For much of the past decade, investors could treat bonds issued by sound issuers as perhaps a dull but dependable part of a portfolio. Then some years ago inflation surged, interest rates rose and bond prices fell sharply. In 2022, shares and bonds dropped together. More recently, another rise in yields has revived an uncomfortable question: if bonds lose value when inflation is high, and fail to protect when equities fall, why own them at all?
The answer is not that the risks have disappeared. Inflation may rise further. Stronger economic performance, higher energy costs and continued friction to global trade could keep retail prices stubborn and force central banks to tighten monetary policy more than markets expect. Bond yields could rise again, and investors holding longer-dated bonds would feel most of the price impact. Anyone presenting bonds as a staid investment proposition is overlooking an experience that has unsettled investors.
Why Higher Bond Yields Matter for Investors
But the scale of the adjustment matters. Bond yields have risen a long way from the unusually low levels that prevailed before the pandemic. That has been painful for existing holders, but it changes the prospective return. A bond bought today offers more income than the same investment did a few years ago. That income provides a cushion: even if yields edge higher, coupon payments can offset some of the fall in price. If yields decline, the price gain comes on top of the coupon income.
This is the first reason to reconsider bonds: after a substantial sell-off, the balance of risk and reward is less one-sided. No one can confidently call the exact point at which yields have peaked. A fresh inflation shock or renewed concern about government borrowing could push them higher. Yet investors no longer need a dramatic fall in rates for bonds to contribute meaningfully to returns. Starting yields are higher, and the income earned while waiting is real.
Bonds vs Stocks: The Case for Diversification
The second reason is what has happened to equities. Shares have enjoyed a powerful run, particularly in the United States, and prices in parts of the market, especially those related to AI, now leave investors with less compensation for taking equity risk than history would suggest. By some measures the US equity risk premium—the extra return investors expect for owning shares rather than safer assets—is unusually low. That does not mean a market fall is imminent. It does mean the reward for accepting equity volatility looks less generous.
Why Quality Matters When Investing in Bonds
But bonds are not one uniform asset class or source of safety. The issuer matters. Government bonds from countries with credible institutions, manageable finances and a record of meeting their obligations can behave differently from debt issued by governments whose finances or ability to repay are in doubt. The same distinction applies to companies: a bond from a financially strong business is not the same as one from a highly indebted company facing uncertain prospects.
When markets become unsettled, investors often seek out the bonds they trust most. Those stronger sovereign and corporate issuers are more likely to retain demand and help steady a portfolio, especially if the shock weakens economic growth and brings interest rates down. By contrast, investors may demand extra compensation to hold debt from weaker governments or companies. That can push those bond prices lower at the very moment shares are falling. In practice, weaker corporate bonds can sometimes behave more like equities than like a safe haven.
That is why a portfolio’s bond allocation needs to be judged by its quality, not just its size. If the purpose is resilience, investors should hold enough bonds from solid issuers to provide income and a potential counterweight to shares. Lower quality bonds may still have a role for investors seeking higher income and willing to accept greater risk. But they should not be mistaken for the defensive part of a portfolio.
Understanding Bond Risks and Portfolio Resilience
Even high quality bonds are not a perfect hedge. If the shock is another burst of inflation, stocks and bonds may both fall, as they did in 2022. And a bond from a strong issuer can still lose value when interest rates rise. Yet bonds have sometimes fallen less than shares and softened the blow to portfolios that hold them compared to those that do not. Their value also comes from diversification: a portfolio is less dependent on one asset class and one economic outcome.
There is no need to shift from equity enthusiasm to a wholesale retreat into bonds. Inflation remains a key risk, and the path for interest rates is uncertain. But abandoning bonds after a severe repricing risks confusing a painful period with a permanently broken asset class. Higher yields have improved the starting point; a meaningful allocation to bonds from sound sovereign and corporate issuers can add income and resilience. Weaker issuers may suffer alongside equities, so selectivity matters. In a mixed portfolio, quality bonds deserve a place—not because they cannot fall, but because the next market shock may not look like the last one.
Written by
Josef Portelli, CFA
Managing Director – ReAPS Asset Management Ltd
The information contained in this article represents the views of the contributor as at the date of publication and is provided solely for information purposes. It should not be interpreted as investment, legal, tax or other professional advice, nor should it be used or considered as an offer, invitation or solicitation to buy, sell or subscribe for any financial instrument. Any forecasts, projections or estimates are based on assumptions and current market conditions and are subject to change without notice. Past performance is not a reliable indicator of future performance. ReAPS Asset Management Limited and/or its clients may hold positions in financial instruments referred to in this publication. ReAPS Asset Management Limited (C77747), with registered address at APS Centre, Tower Street, Birkirkara BKR 4012, is regulated by the Malta Financial Services Authority as a UCITS Management Company and to provide investment services under the Investment Services Act and is registered as an Investment Manager under the Retirement Pensions Act.
