Bonds once had the distinct advantage of making life easier for investment managers and their clients, as they offered inverse correlation with equities and so a lot of diversification, while also paying a respectable yield.
But in the decade since the end of the financial crisis, central bank policies and factors such as ageing populations have caused yields to tumble, and set new record lows over the past decade.
The raison d'être of multi-asset funds is to achieve diversification of returns, but if bonds and equities are correlated in terms of returns, why use bonds at all?
The answer, says Will McIntosh-Whyte, multi-asset investor at Rathbones, is that while the correlations might have changed in the short term, “over the long term bonds still play the same role in portfolios.
"We saw when Russia invaded Ukraine bond prices rose and equity prices fell. If more Covid restrictions were to be introduced, then bond prices would likely rise. That is why there is always a role for bonds in portfolios, even if some of the traditional income characteristics are not there any more.”
Eren Osman, co-chief investment officer at Arbuthnot Latham, says: “With bonds, the risks are higher, and the returns are lower than in the past. The diversification effects are reduced.
"The problem is the more risk you take, the higher the correlation to equities, and in that scenario you have to ask yourself, what are you trying to achieve? Is it about getting the diversification, or is it about getting the returns, because right now that is the choice, and it is important to know what you are trying to achieve."
The problem, says Sebastian Mackay, multi-asset investor at Invesco, is that bonds and equities can be expected to move in precisely the same way in a market environment where interest rates are rising and inflation is high, so the inverse correlation that underpins the investment case for most bonds fails.
Bond yields rise (and so bond prices fall) when inflation is high because the real value of the future income from the bond is eroded. Additionally, if the base rate increases, this will cause the interest rates paid on cash to rise, making the interest rate from bonds less attractive.
Most equities suffer in the same environment as higher rates would be expected to dampen the level of economic growth in the economy, and so, depress profits.
Mackay does have some bonds in his portfolio, but says: “They are not the only defensive asset there now. We have also been buying currencies and even some more equities in order to protect against inflation. The reason inflation is a big concern now is people are more worried about inflation than about their jobs, and that tends to mean that inflation persists.”