Are bonds back to the old normal?

Global bond yields have been heading higher, and some of the numbers we’re seeing are quite eye-catching.

The US 30-year Treasury yield ended last week at 5.4 per cent, its highest level since 2007.

The more closely followed 10-year Treasury yield is just below the 16-year high of 5.0 per cent it touched three years ago.

The UK has just issued 30-year government debt at a yield of 5.8 per cent, while Japan’s 10-year bond yield has pushed above three per cent for the first time since 1996.

At 5.0 per cent, the yield on a 10-year New Zealand government bond is at similar levels to its US counterpart right now.

That’s higher than it was a year ago, but some way below the 12-year high of 5.5 per cent it reached in 2023.

Global bond yields are interconnected, and there are several reasons they’ve been rising.

Many economies are running budget deficits, government debt is projected to keep climbing and a lot of debt issuance looms in the years ahead.

The global economy has been much more resilient than expected (which tends to push interest rates up), while plenty of people expect inflation to be structurally higher in the future.

The AI infrastructure boom has also prompted many large, credible companies to issue debt to fund these developments, which means governments must compete more fiercely for capital when they want to borrow money.

Bond investors are still happy to lend money to the US government (and others), but all those factors are making them demand higher compensation for doing so.

Understandably, these moves have caused some nervousness across financial markets.

When yields rise, the price of existing bonds falls, while borrowing becomes more expensive and asset prices more broadly can come under pressure.

However, we should also remember that we’ve been through a very abnormal period, which makes some comparisons misleading.

The extraordinarily low interest rates we saw in the wake of the global financial crisis (GFC) and then the COVID-19 pandemic were the exception, rather than the rule.

That era initially became known as the ‘new normal’ and it was a world of subdued growth, low inflation and even lower interest rates.

Between 2008 and 2021, the US 10-year Treasury yield averaged just 2.4 per cent and fell as low as 0.3 per cent in the depths of the pandemic.

At times, government bond yields in Europe and Japan were negative, while central banks kept official interest rates near zero and bought enormous quantities of bonds as part of quantitative easing policies.

Against that backdrop, a government bond yield of more than five per cent sounds extreme.

However, in the decade leading up to the GFC the US 10-year Treasury yield averaged about five per cent while core inflation averaged just 2.2 per cent.

Today’s yields look much less unusual through that lens.

Deutsche Bank’s Jim Reid, one of the best in the business, recently offered another way to judge today’s yields.

He noted that since the early 1960s, the US 10-year Treasury yield has averaged about 0.7 percentage points below nominal US GDP growth.

In the June quarter, nominal GDP growth was running at a year-on-year rate of 6.6 per cent, the strongest since 2005 (outside of the post-pandemic bounce back).

While Reid points out that this growth rate has been inflated by energy prices, he suggests that 5.5 or 6.0 per cent might be a more sustainable level.

On that basis, you could argue the 10-year yield should probably be in the high fours or low fives.

We’re in the middle of that range today.

For savers and conservative investors, the return of higher yields isn’t a bad thing at all.

For the best part of 15 years, people have grumbled about low interest rates and the pitiful returns they were getting from fixed income.

However, today we can once again earn meaningful income from high-quality fixed income.

A higher starting yield also provides a cushion against further increases, with positive total returns more likely even if prices come under more pressure.

There are still good reasons to be wary, but conservative investors shouldn’t run scared of fixed income.

If fiscal pressures keep yields high, investors will earn increasingly attractive levels of income.

If growth slows or the AI boom stumbles, bonds could regain their traditional defensive role.

Either way, conservative assets are starting to look more useful than they have been for most of the past decade.

We just need to think more carefully about the duration of some of these investments, and how else we might diversify and protect ourselves against a wider range of fiscal and economic risks.

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