Tuesday 07 July 2015 by FIIG Securities peaceful Opinion

When the going gets tough, the tough rebalance

Heightened volatility has investors seeking safer investments. Derisking strategies include increasing your cash holdings, preferring investment grade bonds over high yield and investing in “safe havens” such as the US dollar

Growing uncertainty in fixed interest markets is making investors nervous and, let’s face it, there is plenty on the radar to warrant concern.

Greece remains a worry, raising fears about contagion to other European countries; there is a material slowdown in China and it has worrying share market and property bubbles; Puerto Rico is reportedly on the verge of default, Islamic State is rising, and there are wars in 65 countries including Syria, Iraq and Afghanistan.

When professional investors worry about financial markets they start switching from higher risk investments to lower risk choices: Their goal changes from “how can I maximise returns” to “how can I preserve capital?” They sell higher risk assets such as shares and invest in lower risk investments such as cash and bonds.

Some commentators will encourage private investors to hold onto their higher risk investments and ride out the storm, but this is not the strategy employed by the professionals. A number of prominent fund managers have publicly stated they are increasing their cash holdings. This is also a sound strategy for individual investors.

Deposits across about 160 financial institutions, including banks, credit unions and building societies are protected by the government guarantee for up to $250,000 per institution, per entity. Cash should be a component in every investor’s portfolio.

Some commentators suggest holding three years’ cash requirements, allowing time to recover from a major stress event. If you take the Association of Superannuation Funds of Australia’s required cashflow to allow for a comfortable retirement for a couple at $58,444, then total cash needed would be $175,332.

Low risk bonds are also an option. Bonds are a legal obligation of the entity issuing them. Interest income must be paid on specific dates, and bonds will naturally preserve capital as they have fixed maturity dates. As long as the government or the company survives, investors who hold the bonds for their duration will be paid face value of the bond at maturity.

At times of crisis investors that hold bonds start selling the highest risk ones and replacing them with lower risk alternatives. Commonwealth and state government bonds have the lowest risk and have the highest investment grade credit ratings. The lowest risk investment grade corporate bonds are also possibilities.

Only three investment grade companies in Australia have defaulted — HIH, Pasminco, and Babcock and Brown — making investment in investment grade corporate bonds a good capital preservation strategy.

The four major banks’ senior bonds are considered safe haven investments as are high rated bonds issued by GE Capital Australia, Australian Rail Track and Macquarie University. Short dated investment grade bonds are also attractive high quality investments. Bonds issued by the Suncorp subsidiary Vero and the NAB subsidiary National Wealth Management would make good investments. Returns on these investments are low but the bonds are tradeable and if the market encounters another severe event, could be in high demand, pushing prices higher, offsetting losses elsewhere in your portfolio.

The US dollar continues to be a safe haven. Investments in the greenback or investments in high grade US dollar bonds are other defensive approaches. Gold has also performed well when times are tough. Whatever your strategy, ensuring you preserve capital and keep a certain percentage intact must be a key priority.