The great global bond sell-off has continued this week, with yields continuing to rise, leaving borrowing costs at multi-decade highs.
In the UK, the 10-year gilt yield rose to 5.27%, the highest level since 2008, as investors sold off fixed income assets due to fears of spiralling inflation and worrisome deficits.
This rise in yields stems from a resumption of military activity between the US and Iran, which pushed up the oil price as investors anticipated the continued effective closure of the Strait of Hormuz. This should increase energy prices, upping inflation and, in turn, making it more likely that central banks will raise interest rates.
Matthew Amis, investment director of rates management at Aberdeen, said: “The summer holidays are over and yet the Iranian conflict is still no closer to a resolution. Tensions in the Middle East increased again last night, as such both oil and natural gas moved higher. UK 10-year gilt yields are up over 10 basis points this week.
"At the front end of the UK curve, markets are now pricing in three hikes from the Bank of England over the next year. Gilt yields look elevated here but until oil and gas start freely moving in the Strait of Hormuz, gilt yields are going to struggle.”
However, it is far from just a UK problem. By Tuesday evening, the US 10-year treasury yield stood just shy of 4.8%, its highest level since Donald Trump returned to the White House. This morning it stood at 4.81%.
Mike Goosay, chief investment officer and global head of fixed income at Principal Asset Management, said: “The sharp rise in global bond yields reflects investors reassessing inflation risks, policy expectations and the growing supply of government debt across major markets.
“While markets are increasingly pricing the possibility of additional policy tightening, we believe higher long-term yields also reflect structural factors such as elevated issuance, ongoing fiscal financing needs, and a rise in term premium.”
The key question for investors will be whether we are moving into an era where rates are higher for longer, or if this is a short-term phenomenon, said David Roberts, head of fixed income at Nedgroup Investments.
While higher government borrowing around the globe and tensions in the Middle East have taken yields higher, growth is “downright anaemic” once AI spending is stripped out, while “employment across the G7 seems, at best, stable”.
“Right now, it’s difficult to see a change in fortune for bonds. Certainly, a long-term solution to the Iranian situation would help,” he said.
Today’s yields could offer an attractive entry point, with both Roberts and Goosay suggesting there were opportunities. The former noted that the income on offer provides a total return cushion should capital prices fall further, while the latter was more bullish, suggesting that higher yields offer a good starting point for long-term investors.
“We continue to see value in high-quality sectors, including investment-grade credit and select securitised assets,” he said. “We also believe there is room for measured exposure to risk assets such as high yield and emerging market debt.”
Higher yields pose both problems and opportunities for a range of assets outside the bond space too, said Charu Chanana, chief investment strategist at Saxo. In the first two days of September, for example, equity markets have followed the bond market and pulled back.
She noted that companies with strong balance sheets are generally less exposed to refinancing pressure and can continue investing even when capital becomes more expensive, making them more resilient, although strong balance sheets “do not eliminate valuation or company-specific risks”, she said.
Still, this could provide a catalyst for quality stocks to outperform, after years in the doldrums, with Chanana highlighting stocks such as tech giants Microsoft and Alphabet.
Speculative growth stocks, however, may struggle, as higher interest rates lead to an increased discount rate applied to future earnings, which matters more for companies that produce lower profits today but promise future growth.
“This is also where the distinction between profitable AI leaders and speculative AI stories becomes increasingly important. High rates do not necessarily hurt technology; they raise the bar on valuation and profitability,” she said.
Financials should also buck the market trend, as higher yields (and implied higher interest rates) boost net interest income.
“Market volatility can also support exchanges and trading businesses,” she said, as people trade more during volatile times.
However, she noted that “persistently high rates can weaken credit quality, raise funding costs and increase loan losses, so the impact is not uniformly positive across financial companies”. Options in this bracket include JP Morgan, Goldman Sachs and Berkshire Hathaway.
Energy and commodity producers should also thrive given the sell-off is being driven by higher oil prices. “Commodity producers can benefit when higher rates are being driven by stronger nominal growth, inflation, supply constraints or geopolitical risks,” she noted.
UK stocks Shell and Rio Tinto, as well as US giants Exxon Mobil and Chevron, are all illustrative company examples that should do well.
Healthcare is one sector likely to be relatively immune to higher yields as they are “relatively insensitive to interest rates and the economic cycle”.
Lastly, while higher rates tend to slow household spending, consumer staples with strong brands, recurring demand and pricing power may be able to buck the trend.
“Staples can still face margin pressure from higher input costs, weaker consumer demand and valuation risk, particularly when defensive sectors trade at elevated multiples,” said Chanana, so selectivity could be key.
However, she noted that higher mortgage, auto-loan and credit-card rates reduce disposable income, which will adversely affect consumer discretionary stocks, particularly those focused on lower-income consumers.
Elsewhere, companies with a lot of debt could come under pressure as refinancing “becomes more painful” when rates rise.
In particular, she noted that smaller companies tend to have “less access to capital markets” and therefore greater reliance on bank loans and shorter-duration borrowing – although this is not always the case.
Similarly, companies in the emerging markets may also struggle with funding commitments – particularly those denominated in dollars, as a higher US yield tends to strengthen the currency.
Lastly, the property market could also slow, as elevated mortgage rates can reduce housing affordability and demand – a difficult environment for housebuilders.
“Strong rental growth, housing shortages and well-managed balance sheets can still offset some of these pressures, so selectivity matters,” she said.