bad result.

We usually accept a level of risk with shares and property as we are comfortable that the likely long-term upside justifies the potential short-term volatility. With Bonds, we use these to limit the risk of the growth assets. At the moment, they are actually increasing the risk. This is the problem we now face.

The challenge is how to protect the portfolio from downside risk in this current environment. There is no perfect answer here. Most solutions are going to introduce different potential risks or forego opportunities for growth.

The most defensive way to approach this is to remove all funds from Bonds and place in cash. This removes further downside risk that is possible, even likely, with Bonds. Unfortunately, this doesn’t provide an opportunity to offset any potential losses from growth assets.

Another method which is likely to be the most popular is to introduce investments that are non-market linked to the portfolio as an alternative to Bonds. There are a number of funds that serve this purpose with wide ranging strategies. The theme being, that their returns are not linked to the performance of the markets.

These style of funds, if they have low or negative correlation with the growth assets, will help to offset any downside risk that may occur within the growth assets.

We currently have a unique situation in that, those with what we would consider a safe investment option are probably most at risk. I advise anyone with a defensive portfolio to speak to their advisor about their options.