What should your defensive asset allocation look like? How do the fixed income asset classes and bond sub-asset classes fit together?
We often hear from readers who’d like help with this aspect of portfolio construction. So let’s talk through the best defensives and table some asset allocation suggestions.
Let’s also acknowledge that many people are nervous about holding bonds right now and wonder whether they still have a role to play. If that’s you, then first read up on why we think bonds are a good investment [1].
What’s on the defensive asset allocation menu?
Defensives are asset and sub-asset classes that can fortify your portfolio. Here are the ones you need to know about.
Index-linked bonds
Best for: Keeping pace with very high inflation – one of the most frightening risks investors face.
Downside: High demand for index-linked bonds means they currently pay negative yields [2].
They also typically underperform conventional bonds in a standard, deflationary recession.
Look for: Investment grade, developed world, government index-linked bond funds/ETFs. Index-linked gilt funds are theoretically ideal. However that market is potentially distorted [3].
The alternative is short-dated global index-linked [4] bond funds hedged to the pound. These may include some (less desirable) corporate bonds. But if the majority of the fund’s holdings are index-linked government bonds (issued by advanced nations) then put them on your shortlist.
Index-linked bond funds often use the term ‘inflation-linked’ in their name.
Note, short-dated index-linked bonds will be a better inflation hedge [5] than longer term funds because they’re less affected by rises in the real interest rate.
Short-dated government bonds
Best for: Short bonds [6] mature quickly. They are less vulnerable to rising interest rates than longer maturity bonds.
Their lack of volatility makes short bonds useful for decumulators who want to pay their bills without worrying about sudden changes in capital values. (This logic applies to index-linked bonds too, as noted above.)
Downside: Short bonds offer flimsy refuge in a stock market crash, compared to longer dated bonds.
Look for: Bond funds holding investment grade government bonds with maturities of 0 to 5 years. Gilt [7] funds and global government bond funds hedged to the pound fit the bill.
Intermediate government bonds
Best for: A reasonable compromise between short and long bond vehicles. Intermediates offer better crash protection than short bond funds without the egregious interest rate risk [8] of 100% long bonds.
Downside: Intermediates suffer more in a rising rate environment than short bonds, and can’t compete with long bonds in a recession. Like a superhero, their very strength is their weakness. Ultimately, you must decide where you want to be on the risk / reward [9] curve.
Look for: Investment grade government bond funds that offer a spectrum of maturities from 1 year to 15 years or more. Check the duration [10] metric on your bond fund’s webpage. An intermediate fund will sit somewhere between 7 and 14.
Gilt funds are good, and global government bonds hedged to the pound are fine, too.
Global government bonds hedged to the pound
Best for: An alternative to gilts for British investors. Choose if you’re wary of 100% exposure to the credit risk of the UK Government.
Hedging offsets the risk of adverse currency movements swamping your bond returns, which would add unwelcome volatility to the defensive side of your portfolio.
Intermediate global bond funds generally have shorter durations than their gilt cousins.
Downside: Global government bond funds tend to offer less crash protection than UK counterparts. That’s due to their lower durations. You’ll also pay more in management fees versus gilt funds.
Look for: Funds that explicitly say they’re hedged to the pound. The right funds for defensive purposes hold investment grade, developed world, government bonds. They don’t hold emerging market bonds.
Most global bond funds hedged to the pound own some corporate bonds and are called aggregate bond funds. Holding riskier corporate bonds means you can expect a bit more yield overall. However they offer less shock absorption in a downturn.
Cash
Best for: Convenience, liquidity, and reducing interest rate risk.
Downside: Cash doesn’t have the capacity to spike in value like intermediate and long-dated bonds.
Look for: Accounts paying interest rates that beat the yield-to-maturity (YTM) of bond alternatives.
Gold
Best for: Rocketing when other assets crater.
Downside: Gold [11] has performed incredibly during a handful of recessions. But it’s been about as useful as a deckchair on a submarine at other times. The case is marginally positive overall.
Look for: A low-cost Gold ETC (Exchange Traded Commodity fund).
Off the menu: these are not defensive
From the perspective of your defensive allocation, you should avoid:
Sub-investment grade bonds (also known as junk bonds) sport tempting yields. Here you’re exposed to the default risk of dodgy debtors.
