For decades, investors had a tried and tested method for protecting their portfolios against volatility. The classic 60/40 investment portfolio provided a diversified blend of stocks and bonds, exposing investors to upside potential while safeguarding against downside risks. But, in 2022, both stocks and long-term bonds declined, failing to provide the diversification benefits investors have come to expect. While markets have recovered in 2023, investment managers generally agree that a defensive posture is required to navigate market volatility and the growing possibility of a recession.
Defensive Investing Defined
Defensive investing is a method of portfolio allocation that seeks to minimize the risk of losing one’s principal. Instead of investing for higher returns, a defensive strategy builds a portfolio around lower-risk assets, such as cash, bonds, Mortgage Investment Corporations (MICs), Guaranteed Investment Certificates (GICs) and dividend-paying stocks in defensive sectors. This conservative approach recognizes that current market conditions or an investor’s underlying investment goals are unsuitable for higher-risk investing. Therefore, defensive portfolios seek to preserve capital first and foremost, with growth being a secondary objective.
The primary benefit of defensive investment strategies is capital preservation – a feature that produces peace of mind during extended periods of market volatility. Defensive strategies are suitable for retirement planners, investors with limited time to recoup losses in the event of a market downturn and those looking for predictable cash flow to finance their lifestyle.
Of course, the potential downside of an overly defensive posture is lower returns, which raises the risk of your portfolio underperforming inflation. Consumer cost pressures have grown significantly since 2021, with every major inflation metric reaching a multi-decade high. Additionally, less risk doesn’t necessarily mean risk-free, as your investments can still lose value over time.
Types of Defensive Investments
Defensive portfolios often include high-quality short-maturity bonds, as well as cash and cash equivalents, such as Treasury bills, Government of Canada bonds and commercial paper. Government bonds are the safest investments because they are fully backed by the federal government. As such, they tend to be long-term investments that protect during market downturns and turbulent stages of the business cycle. Usually, bonds can also help investors keep pace with inflation, especially in the case of Government of Canada Real Return Bonds.
However, one of the most significant downsides of holding too much cash and cash equivalents like long-dated bonds is the cost of managing your portfolio. If your portfolio is actively managed by an investment manager, higher fees and modest to lower returns may negate the purpose of your defensive strategy. Cash and cash equivalents are also an expensive luxury because of their opportunity cost, especially during the recent streak of surging inflation.
Guaranteed Investment Certificates can also produce the same predictable income stream as bonds and are guaranteed (to a limit of $100,000 per insured category) by the Canadian Deposit Insurance Corporation. However, interest rates on GICs are typically very low – and over the past year, they’ve remained well below the rate of inflation.
Defensive stocks with a track record of consistent dividend growth and stable earnings are also considered defensive investments. These stocks are typically utility companies and consumer staples whose performance does not closely depend on the current state of the stock market or economy. In the case of utilities, people need electricity and water regardless of how the economy performs. Consumer staples produce food and other essential products whose demand remains constant regardless of the business cycle.
The benefits of defensive stocks are low volatility, dividend growth and strong balance sheets – factors that make them more attractive during bear markets. However, these positive factors can also turn negatives, as defensive stocks tend to underperform during bull markets. Additionally, defensive stocks still exhibit a high correlation with the broader stock market, something that defensive investors are keen to avoid.
Mortgage Investment Corporations as a Defensive Strategy
The traditional portfolio mix of stocks and bonds has come under scrutiny in recent years, as both asset classes have struggled to deliver the diversification benefits that defensive investors have come to expect. As a result, more investors are turning to alternative assets to bolster their defensive edge. Mortgage investments are a class of alternative assets that meet the needs of investors looking to minimize downside risk without completely compromising on returns.
Mortgage investing through a Mortgage Investment Corporation enables investors to participate as lenders in Canada’s residential housing finance market. By owning shares in a MIC, you invest your money in a corporation that manages a secured pool of mortgages. A MIC represents a diversified portfolio of residential mortgages carefully selected to meet the fund’s underlying investment objectives. For investors, mortgages are defensive cash flow investments secured by real estate whose returns can be reinvested or withdrawn as cash. It’s not uncommon for leading MICs to produce average annual yields of over 8%, much higher than GICs and bonds.
Savvy investors choose private mortgages because they have historically outperformed other fixed-income assets while maintaining a lower risk profile and low correlation to equity and other fixed-income markets. In the case of MICs, a team of administrators, adjudicators and fund managers carefully evaluates each mortgage application to ensure it meets strict lending guidelines and to determine its appropriate fund allocation. Historical trends show that mortgage lenders that practice proper due diligence tend to achieve their yield targets while maintaining a risk profile suitable for defensive investors.
Put Your Defensive Strategy to Work With CMI
CMI Mortgage Investments is one of Canada’s fastest-growing non-bank financial institutions. With over $1.9 billion in cumulative mortgage investments, our investment strategies have produced annualized returns of between 6% and 16%. For defensive investors, CMI MIC Funds are a top choice for defensive investors because they provide monthly income, a dividend reinvestment plan, diversification across a broad range of first and second residential mortgages and low correlation with public markets. Our funds are RRSP, TFSA, RRIF and RESP eligible.
To learn more about mortgage investing with CMI, contact us today for a free consultation.