Portfolio Manager Jonathan Ramsay explores the role of credit default protection as a diversification tool and discusses the outlook for Australian interest rates with Fortlake Asset Management CIO Dr Christian Baylis.

When Traditional Diversifiers Fail

Christian's observations challenge conventional fixed income wisdom. Over the past 6-12 months, markets have witnessed unusual dynamics: dollar weakness during risk-off periods, interest rates rising during capital market dislocations, and the breakdown of traditional correlations. As he notes, "a lot of these traditional hedges that you would use to help manage credit risk really haven't been working in their historical ways."

This breakdown of historical relationships has profound implications for portfolio construction. Duration, long considered the primary tool for managing equity risk in balanced portfolios, has become unpredictable. With implied volatility across interest rate markets at low levels despite underlying uncertainty, the reliability of bonds as portfolio ballast is increasingly questioned.

Credit Default Protection: The New Diversifier

In this environment, credit default protection emerges as an alternative source of portfolio insurance. By purchasing protection against high-yield credit indices—particularly those with exposure to vulnerable sectors like logistics, travel insurance, and trade finance—investors can potentially benefit from increasing corporate distress while maintaining core portfolio stability.

Christian emphasises that this isn't just about defaults themselves, but about trading recovery rates as a "micro asset class." With modern companies holding more intangible assets and less hard capital, recovery rates in bankruptcy have structurally declined. This creates opportunities for those positioned correctly ahead of the distress cycle.

The European market presents particular opportunities due to its fragmented regulatory landscape, 27-28 different solvency regimes create complexity that sophisticated investors can exploit. Many companies that positioned themselves as infrastructure plays during the zero-rate era are now revealing operational vulnerabilities.

Early Warning Signals

Several indicators suggest rising distress ahead: increasing Chapter 11 filings, upticks in restructuring inquiries, and SMA (Severely Modified Accrual) restructurings reaching all-time highs in U.S. bankruptcy courts. As Christian metaphorically puts it, "if a sick patient came into the hospital, you'd probably keep them there for a little bit longer... there's a few vital signs here that don't look too good."

For those seeking portfolio protection, being positioned before widespread recognition of credit stress proves crucial. The asymmetric payoff structure of credit protection—limited downside with significant upside during dislocations—offers compelling diversification benefits when traditional tools fail.

The Australian Rate Outlook: Higher for Longer

Perhaps most relevant for Australian investors is Christian's sobering assessment of the domestic rate environment. With inflation at 3.2% and the cash rate at 4.35%, real rates remain relatively low by historical standards. More concerning, several factors suggest the RBA may have already moved beyond neutral:

- Labour markets are tightening rather than loosening

- Household savings balances are declining

- Discretionary spending components of CPI are accelerating

- Consumer spending remains robust

Christian suggests the RBA is "scratching around in the dark, trying to find where neutral is," and may have inadvertently shifted into accommodative territory. His stark conclusion: rates could remain at current levels for "12, 18 months, two years even," with the next move more likely up than down.

For mortgage holders and advisers, this implies a shift in expectations. Rather than planning for rate relief, Australians should prepare for sustained or even higher borrowing costs, marking a decisive end to the era of ultra-low rates.