Watch Christie Goncalves, Fixed Income Assistant Fund Manager, and co-panellists discuss rising rates, expanding deficits, and volatile credit dynamics are reshaping the fixed income landscape, demanding a sharp, highly disciplined strategy.
Article last updated 7 October 2026.
It’s been a challenging summer for bond markets. Worries about inflation and interest rates have collided with concerns about rising government borrowing. At the same time, the glut of new issuance from America’s biggest tech companies has stoked unease about how much debt investors can comfortably absorb, helping to push up borrowing costs.
These pressures have combined to drive a significant reset in bond yields across fixed income markets. For investors who look to bonds as a source of stability, that’s sometimes been uncomfortable. But higher yields are also creating very attractive opportunities, particularly for active managers with the flexibility to choose where to take risk and which bonds to own, rather than simply following an index.
Oil in the driving seat
The key catalyst for the rise in yields has been the sharp increase in oil prices since the start of the conflict in the Middle East. As the war has rumbled on, severely disrupting global energy flows, the price of a barrel of oil has risen from $60 in February to around $100 at the end of September (via $120). Because higher energy costs feed directly into inflation, that’s driven a dramatic shift in interest rate expectations. In late February, investors were pricing in two quarter-point rate cuts from both the US Federal Reserve (Fed) and the Bank of England (BoE) this year. By September, investors were expecting several hikes, adding up to roughly a full percentage point of tightening over the next 12 months. The Fed has already begun raising rates again, taking its benchmark rate to 3.75–4.00%.
In our view, central banks are more likely to make one to two hikes over the coming year, depending on how the Middle East conflict proceeds and how it flows through to inflation via energy prices. That’s roughly half the tightening that the market expects. If energy prices stay high, the resulting drag on economic growth will also intensify, making successive rate rises less likely. Here in the UK especially, the risks remain skewed to a slowdown as opposed to an overheating economy. While the Middle East energy shock will likely push the BoE to hike rates by a quarter-point in November, we think expectations of between three and four quarter-point hikes in total look overly aggressive. Given this view, we’ve been carefully adding to our duration exposure (our sensitivity to the direction of interest rates) over the summer.
Inflation is only part of the story…
Shorter-dated bond yields have taken the biggest hit over the last couple of months as they’re most directly anchored to shifts in central bank policy. But longer-dated bond yields have been grinding higher too. That’s been fuelled by growing investor unease about the huge amounts of debt issued by many governments since the pandemic and the growing cost of servicing it. Years of heavy borrowing, combined with higher rates, mean many governments are spending ever larger sums on debt repayments. The US government, for example, is now paying out $1trn a year on debt interest alone – more than it spends on anything except social security. Governments across the developed world face mounting spending pressures from ageing populations, higher defence commitments, and energy infrastructure investment, leaving few easy options for bringing borrowing down. All this means investors are paying more attention to the sustainability of government spending plans and demanding more compensation (via higher yields) to lend to some governments long term.
At the same time, investor demand for government bonds – particularly longer-dated debt - is looking less dependable. For many years, governments have been able to rely on a deep pool of relatively price-insensitive buyers (like central banks, sovereign wealth funds, pension funds and insurers) to absorb vast amounts of their long-dated debt. Today, that buyer base is dwindling. Japan, the largest foreign holder of US Treasuries, is a good example. With 30-year Japanese Government Bond (JGB) yields now above 4% and 10-year JGB yields close to 3% for the first time in almost 30 years, Japanese investors have far less reason to buy Treasuries in search of income. China, too, has been reducing its holdings. Governments can no longer count on buyers like these turning up regardless of price - and that’s showing up in yields.
The supply and demand picture is further complicated by the recent deluge of new debt from the world's largest tech companies to pay for the computing power, data centres, and energy infrastructure needed to build out artificial intelligence at scale. Much of this debt comes at long maturities and carries very strong credit ratings, often in the AA to AAA range. That gives it some of the characteristics long-duration investors have traditionally looked for in government bonds. Because the AI hyperscalers have issued so much so quickly, they’ve had to sweeten their yields in order to get their deals away. This may be helping drive up governments’ long-term borrowing costs as they try to compete with the tech giants to attract a limited pool of long-duration capital.
