Government bonds are in the midst of a major shift in ownership. For the two decades leading up to the pandemic, the official sector – institutions run by the state – moved from owning around a third of major government bond markets to owning more than half. This was driven initially by the growth of currency reserves and then, following the 2008 financial crisis, by successive rounds of central bank bond buying.

Since the pandemic, the process of official ownership has moved sharply into reverse. Currency reserves have not grown meaningfully for a decade, and currency intervention is firmly opposed by the new U.S. administration. Meanwhile, central banks have now focused on shrinking their balance sheets rather than expanding them.

Most importantly, fiscal policy has become structurally more active. Just in the past few weeks, the U.S. has passed its “One Big Beautiful Bill,” Germany has formalized its €850 billion multi-year spending package and the UK government has struggled to find support in Parliament for welfare cuts. These factors together mean that official sector holdings have fallen back to approaching a third of major government markets, reversing a powerful two-decade trend in only four years.

Yields have repriced as central banks hand over the reins

There are several important implications from this shift in buyer dynamics. First, central banks conducting bond purchases were non-economic buyers, and thus moved yields to artificially low levels. Now that the private sector is the price setter, higher yields are required to absorb the flood of government issuance. 

The repricing in yields is clear in a range of measures of bond valuation. For example, swap spreads (the difference between yields on government bonds and interest rate swaps) and term premia have moved sharply higher. Real yields have moved back to delivering the 2% real return typical for government bonds over the very long run, after an extended period of negative real yields. This move in valuations has been seen across bond markets, since the changes in central bank and fiscal policy have been global, and because government bonds are substitutes for each other, so higher yields in one market tend to push up yields in others.

Government debt share of economy is increasing

The mirror image of large government deficits is, by definition, large private sector surpluses. This means that while government debt has been rising as a share of developed economies, private debt has been falling, contributing to narrow spreads on non-government bonds. That implies reduced recession risk because recessions are typically caused by an abrupt reversal of imbalances in the private sector, often in housing markets. This time, the main imbalance is in the public sector, and there is usually less pressure on government deficits to be cut quickly.

Are bonds still a risk hedge?

Another key change that has occurred is the hedging properties of government bonds. For most of the past few decades, government bonds were an excellent hedge for risky assets because central banks eased policy when growth weakened, supporting bonds just when risky assets were under pressure. Higher inflation since the pandemic challenged that negative correlation, by making it harder for central banks to respond to growth weakness. More active fiscal policy had much the same impact – if government deficits are cushioning growth, central banks don’t need to.

As inflation has come back down, shorter-dated bonds have regained their negative correlation with risky assets. But this is less true for longer-dated bonds, which are more affected by fiscal uncertainty. Indeed, there have been several episodes in recent years, such as the 2022 UK “mini” budget and the 2024 French election, when fiscal uncertainty made bonds the cause of market volatility rather than a hedge for it.

Fiscal sustainability challenges are very real for a number of developed economies, and will continue to drive episodes of volatility, but appear more likely to crystallize in the medium term. Interestingly, government bonds in Germany, where inflation and fiscal risks are lower, have become a better hedge for risky assets in recent years than U.S. Treasuries.

Governments go short in new debt issuance

The official sector has already started to respond to the change in the supply-demand balance for bonds. Most central banks are either no longer reducing their bond holdings or doing it at a slower pace. In fact, we expect the U.S. Federal Reserve to resume buying U.S. Treasuries next year, returning to the normal growth in their balance sheet as the economy grows. The Bank of England cited the increase in long-maturity UK yields as a factor in their upcoming September decision on how many of their bond holdings to sell. After all, higher long-term yields represent a tightening in financial conditions, just like an increase in the policy rate.

Governments are also being more proactive in aligning bond issuance with investor demand. On top of the overall increase in government bond supply, there has been a reduction in demand for long-maturity bonds by pension funds and life insurers in a number of countries, for regulatory and other reasons. Governments have recognized the change in the demand outlook and reduced issuance of long-maturity bonds by half in the UK and around a quarter in Japan, with a corresponding increase in shorter-maturity issuance where demand is more stable.

Eurozone governments are likely to respond in a similar way to an upcoming change in Dutch pension fund regulation, which will see reduced demand for long-maturity eurozone bonds. The U.S. has focused its higher issuance needs on the shorter end of the yield curve, and the Treasury secretary has been clear that he has no intention of increasing long-maturity issuance when yields are this high. Shortening the maturity of issuance is no panacea, but it should make the wave of government bond supply easier to absorb.

Seizing the opportunity in core fixed income

Now that government bonds have undergone a significant repricing, they can once again do what they should, which is provide real income. Short- to intermediate-maturity government bonds have shifted from a long period of very low yields to now offering historically typical inflation-adjusted returns of around 1% to 2%.

We think yields are unlikely to move significantly higher from here and that current levels offer an attractive entry point for investors looking to increase their exposure to core fixed income and diversify their portfolios, particularly if growth begins to slow. For example, if the gradual loosening in the U.S. labor market gathers pace or the disinflation trend reasserts itself after the impact of tariffs, yields are likely to move lower, even with elevated bond supply.