Whenever we experience a spell in financial markets where high quality bonds lose value at the same time as equities a glut of commentaries appear either announcing the ‘death of the 60/40’, showing rising equity / bond correlations or proclaiming bonds have lost their diversifying properties. While part of this is usually an effort to sell alternatives, there also seems to be a genuine concern that bonds have evolved to develop a new set of characteristics. I find this puzzling – high quality bonds seem to be behaving just as we might expect them to. They are a good diversifier to equities but not a perfect one.

When bonds and equities lose money in unison there is almost always the same explanation – inflation. Bonds can offer strong protection from equity market risk when there is a growth shock (profits fall, but so do interest rates and inflation); they are not, however, a helpful equity diversifier when an inflationary problem arises (yields push higher and Central Banks are unable to cut rates).

This behaviour has always been a feature of how high quality (nominal) bonds act relative to equities in a portfolio. Very little has changed in that regard. All that has happened is that inflationary shocks have become far more common after decades where disinflationary pressure was the dominant trend.

This doesn’t mean that the relationship between equities and bonds doesn’t matter, it is just that it is important not to misdiagnose the problem. The real issue is that through a prolonged spell of subdued inflation, many investors became complacent about the role bonds play in a portfolio – neglecting the scenarios in which they might struggle.

Since we have experienced a succession of inflationary supply shocks through COVID, Russia-Ukraine and now the Iran conflict, these risks are now front and centre in our thinking. This has been coupled with a huge amount of angst about ‘fiscal sustainability’, which for countries who issue bonds only in a currency that they can also print (such as the UK and US) ultimately comes down to a question about future inflation.

These issues have led to bonds getting a very hard time.

It is worth reiterating that high quality bonds are a superior diversifying asset for portfolios where equities are the most prominent risk factor. Equities are a volatile asset class that can generate high long-term real returns, but are acutely vulnerable to weak growth and recessions. Bonds almost certainly diversify this risk better than any other option. This remains true today.

If an investor is considering reducing their allocation to bonds within their portfolio (which unsurprisingly more people seem keen to do at 5% yields than they did at 0%); it should not be because bonds no longer play a valuable role, but rather because they are attaching a higher probability to the occurrence of troublesome inflation.

This is a perfectly sensible view to hold, but we should remain cognisant of our propensity to exaggerate whatever risk is salient or fresh in our minds. The dangers of the availability heuristic notwithstanding, investors should be seeking to create portfolios that are well-balanced and resilient to a range of economic scenarios, including those in which equity and bond correlation is on the rise.

There are supplementary asset class options that might fill the gaps not covered by high quality bonds – inflation linked bonds, commodities and even trend following strategies. These choices are not unreasonable and a case can be made for their use in a diversified portfolio (alongside many other candidates). They all, however, come with weaknesses and require the acceptance of trade-offs (some very significant). Most importantly, none work as consistently well as a diversifier to equities in a growth downturn.

If we are in a world where the incidence of inflation shocks relative to growth shocks rises then we should expect a higher (average) correlation between equities and bonds, and probably some extra term premium (if inflation risk is greater, I want some additional compensation). This might impact portfolio allocation decisions, but I would be wary about our ability to anticipate future economic environments. I would be more confident in predicting that when the next recession arrives, we will all be glad to be holding high quality bonds in our portfolios.

Despite all the noise, bonds are behaving in just the way we should expect them to. It is probably fair to say that in an era of low inflation and falling yields investors didn’t make their portfolios sufficiently resilient to scenarios where bonds don’t complement equities as effectively. Yet this is the fault of investors, not the bonds. Making some adjustments to portfolios because of this oversight seems prudent, writing off bonds for performing in a perfectly predictable way far less so.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.