Bond navigators: how far can yields rise before duration hurts?

It has been an uncomfortable period for bond investors. Headlines continue to focus on persistent inflation, rising debt levels and the risk that interest rates remain higher for longer than previously expected. As government bond yields have moved sharply higher, many investors have questioned whether duration remains an attractive investment.

It is a fair question. However, focusing only on the recent sell-off misses an important part of the picture: carry. A bond's total return comes from two sources: (i) price return, which is the capital gain or loss as yields move, and (ii) income return, which is the coupon income, or carry, earned while holding the bond. In a rising yield environment, carry mitigates the impact on returns.

Yields across many developed government bond markets are at levels not seen for many years, meaning investors are once again earning a meaningful level of income simply for holding bonds.

For much of the post-financial-crisis period, carry offered little protection. With yields close to zero, even modest increases in yields could quickly result in negative total returns. Today, the picture is different. Yields across many developed government bond markets are at levels not seen for many years, meaning investors are once again earning a meaningful level of income simply for holding bonds.

Chart 1 below shows how one-year total returns across major developed government bond markets respond to different yield scenarios.

Chart 1: The asymmetric return profile of government bonds

Chart shows potential one-year return from end of September 2026 for different government bonds for a given change in overall yields over the next 12 months. For illustrative purposes only.

Data source: Bloomberg; on-desk analysis by Royal London Asset Management

What stands out is how resilient returns remain, even if yields move higher from current levels. A further 50bps rise in yields from current levels still generates positive one-year returns across most major government bond markets, while even a 100bps rise results in only modest losses in many cases. Put simply, higher starting yields make bond returns much more resilient than they have been for most of the last decade.

We took this a step further, looking at the yield levels where a 100bps rise would see no losses across all of the markets shown, and seeing how close we are to those levels. Chart 2 shows the amount that yields would need to increase to reach the level where markets can absorb a 100bps yield increase.

Chart 2: How much further would yields need to rise?

Data source: Bloomberg; on-desk analysis by Royal London Asset Management 

The results are striking. Across all markets, yields could move materially higher before a further sell-off would result in a negative one-year return. Markets with higher starting yields are naturally closer to this break-even point, reflecting the greater income available to investors today.

While yields could move higher in the near term, today’s starting levels provide investors with a meaningful cushion against further rises in rates.

This highlights an important shift in the investment landscape. While yields could move higher in the near term, today’s starting levels provide investors with a meaningful cushion against further rises in rates. At the same time, we believe UK interest rates will ultimately move lower as inflation continues to moderate and restrictive policy weighs on growth. While the timing remains uncertain, markets continue to price a relatively elevated path for UK rates. If policy rates ultimately prove lower than currently expected, duration stands to benefit.

This is one reason we remain comfortable holding duration despite the uncomfortable headlines. With government bond yields at levels not seen for many years, we believe that investors are once again being paid to wait.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.