BONDS have worked so well for so long that it can be hard to picture your portfolio without them. Yet, following the worst year for global bond markets in decades, there are real anxieties over their prospects going forward.
The biggest threat they face is inflation. As prices rise, they erode the value of the fixed income payments you receive on a bond. If you’re earning 3% interest on a bond but inflation is 5%, you’re actually losing money in “real”, inflation-adjusted terms.
Rising inflation means rising interest rates, which in turn means rising bond yields. Because bond prices are inversely related to yields, that’s bad news for bond prices.
Add all this up, and you have a new market environment that bodes ill for bonds.
But that’s not to say bonds are now worthless. Judging them on their returns only tells half the story. For most people, bonds serve primarily to protect their portfolios, not generate outstanding returns. They generally perform differently from equities, meaning that when share prices drop, investors who hold both bonds and equities are spared some pain.
It’s for this reason that the simple mantra of a 60/40 portfolio split between equities and bonds worked well for many investors. 60% in equities meant you were exposed to their rewards, while 40% in bonds tempered the excesses.
Unfortunately, bonds are starting to struggle here as well. Part of the way they protected a portfolio was through their ‘negative correlation’ with equities – i.e. by performing differently. It’s unclear if that negative correlation still holds. Inflation could hurt both asset classes at the same time, while rising interest rates threaten certain stocks, whose earnings are forecast long into the future, in much the same way they do bonds.
Nevertheless, bonds will always provide some kind of buffer. They’re not as volatile as equities, meaning you’re less likely to lose as much on your bonds as you could on your shares.
In this context, bonds still make sense. But do they justify the 40% weighting they occupy in a typical 60/40 portfolio? Perhaps not. That’s a large chunk of your portfolio to surrender to minimal returns, especially if bonds do begin to move in line with equities.
Now may be the time to look at your bond exposure, and perhaps embellish it with inflation-linked bonds. The ASI Global Inflation-Linked Bond Fund, for instance, is designed to increase in value as inflation rises, though it will fall if real interest rates rise.
Consider some alternative asset classes too. The classic one is gold, which is supposed to retain its value (unlike bonds) through rising inflation. My colleague, Tom Stevenson, has included the Ninety One Global Gold Fund as one of his four fund picks for 2022. Other alternative investments, such as infrastructure and property, will also help diversify your portfolio.
Changing your portfolio allocations may be daunting, but the simple rules of investing that have worked no longer apply.
To help you navigate these shifting sands, you can check out Fidelity’s latest quarterly Investment Outlook, which you will be able to find here tomorrow. In it, you’ll be able to find our views on all major asset classes and regions, and commentary on the direction for markets over the coming months.