Such risk typically materialises at the worst possible time, sending junk bonds diving just when you want your defensives to stabilise your portfolio. The weak go under, and defaults batter those yields that lured you in like an anglerfish’s light. (Or at least the market fears as much, and so marks down their value.)
Long bonds, which could deliver equity-scale gains or losses, depending on the interest rate dice.
Unhedged global bonds [12]. These require you to bet on the wild horses of the world’s currency markets. Great sport when it pays off but advocates go quiet when they back the wrong nag.
Investment grade corporate bonds aren’t needed. They’re unlikely to perform as well as government bonds in a recession (companies go bust, governments less so) yet are outpaced by equities over the long-term.
Broad commodities wrap up low returns with high volatility in a Scotch egg of grimness.
Equity sub-asset classes touted as defensives prove to be anything but when they domino in line with the broad market. So take a bow tumble:
- Infrastructure
- Energy
- REITs
- Timber and farmland
- Low volatility
- Dividend aristocrats
There’s nothing wrong with investing in any of the above. But they belong in the growth side of your asset allocation, not in your defensive bastion.
Model defensive asset allocations
The following asset allocations are starting points keyed to different investing milestones. No size fits everyone. Always adapt model portfolio ideas to your personal situation and risk tolerance [13].
Because we’re in defensive mode today, I’ll leave the growth side as a global equities [14] percentage without drilling any deeper.
Young accumulators
| Asset class | Allocation (%) |
| Global equities | 80 |
| Intermediate government bonds (Gilts) | 20 |
You’re young, you’re starting out, and you have at least a decade of investing ahead of you. Your main risk is a market crash that exceeds your risk tolerance and puts you off equities for life.
Your best defence is high-quality (developed world/investment grade) conventional government bonds.
Older accumulators / lower risk tolerance
| Asset class | Allocation (%) |
| Global equities | 60 |
| Intermediate government bonds (Gilts) | 20 |
| Short global index-linked bonds | 20 |
As the sands drain from the top chamber of your personal hourglass into a peak of wealth below, you will increasingly think about protecting what you have.
That means increasing your allocation to bonds generally, and increasing your defence against inflation specifically. Use a wedge of index-linked bonds to hold the money munching monster at bay.
Check out our piece on managing your portfolio [15] through accumulation.
Decumulators – simple
| Asset class | Allocation (%) |
| Global equities | 60 |
| Intermediate government bonds (Gilts) | 15 |
| Short global index-linked bonds | 15 |
| Cash and/or short government bonds (Gilts) | 10 |
Spending down [16] your wealth is trickier than accumulating it because your portfolio must meet a variety of needs:
- The need to be certain you can pay the bills for the next few years – hence you’ll hold cash and/or short dated bonds
- The ever-present risk of a crash – which is why you own intermediate bonds
- The long-term risk of high inflation impairing your spending power – prompting the 15% slug in index-linked bonds
Decumulators – max diversification
| Asset class | Allocation (%) |
| Global equities | 60 |
| Intermediate government bonds (Gilts) | 10 |
| Short global index-linked bonds | 10 |
| Cash and/or short government bonds (Gilts) | 10 |
| Gold | 10 |
This portfolio adds gold to an armoury of strategic diversifiers that have proven useful against threats from depression to stagflation [17].
This suggested split should also allay the fears of people who believe that bonds are tapped out by low interest rates and looming inflation [18].
There’s no need to bet all for or against one possible future. Instead you can diversify against a spectrum of risks, using a modest proportion of your wealth to defang each danger.
On the defensive
Okay readers, have-at-ye! Asset allocation is as much art as science so I’m looking forward to a hearty debate in the comments.
For anyone who’d like some more background:
- Investigate the best bond funds [14] that can man the ramparts of your defensive allocations. We’ve also covered important bond metrics like duration and yield-to-maturity in this one.
- Discover how to build your own asset allocation [19] from first principles.
- See more model portfolios [20].
Take it steady,
The Accumulator
P.S. Shout out to Monevator reader John who tipped us off about a new shorter-dated global linker fund that neatly fills a gap in the market. It’s very new, but if you’re interested: Lyxor Core Global Inflation-Linked 1-10Y Bond ETF – Monthly Hedged to GBP (GISG).