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Every defensive allocation starts from a price, and for most of the past decade that starting point was generous: bond yields had room to fall and credit spreads had room to compress. Today the position is reversed. Government yields are grinding higher rather than mean-reverting, and credit spreads sit near their tights. The defensive leg of a diversified portfolio is being asked to do its job from the least helpful entry point in years, with both of its traditional components compromised at once.

Christian Baylis of Fortlake Asset Management, whom we spoke with a few months ago, has been wary of US Government bond risk for a while, much of the reasons the market is picking up now. He has made the case that much of what bond markets here and overseas are digesting is structural rather than cyclical and increasingly he sees Australia as an outlier that faces some very specific structural challenges. On his figures, Australian productivity has gone backwards — we produce less per hour than four years ago — against a United States compounding productivity at roughly 2.1% annually since 2019. His analogy is a V12 engine firing like a V4. With government expenditure near 27% of GDP and debt around $1.2 trillion, fiscal and monetary policy work across purposes in an economy with no spare capacity, which he argues could ultimately require a cash rate closer to 5%. The telling detail is that a housing correction of 8%, and perhaps 13% before it is done, has barely touched the structural influences that are keeping core measures of inflation elevated. The implications are that slowing economic activity might not be enough to cool inflation as it has in quite reliably during the Great Moderation of the last 2 decades.  

The supply side compounds this. US deficits are running at 6% of GDP, and Baylis points to US$500–600 billion of hyperscaler debt still to be issued, much of it at the long end, Alphabet has already tapped the Australian market. As capital expenditure approaches and then exceeds operating cash flow, that funding is coming from bond markets. Some long-dated issues are down 15–20%. His conclusion: the term structure over the next ten years is likely to sit materially above the last ten.

Nor do credit spreads compensate for investors who are seeking returns but no longer trust duration. Beneath a calm surface, Baylis describes pressure in the plumbing. CLO managers — who absorb around 60% of direct lending deals, and are the marginal buyer in private credit — have seen returns fall with declining net interest margins (they are basically a banking business model) , are pressing against their triple-C limits as debt migrates across the B-minus boundary, and they are being forced to sell. Some reset auctions are failing, clearing 10–15% lower than current NAVs. Defaults are rising and he expects recovery rates to disappoint, because technology issuers carrying substantial intangibles and thinning covenants have little to offer creditors in a restructuring. 

Which returns the question to what a defensive diversifier now has to look like. Yield is not diversification, and neither is a holding that merely loses less. What advisers are short of is negative correlation, which is both dearer and harder to find than it was. Fortlake's answer is to buy default protection while it remains cheap, funded by a cash-plus running return driven by high quality investment grade floating rate notes, so the portfolio is positively exposed to adverse credit events without the bleed that makes a pure short position unownable. That is why this part of the strategy is proving to be fertile ground that should be more reliably defensive in a downturn than duration, especially if the upwards pressure we are seeing on rates turns out to be a secular shift. For now, the fact that much of this is happening below the surface and in the absence of overt recession fears means that usefully the cost to acquire this insurance on credit risk has not spiked yet as it tends to in pronounced downturn but it is still additive to returns when duration is adding volatility and the upside to quality credit is increasingly meagre.      

Advisers may wish to consider testing their own defensive sleeve on that basis: not what it yields today, but what it is expected to do on the day the growth assets fall. On that test, the field thins quickly.