© Serg Zastavkin - stock.adobe.com
As with any investment, your capital is at risk.
Why do we buy home insurance?
We do it because the cost of being uninsured, in the unlikely event that your house burns down, is so catastrophic that accepting a small, steady cost is a rational trade-off.
Now imagine a different world, one where, rather than paying for that insurance, you were actually paid to hold it. That is the situation with bonds today.
What has happened recently?
For much of the 2000s and 2010s, equities and bonds tended to move in opposite directions. When equities fell, bonds often rallied, cushioning the impact on a balanced portfolio. This negative correlation made bonds a natural and effective counterweight in a balanced portfolio.
That relationship, however, has become less reliable in recent years.
Since around the beginning of 2022, the correlation between stocks and bonds has turned positive, meaning they’ve more commonly moved in tandem, so that when equities have fallen, so too have bonds.
The driver here is simple: the return of inflation.
The correlation between equities and bonds has recently turned positive …
… likely driven by inflation remaining above target
Higher inflation reduces the real value of future cash flows, which pushes bond yields higher and prices lower. At the same time, it limits central banks' ability to cut interest rates to support growth.
For much of the previous two decades, inflation was low and stable, which made it easier for bonds to respond positively to economic weakness. With inflation once again above target, however, that cushion has been less dependable.
This has understandably unsettled investors: if bonds can fall at the same time as equities, what is the point of holding them?
Two types of shock, two very different outcomes
To answer that, we need to outline a simple yet powerful framework, one which is the key to understanding why bonds still work in balanced portfolios and should still be held – we need to distinguish between two different types of economic shocks: growth shocks and inflation shocks.
Growth shocks occur when an economy slows sharply or enters recession. Think of the financial crisis in 2008 or the onset of the pandemic in 2020. In these periods, equities tend to fall, often significantly, as earnings expectations decline and uncertainty rises. Bonds, however, typically rally as central banks cut interest rates and investors seek safer assets. In this scenario, equities and bonds move in opposite directions – and diversification works.
Inflation shocks occur when prices rise faster and higher than expected. Think of the oil crises of the 1970s or the post-pandemic surge in 2022. In these environments, bonds fall because rising inflation erodes the value of their fixed payments. Equities can also struggle as valuations compress and central banks tighten their policy rates, meaning stocks and bonds move in the same direction. The hedge breaks down, and diversification is less effective.
The key takeaway here is that the relationship between equities and bonds is not fixed. It depends on which type of shock is driving markets. When growth is the dominant concern, bonds tend to provide protection. When inflation dominates, that protection can weaken.
The experience of recent years reflects the latter. It doesn’t, however, tell us that the role of bonds has stopped working.
Is everyone worried about the wrong scenario?
Here is the point that often gets lost in most of the commentary: these two types of shock are not equally dangerous for equity investors.
Growth shocks have historically been the most damaging. Equity drawdowns in recessions or crisis periods are often rapid and deep. These are the environments where bonds have consistently provided meaningful protection.
Inflation shocks are uncomfortable but rarely devastating for equities. Equity drawdowns during inflation episodes have historically been roughly half the size of those during growth shocks. In some cases, equities have delivered positive returns through an inflation shock. The pain is real, but it is manageable.
This asymmetry matters.
Reducing bond exposure to guard against inflation-driven periods risks weakening the protection against the very scenarios that have historically caused the greatest damage to portfolios.
To return to the analogy: understanding that your insurance policy does not cover every eventuality is useful, but it does not invalidate the need for insurance. You buy it for the scenarios that matter most. In markets, those are the sharp and unexpected downturns in growth.
Not all bonds are created equal
There is a further point that is easy to overlook: the commonly cited relationship between equities and bonds typically refers to domestic equities and domestic government bonds, most often US equities and US Treasuries.
Our opportunity set is far broader than that.
Our bond portfolio is a global, actively managed collection of opportunities: developed market sovereigns, emerging market government debt, investment grade and high yield credit, spread across geographies and maturities.
This matters because, while inflation shocks can be global, their intensity and persistence often vary across regions. US inflation uncertainty may be elevated right now, shaped by tariff policy, fiscal expansion and energy prices. But other parts of the world look different. There are sovereign bond markets where inflation is closer to target, expectations are better anchored, and central banks have more scope to cut rates.
A global, actively managed bond portfolio also provides flexibility. Inflation dynamics are not uniform across regions, and central banks are not all facing the same trade-offs. This creates opportunities to allocate to markets where inflation is better contained and where bonds are more likely to respond positively to weaker growth.
Paid to protect
We should not mistake the last two decades for the norm, a period characterised by low inflation and a consistently negative correlation between equities and bonds. This was unusual. Looking ahead, the relationship between the two is likely to be more variable.
But the role of bonds has not changed.
They are held not because they hedge every possible outcome, but because they provide protection in the scenarios that matter most – particularly sharp slowdowns in growth.
Importantly, bonds today also offer a level of income that has been absent for much of the past decade. Starting yields are higher, meaning investors are better compensated both for holding bonds and for the risk that diversification may be less reliable at times.
The risk that matters most
Balanced portfolios are designed to navigate a range of environments. While there will be periods when equities and bonds move together, the fundamental case for holding bonds remains intact.
We buy home insurance not because we expect a fire, but because we cannot afford to be without it if one occurs. The same logic continues to apply.
We see no reason to cancel the policy.
Important information and risk factors
This article was produced in June 2026 and has not been updated subsequently. It represents views held at the time and may not reflect current thinking.
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, and Baillie Gifford and its staff may have dealt in the investments concerned.
Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.
Investment markets can go down as well as up and market conditions can change rapidly. The value of an investment in the Fund, and any income from it, can fall as well as rise and investors may not get back the amount invested.
The Fund’s share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the Fund is priced.
Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the Fund invests, particularly in emerging markets, may not be able to pay the bond income as promised or could fail to repay the capital amount.
The Fund invests in emerging markets where difficulties in trading could arise, resulting in a negative impact on the value of your investment.
Further details of the risks associated with investing in the Fund can be found in the Key Investor Information Document or the Prospectus, copies of which are available at bailliegifford.com.
197320 10063539