A different starting point
This summer’s bond market volatility has inevitably rekindled memories of 2022 when central banks hiked rates aggressively after years of ultra-loose policy. That triggered one of the worst bond market sell-offs in modern history. Losses were severe because bonds’ starting yields were so low. When those yields rose sharply, bond prices fell, and there was very little income available to offset the resulting capital losses. A bond yielding 1% offers almost no cushion when yields move to 3% or 4%.
Today’s starting point is very different. Yields have grown much more generous over the last four years, giving investors a far more meaningful income cushion against near-term price swings, particularly in higher-yielding markets such as the UK. As at the end of September, broad indices of sterling investment grade credit were yielding around 5.5%. That’s up from roughly 5.1% at the start of this year and a major jump from just over 2% at the start of 2022.
As the table below shows, the maths of fixed income is working in investors’ favour in a way it wasn’t in 2022.
Estimated 1-year total return for given parallel shift in gilt curve
Moreover, bond markets’ mechanics mean that when bond yields rise, bond duration falls. In simple terms, bonds get less sensitive to future changes in interest rates. That means that a bond market with higher yields is generally better positioned to absorb further rate moves than one where yields are meagre. And the more generous starting yields on offer from many government bonds bolster their ability to act as safe-haven assets in the event of any growth scares and/or weakening in investor risk appetite.
After years of falling short on income, protection and diversification potential, bonds are beginning to behave like bonds again.
Putting the reset to work
The next few months are unlikely to be plain sailing. We’re braced for further volatility as investors shift their focus between inflation, debt sustainability and central bank signals.
The gilt market may well remain more jittery than other major bond markets, given the uncertainty surrounding new Prime Minister Andy Burnham’s first Budget on 28 October. Even so, a lot of bad news already appears to be priced into gilts. If the UK’s fiscal outlook proves less dire than some fear, we think there’s scope for gilt prices to recover. The technical backdrop for gilts has also become more supportive: the Debt Management Office (DMO) has scaled back issuance at the long end of the market and the BoE is halting the quantitative tightening (QT) sales of long-dated bonds that had been adding to supply pressures at the long end.
Most importantly, longer-dated gilts in particular now offer powerful income potential and we’ve been buying more. As we’ve explained, that means we’ve upped our duration exposure. We’re very deliberate about how we take duration risk: we prefer to concentrate it in gilts rather than credit. Very long-dated corporate bonds carry significant spread-duration risk: the risk that any widening in credit spreads further into the future could offset some or all the gains generated by falling government bond yields. That explains why we haven’t been tempted by the ultra-long-dated issuance from the AI hyperscalers. These companies enjoy strong credit fundamentals, but we worry that the additional spread available on their very long-dated corporate bonds doesn’t always adequately compensate investors for the spread-duration risk they’re taking given supply expectations.
When markets are as volatile as they’ve been this summer, choosing what to own, and what to avoid, matters more than ever.
Different parts of the bond market respond in different ways to inflation expectations, government borrowing plans and monetary policy signals. Relative value can therefore shift quickly between government and corporate bonds, across maturities, sectors and currencies. As active managers, we can choose both how much risk to take and where to take it. That means selecting the most attractive points on the yield curve, focusing on issuers and maturities that offer the best balance of risk and reward, and looking beyond sterling when bonds issued in other currencies offer better value. Above all, we can concentrate our exposure where our credit analysis gives us genuine conviction.
Higher bond yields are transforming the fixed income opportunity set. But making the most of that transformation requires sharper choices about which risks to take, how to take them and, just as importantly, which ones to avoid. Little wonder, then, that our research suggests more than 80% of fund selectors expect allocations to active fixed income to increase over the next two years.
