Behind asset allocation decisions, lies inflation

Buying bonds just to (1) reduce volatility in the portfolio (buy 5 year bonds of high quality company) and (2) generate an attractive income over cash, or to have (3) capital appreciation when interest rates fall, these sources of returns for bonds have been taken away. Only real source available now is the (4) credit profile of a company increases so the yield decreases, hence the price goes up. I guess this is why many investors are in high yield and high risk bond investments at the moment. An increase in interest rates can create marked to market losses from a decline in prices. Yields are in absolute terms low. There is little opportunity cost to cash and the risk/reward seems poor. Risk of interest rates increasing, default, regulatory risk if have low capital structure securities of banks or telecom and utility companies, inflation risk, having equities being cheaper offering a higher return (but can always sell the bond with a 10% loss and buy the equity which would have dropped much more). Meanwhile if you dont know what is happening may be better to be invested in bonds and generating the income? The reward is 2 or 3%. I guess it is still 1.5% more than cash. But for how long will cash stay there. I guess that is the final question which will determine whether you buy bonds, or be underweight bonds and overweight cash. I have been the latter. So far it has been wrong as it has detracted from returns. The equities have done well, but the bonds should have helped more to contribute to returns. We are in a period where both bonds and equities are performing positively. This correlation will eventually break down. Increasing inflation is usually the factor that makes this relationship break down. Decreasing or steady inflation allows the conditions for there to be a positive correlation between bonds and equities. Inflation is the great unknown, and one should always try to hedge against it and have a minimal exposure to companies that can be hurt harshly by it.