The traditional playbook for defensive portfolio positioning — shift into government bonds and high-quality credit — is under serious strain. In an environment where interest rate volatility has effectively doubled, credit spreads started from historically tight levels, and inflation is proving stubbornly persistent, the usual safe havens are anything but.

Christian Baylis, portfolio manager at Fortlake Asset Management, puts the challenge in stark terms. Implied volatility in the three-month, one-year part of the Australian interest rate curve has surged from the mid-sixties to around 130 over March — a near-doubling that exposes just how dramatically risk had been underpriced in fixed income markets. That repricing has direct consequences for anyone relying on duration as a portfolio stabiliser. When the risk-free rate itself becomes a source of volatility, discount rates become unstable, equity risk premiums need revising, and funding costs for both investment grade and high yield borrowers ratchet higher. The traditional diversification benefit of holding government bonds starts to look distinctly unreliable.

For defensive allocators, this creates an uncomfortable bind. Interest rate expectations continue to creep higher, meaning duration exposure carries genuine mark-to-market risk. Meanwhile, credit spreads — having started the year at tight levels — offered limited cushion against deterioration. As Bayliss observes, that combination effectively leaves cash as the only truly defensive position, which is hardly a satisfying answer for portfolios with mandated allocations to fixed income.

The RBA's policy framework adds a further layer of complexity. Australia's real(short-term) cash rate remains negative, with headline inflation likely sitting around 4.5% against a cash rate of 4.1%. For a central bank ostensibly fighting an inflation fire, that positioning is hardly aggressive. Bayliss is pointed in his assessment: the February rate cut was a gamble that prioritised employment concerns over the inflation mandate, and it was the wrong call. He argues that central banks should maintain a singular focus on inflation — it affects all 28 million Australians, whereas the employment benefit of marginally lower rates accrues to a relative few.

The silver lining, in Bayliss's view, is that the RBA appears to have absorbed this criticism and is now attempting to get ahead of the curve. That proactive posture matters enormously for duration investors, because a central bank with credibility and room to cut in a genuine downturn is what gives government bonds their counter-cyclical value. On that measure, Australia compares favourably to the United States, where a changing of the guard at the Federal Reserve raises the prospect of rates being held artificially low rather than calibrated to conditions.

The other side of the coin is that there is still much noise and uncertainty and from this starting point government bonds could still have their day if inflationary/stagflationary concerns pivot top recessionary/deflationary ones. So if younger going to hold duration, Bayliss advocates staying firmly in the front end of the Australian curve. Over March, volatility-adjusted one-year rates reached 5.2% and there is a significant chance the RBA will not reach that level, with the downside limited to opportunity cost if held to maturity. The key discipline is treating it as a yield decision rather than a directional punt on rates. In a regime defined by policy uncertainty and geopolitical surprises, that distinction is critical.

In Fortlake’s case there is an alternative source of defensive return that sits outside the traditional toolkit. Bayliss argues that because jump risk (a sudden repricing of asset prices) remains chronically underpriced, the beta relationship between high yield and investment grade credit is materially mispriced — meaning that in periods of dislocation, high yield spreads overshoot relative to their higher-quality counterparts. By running a short position in high yield against a long position in investment grade, a portfolio can capture that convexity when stress arrives. The trade carries a negative day-to-day cost, but the payoff profile is asymmetric: when defaults materialise — and with US Chapter 11 filings running at all-time highs, the fundamental backdrop is clearly deteriorating — the catch-up effect is substantial. It is, in essence, buying cheap insurance in a market that has collectively decided the house will not burn down. For allocators frustrated by the limitations of duration and tight credit spreads, that kind of optionality offers a genuinely differentiated defensive return stream.

The broader message for diversified portfolios is sobering however. Truly defensive positioning in 2026 requires far more than a simple rotation into bonds. It demands an acute awareness of where risk is actually being priced, and, more often than not, where it is not.