After more than a decade of low interest rates, the bond market is becoming more attractive to investors. Central banks had pushed rates to near-zero, making borrowing almost free but starving savers and bond investors of income. As a result, many households began looking for higher-yielding alternatives to protect their cash.
However, with inflation surging and persisting, central banks changed their approach, and interest rates rose steeply. This shift caused a decline in both bond and equity markets, with bonds failing to provide the expected hedge in a typical 60/40 portfolio. Stock indices also slipped as higher financing costs weighed on corporate earnings.
Bond Market Revival
Today, the era of artificially lower-than-inflation interest rates is over. Yields on long-term government bonds, such as the US 10-Year Treasury note, have climbed dramatically, making bonds more attractive to investors. The yield curve has steepened, signaling that longer-dated debt now offers a premium over short-term borrowing.
To understand where bond rates are headed, it is essential to look at what is driving them. Many analysts argue that irresponsible fiscal policy and spendthrift governments are to blame for high bond rates, with investors demanding a higher return to hold debt.
However, some data suggests that the recent rise in US bond yields may simply reflect robust economic growth. Over long periods, government borrowing costs naturally follow nominal economic growth, which is real economic output plus inflation. This relationship means that when the economy expands, investors expect higher returns on sovereign debt. And that’s relevant because current US economic growth is mirroring levels not seen since the mid-1980s, naturally pushing expected interest rates higher.
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A comparison with China supports this argument. While US bond yields are high due to rapid economic growth, China’s yields are low because of sluggish domestic demand and relatively weak growth. The contrast highlights how local growth trends can shape sovereign borrowing costs. China’s domestic economy suffers from sluggish demand and weak growth, which keeps its sovereign yields low despite similar fiscal settings.
The US Treasury term premium is also below zero, with some analysts suggesting negative-50 basis points.
The reason for the negative risk premium on US debt is that US Treasuries serve as the primary collateral for the global financial system. Major banks and global financial institutions use US Treasuries to back trillions of dollars in daily loans, trades, and refinancing operations. Their reliance on these securities reinforces demand regardless of yield levels.
Implications for Investors
Financial markets constantly move through cycles. As the economy shifts from a strong growth phase into a cooler, more turbulent phase, two major forces begin working in favour of bond investors at the exact same time. As economic growth cools, central banks usually cut short-term interest rates to stimulate activity, lowering the first component of the bond yield equation. Secondly, as financial conditions tighten, institutional demand for Treasuries as safe collateral remains strong, keeping the term premium low or driving it lower. This dual effect can create a scenario where falling yields boost bond prices, offering capital gains while the low term premium limits further yield upside.
