Bonds are back in focus. What rising yields mean for investors.

In recent years, low interest rates suppressed bond yields. The sharp shift in the global interest rate environment in recent weeks has changed that. Bonds are back at the centre of the conversation. Yields have risen sharply, bond prices have fallen, governments are issuing record amounts of debt and investors are once again being offered meaningful returns for lending.

Global bond markets have come under renewed pressure in recent months, with government bond yields rising significantly across major markets. The US 10-year Treasury yield recently moved above 5.3%, its highest level since 2002, while yields in several European markets and Japan have also reached multi-decade highs.

There are several reasons behind the move. Inflation has proved more persistent than central banks would have liked, while higher energy prices have added another layer of uncertainty. At the same time, governments are running substantial fiscal deficits and need to issue large amounts of debt. More recently, strong investment in areas such as artificial intelligence has also contributed to increased corporate bond issuance. In simple terms, there is a lot of borrowing taking place, and investors are demanding greater compensation for providing that capital.

The euro area is not immune to these developments. The European Central Bank raised its key interest rates by 25 basis points in September, taking its deposit rate to 2.5%. In Japan, after decades of ultra-low inflation and near-zero interest rates, monetary policy shifted in early 2024 as interest rates moved back into positive territory. As a result, yields on 10-year Japanese government bonds are now just over 3% up from 0.9% two years ago. This led institutional investors to redirect capital towards domestic government bonds, reducing their demand for US Treasuries and European sovereign debt.

How did we get here?

The current situation is easier to understand when viewed against the extraordinary period that preceded it. Following the global financial crisis of 2008, central banks kept interest rates extremely low for an extended period and introduced large-scale bond-buying programmes. The objective was to support economic activity, encourage borrowing and investment, and preventing economies from falling in a deflationary trap.

The pandemic pushed this even further. Interest rates were cut sharply and central banks purchased substantial quantities of government and corporate bonds, injecting financial liquidity in the process to stimulate confidence and economic growth.

That environment changed dramatically in 2022. As economies reopened following the pandemic, inflation surged, initially driven by supply chain disruptions and later amplified by soaring energy and commodity prices after Russia’s invasion of Ukraine. In response, central banks embarked on one of the most aggressive interest rate tightening cycles in decades. More recently, persistent geopolitical tensions in the Middle East and higher oil prices have fuelled concerns that inflation may remain elevated for longer, increasing the likelihood of higher interest rates and continued upward pressure on bond yields.

Bond prices fell sharply as yields rose. For investors who had become accustomed to thinking of bonds as relatively stable investments, this is an important reminder that fixed income does not mean fixed capital value.

What does this mean for investors?

The most obvious consequence is that bonds have become more attractive from an income perspective. An investor can now potentially lock in yields of 4%, 5% or more in parts of the fixed-income market, compared with the very low yields available only a few years ago. In Malta, the latest Malta Government Stock issue offered a 4.3% bond maturing in 2037 against a 3.8% bond maturing in 2036 issued only 3 months ago.

Higher yields can be attractive, but they rarely come without trade-offs. In the bond market, yield is often a reflection of risk. A corporate bond may offer a higher return than a government bond, but investors are being compensated for taking on additional credit risk. Likewise, bonds with more complex structures or lower ranking in the capital structure typically provide a yield premium in exchange for a greater level of uncertainty.

Investors also need to consider duration. Someone investing in a long-term bond and holding it until maturity, assuming the issuer meets its obligations, has a very different risk profile from someone who may need to sell the bond in three years.

There is also inflation risk. A 5% nominal return may look attractive, but its real value depends on how inflation evolves over the investment period.

Perhaps the biggest change, is that bonds once again have a meaningful role to play in portfolio construction. The lesson is not that investors should abandon equities and move entirely into bonds. Rather, different asset classes serve different purposes. Equities can provide long-term capital growth, while high-quality bonds can provide income, diversification and greater visibility over future cash flows.

After an extraordinary period of ultra-low interest rates, today’s bond market offers investors something they have not had for some time. That does not mean yields cannot rise further or bond prices cannot fall further. Nobody can reliably identify the exact peak in interest rates. For investors, the more important question is whether the return available today adequately compensates them for the duration, credit and inflation risks they are taking.

This article is intended for general information purposes only and does not constitute investment advice, an offer, or an invitation to buy or sell any financial instruments. Investments are subject to market fluctuations and the value of investments, and any income derived from them may rise or fall. Investors may lose some or all of their invested capital. Investment returns and income are not guaranteed. Past performance is not indicative of future results and any reference to potential returns, yields or investment outcomes should not be interpreted as a guarantee or expectation of future performance. Investors should seek appropriate professional advice and refer to the relevant product and service documentation before making any investment decision. Jesmond Mizzi Financial Advisors Limited is licensed to conduct investment services business by the MFSA under the Investment Services Act and is a member of the Malta Stock Exchange. The directors or related parties, including the Company and their clients, may have an interest in securities mentioned in this article.