Bond yields on the rise

At the start of the year, the outlook for Bonds looked good.  Inflation was declining, there was a prospect of rate cuts and the potential for AI-led productivity gains meant that economic growth could tick up making Debt/GDP ratios look less stretched with time.

But the US-Iran War changed all that.  The conflict in the Gulf and the closure of the world’s largest oil shipping lane has sent oil and related product prices up, nudging up inflation risk and raising the prospects of rate hikes, not rate cuts.  Rising concerns around debt affordability, a new Fed chair and geopolitical tension only add to the febrile mood.  What is going on in the Bond market?
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Bond Yields on the Rise: Implication for Allocators

Bond yields unsettled… and unsettling

Bond yields are on the rise again this year, and it is one of the questions being asked the most. When the value of a “safe-asset” declines,  people rightly want to know why: is it is a warning sign, or is there a risk of another Gilts market crisis?

Why long-dated yields keep climbing

The main driver is no mystery: persistent government overspending (“budget deficits”). A deficit simply means a government spends more money than it takes in.  Government income comes largely from tax receipts, while spending goes on pensions, social security/welfare, public services and, increasingly, the interest on debt already borrowed. When spending runs ahead of income year after year, a government's creditworthiness slowly deteriorates, and lenders (i.e. investors in bonds) demand a higher yield to buy and hold that debt.

Just like with a household – the stronger your personal finances, the lower the interest rate you are charged for a loan.  Same with governments, the stronger your government finances, the lower the interest rate you are charged for borrowing from the debt investors.

Following the Global Financial Crisis of 2008, and even moreso during Covid, US/UK government debt soared to levels not seen since WW2 to protect the financial system and economy respectively.
US and UK Total Debt to GDP now  tands at 123% and 94% respectively on most recent data as at December 2025.  Before the 2008 financial crisis, 40% Debt/GDP was thought to be the “comfortable” level of borrowing.

If government’s spend more than they get, then they are running a deficit and that deficit has to be funded by debt.  Continuous annual deficits means the total amount being borrowed keeps increasing. 
The chart below from the UK’s Office of Budget Responsibility (OBR) shows how total government debt has kept climbing and its forecast trajectory has kept rising.

Government Debt/GDP: Outturn vs Forecasts

Source: https://obr.uk/box/the-rise-of-public-sector-net-debt-over-the-past-25-years/

Successive governments have failed to address the UK’s debt problem and since Covid, it’s even harder has debt has soared and growth has slumped.

Deficits add to the problem

Since the pandemic, the level of total borrowing has soared and annual deficits in the US and UK, have run at roughly 5 to 7% of GDP, and neither government looks likely to close the gap soon.

There are only three ways to plug an annual deficit: 1) raise taxes, 2) cut spending, or 3) issue more debt. The first two are politically painful, so governments tend to lean on the third. But the this is like paying off one credit card, by using another.

Budget deficit as a % of GDP, US and UK. Source: Elston Research

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What does this means for UK Gilts

A growing share of the problem are interest payments.  Following the financial crisis, interest rates (Bank of England Rate which anchors interest rates) was near zero, so interest payments were negligible.  Now that interest rates have normalised (Back of England Rate now at 3.75%), the cost of those interest payments on all that debt has soared to the extent that the British government now spends more on interest payments than it does on Defence.

In fact, so much government spending now goes on interest payments that it crowds out almost everything else.  Higher yields make each new round of borrowing dearer still, while worsening financial conditions chokes off growth creating what’s called a public finances “doom loop”. 

In the absence of economic growth, and with persistent inflation, a “higher for longer” interest rate environment is bad news for longer-dated bonds (their future cashflows are worth less in today’s terms).

Furthermore, absent a productivity revolution, the overall Debt/GDP level (like the loan to value for a house) is set to soar in the UK as time goes on, raising questions as regards the sustainability of overall debt levels.  That’s why as a long-term investment now is not the time to be buying long-maturity bonds.

Concerns around the Gilts market is why our portfolios have broadly avoided exposure to Gilts since the middle of 2025.

