Rising bond yields
and why it's not all bad news
Investing
5 min read
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For much of the decade following the Global Financial Crisis, bond markets became unusually quiet. Interest rates were close to zero, central banks were buying enormous quantities of government bonds and inflation appeared largely defeated. Governments could borrow cheaply and investors became accustomed to extraordinarily low bond yields.
That world is disappearing. Government bond yields have risen sharply across most major economies. US 10-year Treasury yields are now around 4.8% [1], while yields in Japan, Germany and the UK have recently reached levels not seen for decades. New Zealand has not escaped the move, with our 10-year government bond yield also pushing towards 5% [2].
Part of that reflects the economic cycle. Inflation remains above central-bank targets in many economies, while the recent rise in energy prices has added another layer of uncertainty. Markets have consequently reassessed how high interest rates might need to go.
Governments need to borrow a lot of money
But there is a bigger story here. One of the most important changes in the global economy is the deterioration in government finances.
The COVID-19 pandemic accelerated the trend, but it didn’t create it. Ageing populations, defence spending, infrastructure requirements and the energy transition are all putting upward pressure on government spending. At the same time, political appetite for either higher taxes or meaningful spending restraint remains limited.
The United States provides the most obvious example. Large budget deficits are now being run even when the economy is relatively strong. And as existing debt matures, governments are having to refinance borrowing undertaken when interest rates were much lower.
That creates a potentially uncomfortable feedback loop: more debt means more interest expense, which means larger deficits, which means still more borrowing.
The return of the term premium
Bond investors are taking notice. A government bond yield can loosely be thought of as having two components: expectations about future short-term interest rates, and a “term premium” that investors require for committing their money for a long period.
That second component matters increasingly. If inflation is less predictable, government debt is rising and the future supply of bonds is likely to be substantial, then investors quite reasonably demand greater compensation for owning long-term bonds.
This helps explain something that might otherwise seem puzzling. Central banks can eventually stop raising interest rates, or even cut them, without long-term bond yields necessarily returning to the exceptionally low levels of the past.
That is a significant change from the investment environment that we became accustomed to after the Global Financial Crisis.
Central banks are stepping back
There is another important structural change underway. For years, central banks weren’t just setting short-term interest rates. Through quantitative easing, they were also enormous buyers of government bonds. That helped suppress longer-term yields and reduce the cost of government borrowing.
That era is largely over. Indeed, central banks increasingly appear keen to step back from the prominent role they have played in financial markets. That means markets will have to do more of the work of determining the appropriate price of government debt. Governments may not always like the answer.
What does this mean for investors?
At first blush, rising bond yields sound like bad news. Bond prices fall when yields rise, and fixed income investors have certainly endured a difficult adjustment from the ultra-low-rate world.
But there is another side to the story. Higher yields mean prospective bond returns have improved considerably. Bonds once again offer meaningful income, while providing the diversification benefits that make them an important component of a balanced portfolio.
There are implications beyond bonds too. Higher government bond yields raise the hurdle rate against which other investments are judged. When investors can earn close to 5% from high-quality government bonds, they have less incentive to stretch for returns elsewhere. That matters for equity valuations, particularly for highly valued companies whose expected profits lie well into the future. It also matters for property, infrastructure and other assets whose valuations are sensitive to long-term interest rates.
None of this means investors should abandon growth assets. Equities remain an important source of long-term capital growth, while real assets can provide valuable protection in a world in which inflation may prove more volatile.
Rather, the message is about diversification. For years, investors were forced to operate in a world in which bonds offered very little income and unusually low interest rates encouraged capital into riskier assets.
That world is changing. Bond markets are rediscovering their role as both a source of investment returns and an important constraint on governments.
For diversified investors, that creates risks, but it also creates opportunities. After a long absence, bonds are starting to look like bonds again.
Sources and references
[1] Source: https://www.cnbc.com/quotes/US10Y
[2] Source: https://www.cnbc.com/quotes/NZ10Y-NZ
Photo credit: Unsplash, Cook Aynne.