What higher bond yields mean for investors

The bond market has been action-packed over recent weeks.

Global government bond yields have hit multi-year highs, pushing bond prices lower. The yield premium on corporate bonds has increased. Some of the leaders in artificial intelligence (AI) have raised billions to fund their investments. French government bonds have been hit hard relative to their euro area neighbours.

All of this has led to a spike in volatility.

In Goldfinger, James Bond asks the eponymous villain, “Do you expect me to talk?” and in markets at least, bonds have had plenty to say. We’re looking at what these markets are telling us about the outlook, although past performance is not a guide to future returns.

What’s driving bond yields higher?

We can break down government bond yields into three components:

The US government bond market typically sets the tone for global markets. Over recent weeks, the term premium and long-term expectations have been pretty stable. So, we think the increase in yields is mostly explained by an increase in the real yield as investors have raised their expectations for the path of interest rates set by the US Federal Reserve, the central bank.

We see both growth and inflation data contributing to expectations of rate rises. Economic growth has been surprisingly resilient in the face of persistently high oil prices. The Atlanta Fed GDPNow estimate for third-quarter growth is 3.6%.

And inflation is running more than a full percentage point above the target level, at 3.4%.

A longer view

The yield on a ten-year US Treasury bond has risen from under 1% in 2020 to over 5% today. Is this an opportunity?

Over the long term, there’s a link between the 10-year bond yield and long-run nominal GDP growth. This makes sense if you think about the bond yield being a measure of the cost of capital and GDP growth as a measure of return on that capital. And, in practice, both the US 10-year bond yield and US nominal GDP have averaged close to 6% over the last 50 years.

We think that real GDP growth will be around 2% over the next decade and the inflation target is also 2%, which – as a very crude measure – would suggest a 4% bond yield could be appropriate as a long-term equilibrium rate. But the key point is that a yield close to 5% today is somewhere in the range of 4-6% – neither wildly expensive nor obviously cheap.

We think the big structural shift up in yields, from the low rates of the long decade between the financial crisis and the COVID crisis, is behind us.

Inflation expectations stable

The US-Iran war has led to a jump in the price of oil, pushing up consumer price inflation. With this coming after the COVID crisis and the Russian invasion of Ukraine, inflation has been running above target for over five years now.

However, what matters for investors in 10-year bonds is the expected inflation over the next 10 years. The good news here is that expectations have been well anchored, mostly staying between 2.2% and 2.5% since late 2024.

High yield spreads widening

While the overall economy has proved resilient in the face of soaring oil prices and higher bond yields, that’s not true for everyone. Yields on the bonds of the weakest borrowers have soared to their highest level since 2022. These are the companies that are least able to cope with higher borrowing costs.

The yield premiums for investment grade corporate bonds have increased too but remain low compared to historical averages.

French-German spreads soaring

The riots across France have been echoed in a violent surge in French government bond yields. Government debt levels are uncomfortably high at 117% of GDP and tackling this requires making unpopular decisions. The presidential elections due in April 2027 are creating uncertainty.

Candidates from the extremes are performing strongly in opinion polls. Far-left candidate Jean-Luc Melenchon has suggested that France could take bonds held by the central bank and “throw them in the fire”. Far-right candidate Marine Le Pen has proposed big tax-and-spend policies that would push public borrowing higher. We would expect success by either candidate to be taken negatively by bond markets.

In Denmark, where debt to GDP is only 27%, they raised the retirement age to 70 this month. Meanwhile, candidates in the French election are campaigning on cutting retirement age from 62 to 60. And, while students protest about the lack of investment in their schooling, nearly one third of the current spend on education budget is used to fund pensions.

Hyperscalers issuing

The race to become a winner in the AI race has seen some of the world’s largest companies come to the bond market. The likes of Alphabet, Amazon, Meta and Microsoft are raising funds to invest in the computing power, data centres and infrastructure needed to be an AI leader.

These long-dated bonds are increasing the interest sensitivity of bond indices. They also reduce the diversification benefits for investors looking to protect their portfolios from the risk of an AI bubble bursting.

Higher volatility means greater uncertainty

Together, these developments have led to an increase in volatility in bond markets. Higher volatility means a wider range of potential outcomes – for borrowers and investors. This discourages investments funded through the bond market and is therefore negative for growth.

Investment outlook

The US government bond market offers investors an attractive yield, even after adjusting for inflation. What’s more, with yields well above their 2022 lows, they could rise nearly another percent from here and investors would still end up with a positive return over the coming year. The same is true for UK gilts.

The additional yield on offer from corporate bonds is relatively modest by historical standards but they remain attractive as long as the economy remains resilient.

Government bonds performed strongly when equities suffered over much of the last thirty years. However, that has not been the case since the COVID crisis, with a series of supply shocks pushing up inflation, hitting bond and equity markets in tandem. Still, we expect government bonds to continue to offer protection in the case of an economic slowdown.

Concerns about high levels of government borrowing are not limited to France. Debt levels are high and rising across much of the developed world. This means we expect the term premium – the extra return that investors demand for buying long-dated bonds – to continue to trend higher over the long term.

Back to Goldfinger. Bond asks. “Do you expect me to talk?” Goldfinger’s famous reply, “No, Mr Bond. I expect you to die.” Our message? We expect you to diversify.

This article is for information only and not personal financial advice. Investing can help your money grow, but the value of investments can rise and fall, so you could get back less than you put in. Yields are variable and not a reliable indicator of future income. Investing is for the long term, typically 5 years or more.

If you’re not sure whether investing is right for you, a financial adviser can help.