Do bonds have a place in a portfolio during high inflation?

As seen with the current rises in our cost of living, inflation is an issue for everyone. Sometimes, inflation and unemployment can have a trade-off relationship, often with governments opting to control the former over the latter which highlights just how nasty inflation can be. Though, with the UK’s vicious cost-push inflation, we can’t even put down the low unemployment as being the main cause behind it.

The real causes behind the current inflation rate are supply chain issues, along with a war involving countries that the west relies on for important commodities. In January 2022, UK inflation was 4.9% - around double its target inflation of 2%. Though, many are concerned this is a highly conservative figure. The National Institute of Economic and Social Research (NIESR) expects inflation to rise to 7% for the rest of 2022.

Beyond the immediate issues of spending more on a weekly basis for the same standard of living, UK investors will face the issue with the time value of money. The higher inflation is, the more our investments need to grow in order to not fall in real terms.

What does inflation mean for bonds?

So, if we are looking to chase a minimum of 5-7% returns in order for your portfolio to not decline in real terms, surely bonds are a huge risk to investors? After all, they’re known for having much lower returns than stocks and other investments.

This is partly true. In theory, fixed income is a bad idea during inflation, as it’s fixed and not adjusting to our cost of living increases. Usually, this erodes the present day value of such future income, which can impact the price of the bond.

High inflation often leads to interest rate hikes, as we have recently seen in the US and UK. Interest rates and bond values essentially have an inverse relationship. There is no doubt that bonds do not perform very well during inflation, with older bonds suddenly having worse terms than the newer, higher interest rate bonds - but we can still mitigate some of this risk.

One way is to have short maturity bonds to make the investor less exposed to these potential interest rate hikes, as well as intuitively going for higher yield bonds. Furthermore, global bonds can also reduce the impact of domestic (or western) inflation.

Investments that perform well during inflation

If we want our portfolio to rise in accordance with inflation, it’s clear we need to invest, as holding money in a 0.5% savings account will simply be losing eye-watering levels of value each year.

Stocks are one way to ride the wave of inflation. If you think about it, all of the prices in the Consumer Price Index are from goods being provided by companies in the stock market. So, when inflation rises, it’s simply a matter of the companies putting their prices up - which increases revenue. Whilst their costs are undoubtedly rising in accordance to inflation too, there’s a general feeling of stock markets growing riding the wave of inflation. Though, it doesn’t always work out like when it’s not from demand-led inflation, as we have seen the S&P 500 decline since the turn of the year.

Regardless, this would pose some risks, as growth tech stocks, for example, may overweight our portfolio from inflated growth - which makes for a slightly riskier portfolio mix. Furthermore, many of these highly priced tech stocks are factoring in future income into their current valuation. This could be an issue because the value of their future income is of course going to be hindered by inflation.

This is why index funds are popular, because they’re inherently diversified when it comes to industries and size of capitalisation.

Another popular investment during inflation is property, because property markets often tend to increase in value along with inflation too. However, instead of fixed rent contracts, less sticky prices may be a preferred option so income can more quickly respond to inflation. For example, AirBnB, in which prices can be updated as and when.

Why you still may want bonds

So, it may be difficult to see why any investor would choose to have bonds in their portfolio during a period of high inflation. Clearly, you’re resigning yourself to suboptimal returns. But, that’s usually the case with bonds, so what has changed?

Bonds are often used as a tool of diversification and hedging risk. So, whilst we may consider them to perform badly during inflation, they will reduce the catastrophic impact of a portfolio's value if a market crash were to happen. Sometimes crashes are preceded by high periods of inflation, so we cannot overlook the likelihood of one. Furthermore, bonds still protect you from inflation more than having money stored in a savings account.

Generally, stocks and bonds have an inverse relationship, making them a natural hedging tool. Commodities may also be a viable hedging tool, particularly because they’re the cause behind our current inflation, but they’re not income producing like bonds.

Bonds and dividend stocks are income producing investments but as stated earlier, fixed income isn’t ideal during inflation. However, if an economic crisis was to result from this turbulent inflation, staying solvent and receiving income from investments can be a life saver.

Final Word

As with any investment decision, there are pros and cons. Whilst many people will only talk about the cons of bonds during inflation, it’s important to recognise the pros too. Regardless of our preferred investments during certain economic environments, one thing we cannot do is allow a temporary economic situation to completely throw our portfolio off balance. We cannot allow headlines to cause us to panic sell or time the market, or overweight our portfolio to an unhealthy degree. So whilst we should use bonds with caution, if they were a hedging tool in your investment strategy prior to 2020, they shouldn’t necessarily be dismissed and forgotten.

The value of investments can fall as well as rise. You may get back less than you invested.

Past performance is not a guide to future performance