LONDON (Reuters) - Electric vehicle infrastructure, top-end offices and industrial metals - with a resurgence in inflation seemingly on the horizon, investors are slashing their exposure to bonds in favour of “real” assets. While such investments tend to generate income and often appreciate in value, they are particularly prized as a shield against inflation, which many economists expect will make a return as economies recover from the pandemic. That means major changes for multi-asset portfolios run along traditional 60-40 lines. Sovereign debt such as U.S. Treasuries and German Bunds has typically accounted for part of a rough 40% bond allocation - providing an income and acting as an anchor against the lucrative but volatile 60% equity component. But with rock-bottom yields, G7 sovereign debt is offering neither substantial income in normal times nor much safety when things turn rough, and inflation may prove an even bigger headwind. Guilhem Savry, head of macro and dynamic allocation at $22 billion asset manager Unigestion, has slashed bond exposure to nearly the lowest since October 2019, instead favouring energy, industrial metals and commodity-linked currencies. “The reversal of bond yields this year is the game changer for the 60-40 portfolio,” he said. “We think inflation will be much more sustainable than the (U.S) Federal Reserve thinks. The uncertainty for owning fixed income assets has increased sharply.” Inflation erodes the value of future bond coupon payments and fears of a pick up in the measure drove U.S. 10-year Treasuries to a 5% loss in the first three months of the year, their worst quarter since 1987, according to Refinitiv data. It was also the first quarter in more than two years that a 60:40 portfolio underperformed more flexible strategies, according to fund tracker Morningstar. Those sticking to 60:40 models will earn less than 2% on an annualised basis in the next 20 years, Credit Suisse warns, a third of what was generated in the last 20 years. “We’re re-imagining the ‘40’, looking at what else can you own to provide income and diversify,” said Grace Peters, investment strategist at J.P. Morgan Private Bank. Peters has added exposure to construction materials, which are set to benefit from a $2 trillion U.S. infrastructure push. She is bullish too on digital infrastructure, particularly 5G networks and electric vehicle (EV) charging stations, and private, or unlisted assets, such as real estate, where she sees “a broader sweep of opportunities”. Annual returns of 4%-6%, comprising rental income and capital appreciation, exceed those of most G7 bonds, Peters said. European funds are the most keen to cut their exposure to bonds, said Christian Gerlach, a founding partner at boutique investment firm Gerlach Associates. While euro zone inflation remains dormant, yields on two-thirds of the region’s sovereign bonds are negative. CHEAP ALTERNATIVES Real assets were gaining in popularity even before pandemic-linked government and central bank stimulus raised inflation expectations. Consultancy Willis Towers Watson estimates pension funds’ bond allocations fell to 29% over the past 15 years, while “alternatives” nearly doubled to 23%. But broadly they remain under-owned, comprising just 5.5% of exchange traded funds’ assets, Bank of America data shows. The bank’s strategist Michael Hartnett is among those making the case for real assets, believing a secular turning point for both inflation & interest rates has arrived to halt the 40-year bull market in bonds. Valuations for property, commodities, infrastructure and collectibles are the lowest since 1925 relative to financial assets, Hartnett told clients, noting U.S. Treasuries were at their most expensive relative to, for example, diamond prices. Finally, there is a 73% correlation between their returns and inflation, he said, making them “a very good hedge against rising inflation and interest rates in coming years”. Investors will continue to hold the liquid, ultra-safe bonds issued by G7 countries, which are useful as collateral, capital buffers and defensive assets, with rising yields over time likely restore some of their ability to act as portfolio “ballast”. For now though, BofA’s latest monthly survey shows investors are “very short” bonds, versus record high commodity allocations, with a record net 93% of those surveyed expecting higher inflation in the coming 12 months.