Positioning government bond portfolios for a higher yield environment

Bond yields in many markets have risen to multi-decade highs. The catalyst has been rising oil prices, but many other drivers, including resilient global growth, elevated fiscal deficits, surging investment demand and central bank bond sales suggest real yields are likely to remain structurally higher than they were in the decade following the global financial crisis. However, while higher yields create improved income opportunities, valuations alone are unlikely to be sufficient to generate strong returns. Instead, we’re looking to position our portfolios where yields have become attractive relative to fundamentals, and where technical factors can provide support.

Why yields have moved higher

Many investors associate higher bond yields instinctively with higher inflation expectations. However, we believe the association is incomplete. Inflation remains above target in many economies, but inflation expectations have remained relatively contained even as yields have risen. Instead, much of the rise in government bond yields has been driven by higher real yields.

We believe equilibrium real yields have risen for two main reasons. First, government borrowing (and hence bond issuance) is elevated across much of the developed world, as economies invest in artificial intelligence, energy infrastructure, defence capabilities and supply-chain resilience. And second, the composition of bond demand has changed. For much of the last decade, central banks acted as large and price-insensitive buyers of government bonds. Today, many central banks are shrinking their balance sheets or allowing holdings to run off, allowing private investor demand to absorb a growing share of sovereign issuance. As the private sector has become the marginal buyer of government bonds, the compensation required for holding duration (the term premium) has also risen.

While the combination of larger fiscal deficits, private investment demand and reduced central bank support has been driving up yields, economic resilience has also enabled yields to remain higher. One of the most surprising features of the current cycle has been the economy's ability to withstand higher yields while continuing to expand. Conventional wisdom suggests that aggressive central bank tightening, higher borrowing costs and repeated geopolitical shocks should have pushed the major economies into recession. Instead, growth has remained remarkably resilient, supported by strong corporate balance sheets, government deficit spending, surging corporate investment in AI and tentative signs of improving productivity. The result is above-trend growth, even as rates have become restrictive.

In this environment, we believe yields are likely to stay higher, and would not assume an automatic return to the extremely low yields experienced in the 2010s. This outlook for higher structural yields has important implications for investors. On the one hand, government bonds have become substantially more attractive following the recent sell-off, with higher yields creating improved income opportunities. But on the other, attractive valuations are unlikely to be sufficient to generate strong returns.

For yields to move significantly lower, we think a growth slowdown, softer economic data or a moderation in issuance dynamics would likely to be needed. As a result, we’re looking to position our portfolios in markets where yields have become attractive relative to fundamentals, and in areas of the yield curve where technical factors can provide support.

Opportunity at the long end

Although yields have moved higher across curves globally, we believe some of the most interesting opportunities are emerging at the long end of government bond markets, where supply is being restricted at the same time as demand is increasing.

One important reason for this dynamic is that debt managers have become increasingly sensitive to the shape of yield curves and the cost of issuing longer-dated debt. In Japan, the Ministry of Finance has reduced long-end issuance, while the UK’s Debt Management Office has also adjusted issuance plans and the US Treasury has increased buyback activity. None of these actions has prevented yields from moving higher. However, they have demonstrated a willingness among debt managers to respond when borrowing costs at the long end become excessive, helping to reduce pressure on longer maturities and provide technical support when valuations become attractive.

At the same time, institutional demand may also become increasingly important, as pension funds, insurance companies and reserve managers begin to revisit long-duration assets following the substantial increase in yields. In Japan, potential shifts in allocation by domestic investors could provide an additional source of demand.

The favourable technical backdrop does not mean that long-end yields cannot move higher. Supply remains substantial, and corporate issuance continues to add duration to the market, particularly in sectors benefiting from the AI investment cycle. However, compared with the front end of the curve, we believe the long end increasingly offers a more attractive balance between valuation and technical support.

Positioning for higher yields

More broadly, in this higher yield environment we believe portfolio construction should focus on combining attractive carry with selective duration exposure and relative-value opportunities. Our preferred approach is to gradually add duration where yields have become attractive, rather than making a large, strategic bet on significantly lower rates.

Following the repricing seen across global government bond markets, we have become more constructive on duration, particularly in longer maturities. We currently see the best opportunities in the long end of the US, Japan and Australia, where yields have adjusted meaningfully higher while technical conditions are becoming more supportive. Within Europe, we continue to find attractive opportunities through country allocation and relative-value positions. Spain remains one of the strongest structural growth stories in the eurozone, supported by productivity improvements and ongoing investment.

Ultimately, we think the current environment is creating both challenges and opportunities for active fixed income investors. Yields may be higher than we have seen for many years, but generating attractive returns will depend on identifying where valuation, fundamentals and technicals align. The key is to achieve a balance between tactical flexibility and strategic patience. As a result, our focus remains on leaning selectively into duration where value has emerged, maintaining diversified sources of alpha, and positioning portfolios to benefit from a world of structurally higher yields.