As long bond yields rise, where should investors turn?

SINGAPORE – The sharp rise in long-term government bond yields has become one of the biggest questions confronting investors.

In August, the yield on the 30-year US Treasury briefly rose above 5.3 per cent, the highest since 2007. Long-term borrowing costs have also soared in the UK, Germany and Japan.

Fiscal concerns are only part of the story. The rise in long-term yields also reflects a broader shift in the supply and demand for capital, with important implications for investors.

Competition for capital heats up

For years after the global financial crisis, capital was plentiful and cheap. Central banks bought large quantities of government bonds through quantitative easing, inflation was subdued, and governments and companies borrowed long term at exceptionally low rates.

That era of abundant capital is behind us.

Government borrowing needs have risen sharply just as quantitative easing has given way to quantitative tightening. Demand from central banks and other official buyers has diminished too. More bonds must therefore be absorbed by private investors, who demand greater compensation to hold them.

Crucially, governments now face a powerful new competitor for capital: the artificial intelligence (AI) investment boom.

By our estimates, AI capital spending has risen from roughly US$256 billion (S$324 billion) in 2024 to around US$900 billion in 2026, and likely some US$1.2 trillion in 2027. Even the largest technology companies cannot fund investments on this scale entirely through operating cash flows, and are increasingly tapping corporate bond markets, particularly at longer maturities.

That supply ultimately must find buyers. Rising long-term yields are partly the market’s way of rationing capital as more borrowers compete for it.

How much higher can yields go?

That does not mean long-term yields will rise indefinitely.

Long-term bond yields largely reflect three key factors: expected future short-term interest rates, expected inflation, and the “term premium” that investors demand for committing their money for a long period.

The encouraging part of the recent move is that long-term inflation expectations remain relatively anchored at around 2 per cent. Instead, much of the adjustment has come through higher real yields and term premiums, reflecting uncertainty around fiscal policy, bond supply and monetary policy.

Importantly, both real yields and term premiums are now at levels not seen for decades. In our view, much of this structural repricing may already have occurred.

That makes a substantial and further sustained rise in long-term yields less likely, provided the Federal Reserve protects its inflation-fighting credibility.

Fed holds the key

Fed chair Kevin Warsh used his recent Jackson Hole speech to reinforce the central bank’s commitment to its 2 per cent inflation target.

The blowout 162,000 rise in August payrolls, alongside signs that current policies are not restrictive, could give the Fed sufficient reason to hike in both September and December. Still, we expect the upcoming September decision to be a close call.

Paradoxically, a Fed willing to tighten when necessary may be positive for long-dated bonds. The more credible the central bank is in containing inflation, the less compensation investors need to demand for future inflation risk.

Bonds still matter

Higher yields have not undermined the case for owning bonds. In many respects, they have strengthened it.

Other than their ability to cushion portfolios when equities fall sharply, high-quality fixed income also offers meaningful income too. We prefer the two- to five-year area of the yield curve – which offers around 4.5 per cent in the two- to three-year segment and close to 5 per cent in three- to five-year maturities – while limiting exposure to the much greater interest-rate risk of long-dated bonds.

To be clear, we think the 30-year Treasury yield has probably peaked for this cycle. But peaking does not imply a rapid reversal. With limited political appetite for meaningful fiscal consolidation and a continued AI investment boom, investors should get used to a 30-year Treasury yield trading with a 5 per cent handle.

Elsewhere, floating-rate instruments may suit investors concerned about higher rates, while Asia credit provides diversification opportunities and attractive yields of around 5.5 per cent. For longer-term exposure, we prefer selected European and Australian bond markets to long-dated US Treasuries.

Higher yields need not derail equities

Importantly, rising bond yields do not necessarily signal that the equity rally is ending. The underlying drivers matter.

A rise driven by unanchored inflation expectations and a loss of confidence in monetary policy would be concerning. That is not what we see today. Instead, higher long-term yields are occurring alongside resilient economic growth, strong corporate profits and continued momentum in the multi-year AI infrastructure buildout.

Recent earnings results further suggest that momentum is broadening globally. The S&P 500 posted its strongest profit growth in four years, rising 33 per cent year-over-year. The STOXX 600 earnings surged 22 per cent after three years of stagnation, while in Asia ex-Japan, IT earnings rose 342 per cent. Overall, global earnings should rise 26 per cent in 2026 and another 14 per cent in 2027. 

We remain constructive on equities. AI remains a particularly powerful investment theme, although investors should distinguish between the different beneficiaries. Within the AI value chain, we prefer semiconductor capital equipment, followed by foundries and then computing. Following the recent correction, we have also become more positive on Taiwan equities, which offer relatively direct exposure to the secular AI build-out through their leadership in advanced semiconductor manufacturing.

Higher yields and strong earnings can coexist. But they increase the importance of selectivity, particularly as companies with weak balance sheets face a higher cost of capital.

Stay invested, stay BROAD

The surge in long-term yields is not necessarily a warning that risk assets are about to falter, though it does suggest the investing environment has turned more demanding.

For investors, that is a reason to stay invested while being more deliberate about duration, leverage and diversification.

Our message is to stay “BROAD”: incorporate Bonds in the two- to five-year part of the curve, Rotation equity opportunities in cyclicals and laggards, AI, and Diversification across regions, including the US, Europe and Asia.

Source : https://www.straitstimes.com/business/as-long-bond-yields-rise-where-should-investors-turn1