Quick Thoughts: Making Sense of Bewildering Bonds

Originally published in Stephen Dover’s LinkedIn Newsletter, Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Rising bond yields are drawing investor attention. Higher yields offer appealing sources of income, but they also pose risks to economic growth and equity valuations. Bond moves also reflect a confusing combination of factors that can bewilder investors. What is driving bond yields higher and what does that mean for one’s investment strategy?

• Yields are rising globally. Partly, that reflects expectations for a continuing surge in government borrowing—in the United States and abroad. US Treasury debt outstanding recently surpassed US$40 trillion, but that is only part of a burgeoning global government debt burden that today exceeds US$100 trillion, nearly the size of world gross domestic product (GDP).¹
• Bond markets are also responding to a wave of corporate sector borrowing, much of it linked to the rapid expansion of artificial intelligence and its vast ecosystem of energy and real estate development. Together, global public and private sector borrowing has now reached approximately US$350 trillion, roughly three times the size of annual world output.²
• Higher bond yields also reflect expectations for tighter monetary policy. Persistent inflation in Japan, coupled with a weak yen, will likely force the Bank of Japan to hike rates later this year. Higher energy prices could also push the European Central Bank to tighten its policy stance again. Those outcomes are contributing to both rising global bond yields and a soggy US dollar in global foreign exchange markets.
• Higher yields reflect rising real rates, not fears of higher inflation. US inflation expectations (derived from Treasury Inflation Protected Securities) are rock-solid steady. Real rates have driven all of the rise in observed yields this year. That means that the ongoing weakness in bond markets is not a re-run of 2022, when fears of surging inflation led to simultaneous bear markets in bonds and stocks.
• Given the fundamental shifts driving yields higher, we believe recent actions by US Treasury to cap long-term interest rates via buybacks are unlikely to have lasting impact. The Federal Reserve, meanwhile, has adopt a tightening bias (readily detectable even if Chairman Kevin Warsh is dismayed by forward guidance), which also supports elevated yields.
• Of course, higher yields boost income streams for investors. But they can also increase financial risk for less credit-worthy borrowers, crowd out certain forms of investment (e.g., US housing), crimp consumer spending, and lower stock market valuations via higher rates of discount. No wonder, therefore, that some commentators fret today about the risk posed by higher yields to global equity markets.
• And yet—higher yields also reflect a probable acceleration in trend economic growth courtesy of rapid innovation and rising capital expenditures. That’s not fanciful. Productivity growth is already picking up, and record high levels of return on capital and profit margins point to significant gains in economic efficiency.³ Unambiguously, improving long-term growth is a positive for equity investors.
• So, taking all factors into consideration, what do we believe bewildering bond market moves mean for investors?
  • Extend duration. Higher yields are likely to prevail over the rest of this year. That offers opportunities for income and diversification, particularly if risk assets dip. Real yields are also gravitating toward sustainable levels supported by the fundamentals. We therefore favor extending duration along the US curve to more neutral levels, alongside core holdings in corporate credit with sound fundamentals.
  • Position for broadening. Higher yields are driven by a combination of factors that are both negative and positive for growth and equity markets. Accordingly, investors should anticipate a greater dispersion of outcomes, as well as bouts of volatility. We think this is a good time to revisit portfolio resilience, but also to position for broader equity returns across market capitalization, sectors and countries.
  • Don’t count on a quick fix. Rising indebtedness of the government and corporate sectors is global and persistent. A combination of resilient global growth and elevated inflation means that central banks will likely tilt to tightening in the coming months. And if trend growth is improving, then higher real interest rates reflect a blessing in the making.