Bond navigators: where’s the volatility?

Recent moves higher in long-dated Japanese government bond yields probably caught attention for a number of reasons. Not because of the logical knock-on of a massive increase in government spending, but because risk hasn’t translated into higher yields or volatility recently.

Two obvious measures of the perception of risk – government bond yield volatility and investment grade credit spreads – show the same trend: a gradual decrease over the past three years with the ‘Liberation Day’ tariff chaos the only real spike. Since then, the threats to Fed independence, concerns over an AI spending bubble and demands for Greenland have not really registered.

Except for one place. Long yields have increased noticeably over the past year. Government borrowing jumped sharply during Covid: governments in democratic countries are loath to tell electorates that things need to be cut back. Policy makers can hold down short-term rates through keeping rates low, but longer-dated yields are edging higher.

And yet, there is still value in fixed income. We see strong demand from investors for new issuance – notably when there is a yield premium and interest rate risk is low. I can see why. Unless you think that inflation is about to move materially higher, causing a sharp spike in interest rates, I think market yields and credit spreads offer value. As ever, adding investments that provide a healthy yield provides some mitigation if sentiment does turn negative.

Moreover, at a company level, defaults are not rising and balance sheets are healthy. As a credit investor, you still have to look at the fundamentals for each bond you buy – outsourcing investment decisions to ratings agencies is not a sustainable long-term strategy in our view. Is it possible that the geopolitical risk eventually leads to higher yields, higher spreads or volatility? Perhaps. In my experience, trying to predict market sentiment is difficult. As a bond investor, I prefer a strategy where I’m being paid while markets think about how to react.

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