Perennial brings institutional nous to solve the defensive income problem

Speak with any financial adviser today, and it’s likely that their biggest investment concern isn’t related to the equity component of their portfolio. After two years of strong markets, most are sitting on strong returns despite the recent uptick in volatility.

With the near-consensus view that interest rates are set to move higher sooner rather than later, the defensive and fixed-income allocations within portfolios are now attracting most of the attention. And naturally so, given their historical role to deliver diversification when it is needed most, but also a stable income.

In recent research, the team at Perennial has reviewed a number of common ‘defensive income’ separately managed accounts, or SMAs, to understand which levers they are pulling in the pursuit of returns. Speaking with the authors, they confirm that the evolving nature of these products “underscores the challenges faced in a zero-rate world.”

By this, Perennial refers to the fact that “government bond duration and cash holdings have provided the key anchors to portfolio defence” for more than three decades. Unfortunately, the prolonged zero- and negative-interest rate policies used to support the economy have meant that the key benefits of traditional long-duration bonds, including low volatility of returns, running yield and most importantly, anti-correlation with equities, have been significantly diminished.

With cash rates still anchored near zero but bond yields increasing slightly, it is becoming more obvious that the ‘lower bound’ of interest rates has been reached ‘thus limiting the defensive potential of bonds’ going forward. In fact, it seems more than likely that interest rates will rise, which according to the paper means ‘at a minimum, investors face negative real rates of return for the near future and/or potentially larger capital loss in a rising rate environment’.

Following the “TINA” trend, or “There is No Alternative,” most defensive income portfolio managers have turned to fixed-income investments with “equity-like” characteristics, including hybrids and preference shares, but as the March 2020 selloff showed, they were more correlated with equities than many expected.

It is clear that advisers, asset consultants and investors themselves are looking for a solution to deliver solid yields, while avoiding duration exposure and mitigating equity risk. This is a challenge the team at Perennial decided to target in its effort to bring institutional-quality investment options to the wholesale market.

Launched in June 2021, the fixed income specialists at Daintree Capital partnered with Perennial Solutions Group to build a bespoke solution suited to traditional ‘balanced portfolios’ Effectively, the Yield Plus Conservative fund combines two distinct institutional strategies into a single, daily liquid product.

The fund combines the pursuit of a higher yield for portfolios with an ‘explicit protection program’ that has the ability to outperform in significant “risk-off” environments, which are expected to grow in regularity in the years ahead. Commenting on the product, Perennial highlights the role it can play alongside those balanced portfolios with higher credit and equity exposures, being the ability to reduce overall capital loss and volatility.

Titled ‘Building Back Better’ the paper highlights the value and diversification benefits of including even 25 per cent in a Proxy Income Portfolio, which saw a significantly lower drawdown and a material increase in five year compounding returns. This is delivered partially through the protection component and its ability to add an exposure to increasing volatility to the fund. 

Drew Meredith

Drew is publisher of the Inside Network's mastheads and a principal adviser at Wattle Partners.