There has recently been a significant increase in government bond (sovereign bond) yields worldwide. In this article, we analyse the underlying causes and the implications for investment portfolios.
What is driving the rise in government bond yields?
The years following the 2008 financial crisis were characterised by a prolonged period of low inflation, moderate growth and exceptionally low interest rates. Rates were kept low through conventional monetary policy—that is, cuts in official interest rates—as well as unconventional measures such as quantitative easing: large-scale purchases of government bonds by central banks.
Upward pressure on prices was limited, and the main concern was deflation rather than inflation. Interest rates fell towards zero, and Europe even experienced negative rates.
Then came the pandemic, supply chain disruptions, geopolitical tensions, the wars in Ukraine and Iran, and trade conflicts. All of this made inflation higher and more difficult to predict, leading to an increase in interest rates.
This has been exacerbated by public deficits that have continued to grow, even during periods of strong economic activity. In the past, fiscal policy was mainly used to support the economy during recessions, causing a temporary deterioration in public finances before they improved again as growth recovered.
Today, public budgets are being used to finance objectives such as defence, artificial intelligence infrastructure, domestic industries considered strategic, the green transition or, quite simply, securing short-term electoral support.
Even Germany, which was long at the forefront of fiscal discipline, has chosen to use its balance sheet to finance a large-scale programme of infrastructure modernisation and defence spending.
Debt refinancing
All newly created debt—the US federal debt alone has just exceeded $40 trillion—must be refinanced by offering investors an adequate yield. Faced with an uncertain future inflation environment, investors are demanding higher yields to purchase government bonds.
Government bonds must also compete with the considerable issuance of corporate bonds by large technology companies, which need to finance unprecedented investment in artificial intelligence infrastructure. These companies have increasingly turned to capital markets to obtain new funding through the issuance of shares or bonds.
When deciding whether to invest in corporate bonds issued by companies with generally very strong balance sheets or in government bonds issued by countries with steadily deteriorating fiscal positions, many investors have logically chosen to diversify into corporate credit. That said, it should always be remembered that sovereign states issuing debt in their own currency have a central bank capable of monetising that debt—something companies can never do.
The apparent breakdown of the negative correlation between equities and government bonds, a situation typical of an inflationary environment, has also weakened demand for government bonds as a safe-haven asset. In other words, when government bonds reliably rose whenever equity markets fell, investors were willing to accept lower yields in exchange for holding this form of insurance.
Now that this negative correlation can no longer be taken for granted, investors are demanding greater compensation for the duration risk involved in holding government bonds. This is particularly true for longer-term securities, which have been the most affected by the current rise in yields.
Implications for investors
Now that yields have risen, analysts seem to have become universally negative. However, when yields were clearly insufficient to compensate investors for the risks involved, few people expressed concern. This often happens in financial markets: prices shape opinions, not the other way around.
It is therefore worth putting things into perspective. The yield on the 10-year US government bond—perhaps the single most important figure in global finance—currently stands at around 4.70%. This is exactly in line with its average over the past 40 years. These levels are neither abnormal nor incompatible with a relatively strong economy such as the current US economy.
The real anomaly was the era of zero interest rates, not the current environment. This does not mean that there are no structural problems in debt management or, potentially, in the Federal Reserve’s political independence. However, compared with the past, we are still in a relatively normal interest-rate environment—one that appears to compensate for investment risk much more appropriately than it did a few years ago.
Serious problems could arise in the event of a genuine crisis of confidence in central banks, but that does not appear to be the current situation. Long-term inflation expectations embedded in inflation-linked securities remain anchored around the 2% target, suggesting that confidence in central banks’ ability to contain price increases has not been lost.
Implications for inbestMe portfolios
inbestMe offers solutions for every type of investor, regardless of their objectives or view of the market. Our diversified portfolios and bond-only portfolios have more moderate exposure to interest rates for lower-risk profiles and greater exposure for more aggressive risk profiles.
These bonds follow the inverse relationship between prices and yields and therefore decline in value when yields rise, although the Investment Committee always pays close attention to the prudent management of interest-rate risk. Nevertheless, the bonds currently held in the portfolios now offer significantly more attractive potential yields than in previous years.
For investors with short investment horizons, those simply looking for somewhere to hold cash, or those with a strongly negative view of bonds, inbestMe also offers its Savings Portfolios. These portfolios are specifically designed to provide a return that tracks changes in official interest rates, net of costs, without prices being penalised when market yields rise. Put simply, higher rates translate into faster return accumulation.
For investors with defined time horizons of more than one year, Target Portfolios may offer higher returns than Savings Portfolios, provided they are willing to hold the investment until maturity—the target date.
Explore our range of portfolios to find the solution that best suits your needs, even in a rising-yield environment.
