For much of the period following the Global Financial Crisis, bond investors became accustomed to a world of exceptionally low long-term government bond yields.
Central bank asset purchases, subdued inflation and strong demand from institutional investors all helped to suppress the additional return investors would normally require for lending money over longer periods. That environment has now changed.
Although policy rates across many developed economies are comfortably lower than two years ago, longer-dated government bond yields are markedly higher. At first sight, this may appear counterintuitive. Historically, falling central bank rates have tended to pull yields lower across the maturity spectrum. This time, however, longer-term yields have proved more resistant, reflecting forces that extend well beyond the immediate economic cycle.
An important part of the explanation is the re-emergence of the term premium.
An important part of the explanation is the re-emergence of the ‘term premium’: the additional yield investors demand for holding a bond for ten or twenty years rather than continually reinvesting in shorter-dated securities. During the era of quantitative easing, term premiums were compressed to unusually low levels. Inflation was stable, central banks were significant buyers of government debt and fiscal policy in the aftermath of the Global Financial Crisis was, by recent standards, relatively restrained. Investors therefore required comparatively little compensation for taking long-term interest rate risk.
The backdrop today is quite different. In the years following the pandemic, government borrowing requirements have risen materially across much of the developed world. Ageing populations, increased defence spending, investment in the energy transition and persistently large fiscal deficits are all placing greater demands on public finances. At the same time, central banks are no longer expanding their balance sheets and, in many cases, are actively reducing them. As a result, private investors are being asked to absorb a much greater supply of government bonds.
None of the foregoing necessarily points to an imminent fiscal crisis. Most developed economies retain considerable financing flexibility, while their government bond markets remain deep and liquid. An important point that is often missed is that markets are showing little concern about the UK's ability to service its debt. The cost of insuring UK government bonds against default remains stable, is roughly half that of US Treasuries, and is only a small fraction of the levels seen during the Financial Crisis. However, investors may continue to demand greater compensation for lending over longer periods, particularly while the outlook for inflation remains uncertain and public debt levels continue to rise.
For investors, this has important consequences. The higher yields now available across fixed income offer a considerably more attractive source of income than was available for much of the previous decade. But the opportunities are not evenly distributed across the bond market.
In our view, short and intermediate-maturity bonds currently offer a particularly attractive balance. They provide useful levels of income while being less exposed to changes in long-term fiscal expectations and movements in the term premium.
Private investors are being asked to absorb a much greater supply of government bonds.
Longer-dated bonds still have an important role within diversified portfolios, not least because they can provide valuable protection in the event of a sharper downturn in global growth. However, the assumption that long-term yields will automatically fall as central banks cut interest rates may prove too simplistic. In a world of structurally higher government borrowing and more normalised term premiums, long-term yields may remain higher than investors became accustomed to during the years after the financial crisis.
Against this backdrop, we believe the most compelling opportunities in fixed income are likely to come from capturing attractive levels of income rather than relying on substantial capital gains from falling yields. In that environment, high-quality short and medium-dated bonds continue to look well placed as part of a balanced portfolio.
