Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

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 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.

There’s also an income argument here. Rising yields are bad for investors looking to achieve a capital gain on their bonds, but it does mean they finally offer a reliable income stream that’s been absent for many years. Rising yields could eventually become self-correcting - if they continue upwards (above, say, 2%), they’ll eventually become attractive to large funds which need an income allocation. That means higher demand, which in turn would push prices back up again.

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 (at least for now), 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 income you receive on the ASI Global Inflation-Linked Bond Fund, for instance, is tied to inflation. However, investors should note that its value will fall when real interest rates rise, which means rising inflation is no guarantee of positive returns.

Consider some alternative asset classes too. The classic one is gold, which is supposed to retain its value (unlike bonds) through rising inflation - but the flip side is, it doesn’t offer any income. 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.

Here’s the Ninety One Global Gold Fund’s manager, George Cheveley, discussing the fund with Tom:

Changing your portfolio allocations may be daunting, but the simple rules of investing that have worked no longer apply.

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.

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