Our first chart considers the total return that investors would receive from government bonds, depending on how yields move over the next 12 months. If the economic outlook deteriorates over the coming months, the pressure on central banks to cut interest rates will only intensify. In this scenario, bond yields still have significant room to fall from current levels. In the event that 10-year government bond yields fell by 100 basis points over the next 12 months, this would deliver a return of more than 10%.

This is the kind of meaningful diversification against equity losses that multi-asset investors rely on when constructing balanced portfolios, which has not been available for several years given the very low level of yields.

Government bond return scenarios

%, total return over 12 months

Global rates volatility remains elevated as governments grapple with fiscal realities, and markets shift their focus to whichever country is currently in the spotlight. However, these pressures are reflected in higher starting yields which provide a meaningful buffer against bond losses. The yield cushion on global government bonds, which shows how much sovereign yields could rise over 12 months before capital depreciation wipes out one year’s worth of income, has risen from its pre-pandemic low to around 45 basis points. Fixed income investors thus benefit from a substantial buffer against ongoing policy-related uncertainty.

Global government bond yield cushion

Basis point change over 12 months

In Europe, peripheral countries, which had long been seen as lower quality credits, are looking increasingly attractive. A combination of stronger growth, helped by ongoing fiscal transfers from the European recovery fund, and fiscal consolidation following the eurozone sovereign debt crisis has benefited countries like Italy and Greece which have seen the spread between their bonds and German Bunds shrink. Conversely France, which had been part of the European core of lower risk countries, has struggled to resolve its fiscal impasse and has seen its spread widen. Nimble investors who can access the full opportunity set of European bonds can use this changing dynamic to manage country specific risks and improve returns.

Spread to German 10-year government bond yield

Basis points

Our fourth chart looks at the impact of starting yields on subsequent returns. Investors are aware of the impact of equity valuations on subsequent medium-term returns, and the same dynamic is true in fixed income. After the period of low interest rates following the global financial crisis, government bond yields have now returned to a more normal range. This reset in yields significantly improves the return profile of fixed income as higher starting yields have historically led to higher subsequent returns. From current starting yields, investors have typically enjoyed annualised returns of around 6% over the subsequent five years.

Global government bond yields and subsequent 5y returns

%, subsequent return is % change annualised

A combination of attractive all-in yields and resilient corporate fundamentals has led to heightened demand for investment grade corporate credit. This has compressed corporate spreads to historically low levels. Investors may be tempted to wait for a more attractive entry point, however they could be waiting for some time. Credit spreads are biased towards the tighter end of their ranges and only widen significantly when growth weakens materially. As our fifth chart highlights, so long as corporate earnings don’t fall credit spreads should remain contained and investors can step out into credit to capture the additional income on offer.

US earnings drawdowns and US investment grade spreads

% drawdown from previous peak (LHS); basis points (RHS)