Understanding the Rise in Bond Yields: Implications and Opportunities for Investors

The spike in bond yields presents an opportunity for fixed income investors to earn capital gains and diversify portfolios.

The incredible resilience of the U.S. economy, highlighted by September’s payroll numbers, has caused government bond yields to rise sharply. However, we believe the spike in yields is not driven chiefly by concerns over inflation or potential rate hikes by the Federal Reserve. Instead, it is driven by reduced expectations of recession, which counterintuitively could lead to an increase in the supply of government bonds in the future. As a result, investors are demanding a higher premium for holding longer-maturity bonds.

Steepening of the yield curve creates a compelling opportunity for investors in money markets to consider adding longer-duration assets, in our view. Starting yields are high relative to history and to other asset classes on a risk-adjusted basis. This can create a “yield cushion” amid a still highly uncertain outlook. In addition, bonds have the potential to earn capital gains and diversify portfolios. Indeed, investors can now seek to construct resilient portfolios, pursuing robust yields and predictable flows, with a moderate amount of risk.

The spike in rates is also working to tighten financial conditions by making new debt much more expensive. This should eventually raise the cost of existing debt as fixed terms run out on loans to businesses and households. Higher yields have already contributed to stagnating flows of new loans this year. We believe this may eventually slow economic activity and moderate inflation enough for central banks to ease.

Investors demand higher yields to buy bonds

Paradoxically, yields have jumped despite developed market central banks having neared the end of their respective hiking cycles, and as headline inflation rates have moderated meaningfully. This has raised questions about the underlying drivers of the recent market repricing.

Consider that U.S. Treasury yields have risen and the yield curve has steepened with real rates – indicated by yields on Treasury Inflation-Protected Securities (TIPS) – leading nominal bond yields higher. By contrast, the spread between real and nominal rates, or the breakeven inflation spread, hasn’t changed much at all. This suggests that investors aren’t worried about inflation risks, but are nevertheless demanding a higher real term premium to hold longer-maturity government bonds.