Bond investors urged to brace for volatility throughout 2027

Given the tumultuous events of the past few months, most analysts believe global bond markets will continue to remain under pressure for the rest of the year and into 2027. It will not be a linear journey, however, as yields are likely to bounce around as they did in October.

The US 10-year Treasury and French bond yields spiked above 5.3% and 5.14%, respectively, at the beginning of the month, reaching the loftiest points for both since 2002. At the same time, Japan’s 10-year government bonds traded over 3% – the highest level in 30 years – while the UK equivalent jumped to 5.35%, a peak not seen since the 2007 financial crisis.

The picture though, changed as November beckoned, with Treasuries dipping under 5% despite the heightened inflation levels and hotter-than-expected growth. Fears over the sustainability of the AI infrastructure boom gripped market sentiment. Investors sought the safety of government bonds due to disappointing quarterly cash flows and lower than expected AI capital expenditures from tech giants such as Alphabet and Amazon.

While the furore continued into early November, many fund managers such as Laura Cooper, managing director, head of macro credit and global investment strategist at Nuveen, believe the AI investment boom has not dissipated but entered a more challenging and bumpier phase as “funding needs and investor impatience put greater pressure on companies to deliver returns.”

Fundamentally different

This new stage also does not negate the fundamental changes that have been sweeping across fixed income markets. Thomas Sartain, senior fixed income portfolio manager at Invesco notes that the structural forces that have been dominant over the past year will not dissipate. “The dynamics have changed and we are now in a higher inflation and interest rate environment than the post-global financial crisis era of low interest rates and quantitative easing,” he adds.

In fact, inflation is running above many developed countries’ 2% targets mainly due to ongoing geopolitical tensions in the Middle East, most notably the Iran war. It has disrupted global oil markets, triggering energy supply pressures and oil price spikes. As a result, projections have been revised upwards with the International Monetary Fund (IMF) and analysts now expecting the US headline figure to average 3.6% for 2026, remaining the highest among G7 economies. The Bank of England predicts inflation between 3.6% and 3.7% while the German government forecasts 2.7% this year.

The other issue heavily weighing on government bond markets is the ballooning fiscal and national deficits. This is especially the case in France, where economists estimate national debt this year will hit an unprecedented €3.6trn, while the figure for the US is a staggering $40.5 trn – the first time in 80 years that federal debt has topped 100% of GDP.

Central banks though, were much quicker to spring into action to stem the rising inflation tide. Lessons were learnt from the post-pandemic and Ukraine war periods, where they were slow to respond. However, there was a lull as expected at the end of October with the European Central Bank and Bank of Japan holding interest rates steady at 2.5% and 1.25%, respectively, while the US Federal Reserve left them unchanged at 3.75 to 4%, ahead of the mid-term elections.

The Bank of England remained on the sidelines but overall, there was a more hawkish tone across the Western world as energy prices hovered near multi-month highs and a resolution to the Iran war was nowhere in sight.

“Central banks did not wait this time and understood and calibrated their toolkit much better than in the past, “says John Bilton, managing director, global head of strategic research for the multi-asset solutions team at JPMorgan Asset Management. “We saw this with the Silicon Valley Bank and Liz Truss mini budget crises. They are managing the technicalities of the markets and not flooding them with liquidity.”

The way forward

The question is whether the markets will be able to digest this amount of issuance

Andrew Chorlton, M&G Investments

Unsurprisingly, it is not easy to navigate through this morass. Andrew Chorlton, CIO, fixed income, at M&G Investments, believes it is important for investors to balance the risks of inflation, fiscal debt, geopolitical tensions and the competition between corporates and governments.

He notes that AI spending may be slowing down, but the hyperscalers are still expected to spend between $6trn to $10trn on infrastructure. “If you assume two-thirds of that will be debt-financed, at the lower end of the scale it equates to $4trn, which is the equivalent of 10% of the entire outstanding US Treasury market,” he adds. “One of the questions going forward is whether the markets will be able to digest the amount of issuance.

For now, market participants are confident, but they acknowledge investors are focusing much more on the basics. As Gabriele Foà at Algebris Investments points out, at this stage, markets are not questioning the ability of governments or corporates to raise funding, despite higher yields. The key issue, he says, is the cost at which that funding can be secured. Corporate spreads remain historically tight, although the recent widening has become more meaningful. In sovereign markets, the rising interest burden is a clear sign that fiscal fundamentals are deteriorating.

The best way forward, according to Grégoire Pesques, CIO global fixed income at Amundi, is to view fixed income in a relative light. “Normalisation will take some time, but we should see not only income but some capital gains down the road,” he adds. “These needs also to be assessed in light of equity yields which on indices are very low. So, fixed income is risky but attractive in standalone and relative to other assess classes.”

As ever, selectivity will be key and a more proactive approach is advised. This not only means adjusting duration according to market conditions but also increasing or reducing credit exposure, identifying the most rewarding segments and looking across the geographic spectrum.

As John Stopford, head of multi-asset income at Ninety-One, notes, investors should add duration today, but be much more opportunistic and open-minded about countries and sectors to invest in. For example, his team are adding to the US, which led the sell-off, but now has reasonable value. In the emerging market space, South Africa and Mexico are also generating interest because of strong policy management.