Not just a US and UK story

This is a global problem, not just a UK one.  This can be seen in the repricing of government bonds, for key markets. As the chart shows, the UK has overtaken the US as the highest-yielding (most risky) major market this year, a reversal from January. Markets are now pricing more fiscal risk into UK debt than into US debt, even though the US carries the larger headline debt burden.

​10-year government bond yields, 2026. Source: Reuters, Trading Economics, CNBC.

Europe has drifted higher too. Japan stands out: its yield has risen the most in percentage terms. That is less about credit fears and more about the Bank of Japan unwinding decades of ultra-low interest rates. Japanese wage growth came in at 4.1%, which is strong. If people earn more they tend to spend more, and that can push inflation higher, which points to further rate rises. So Japanese yields are climbing as the market braces for a less accommodative central bank.

The common thread is persistent inflation and heavy government borrowing. On top of that shared driver, each country is judged on its own fiscal path, which is why the lines have fanned out rather than moved in lockstep.

What the US Treasury is doing about it

Policymakers are watching this closely. Treasury Secretary Bessent has acknowledged where yields sit — the 30-year is now above 5% — and has responded with a form of debt buyback. In plain terms, the Treasury is issuing short-term bonds to buy back some longer-dated bonds to keep a lid on long yields.  It is issuing short-term bonds, because there is more appetite and less risk for buyers. Coupon auction sizes were held steady in the August refunding, and long-end buyback operations were stepped up from early September. It is a bit like an “operation twist” that alters the maturity profile of looming government debt: reducing the supply of long bonds, and increase the supply of short ones.  Perhaps the UK should do the same, with an Operation “Brit Twist!"

The benchmark or reference 10 year yield

A quick note on why the market focuses on the 10-year yield. The 10-year is the most traded and most liquid government bond, so it is the benchmark “risk free rate” that everyone quotes. When you read “bond yields,” it almost always means the 10-year government bond yield for that country.  The 10 year government bond yield is key in portfolio theory as (assuming a 10 year time horizon) all investments can be referenced as return premium to that “risk-free” asset.  This means changes in government bond yields, directly impact corporate bonds (which trade at a  spread above or below government debt for the same maturity) and other risk assets (where future income is discounted back to today’s terms).

What is duration

The outlook for interest rates, inflation and yields shapes how the attractiveness of bond for inclusion in a portfolios. Yields and Bond values move in opposite directions.  Longer terms bonds have longer duration meaning they are more sensitive to changes in interest rates.  Shorter-term bonds have shorter duration meaning they are less sensitive to changes in interest rates.

The key lesson from 2022 is that if interest rates and inflation are on the rise, don’t hold longer-dated bonds as they will fall far harder than short-maturity ones.  And unlike equities, bonds don’t tend to bounce back after a fall.  They only bounce if inflation and interest rate expectations decline back to the previous level.  This is because bonds are a finite set of cashflows where time value of future payment streams (annual coupons and the principal at maturity) is the main determinant of a bond’s price today.  ​

Staying short duration

Given the outlook for interest rates, our portfolios remain defensive on duration, as bonds with low duration that are less sensitive to changes in interest rates. 

The bond allocation within our portfolios also lean towards emerging-market debt, which has been surprisingly insulated from this sell-off. The big moves in yields have been in developed markets. In a role reversal, many emerging markets are in better financial shape than developed markets.  They also managed the recent inflation surge better and started from higher yields, so their bonds have held up well.

To be clear, we are not forecasting a bond crash or a debt crisis for US Treasuries.  The US Dollar is and remains the global reserve currency and US Treasuries are the most liquid “safe asset”.  For UK Gilts, we are more circumspect.  We are worried about the long-term debt/GDP trajectory for the UK market and the long-term downward pressure that creates on Gilts Sterling.  We do not expect the UK Government to default on its debts (after all, it can always turn the Quantitative Easing money-printing machine back on), but we do worry about the debasement (devaluation) of UK Gilts and Sterling if the UK fiscal position remains on an unsustainable path.

UK government finances could turn round if the Government adopts policies that run counter to its values: cut public spending, and help the private sector kick-start the economy.  But that’s closer to Thatcherism than to Manchesterism, so is unlikely under PM Burnham.

When would we add back duration?

Short-dated debt is currently safer, and that is where our portfolios are positioned. It makes sense to consider adding duration back when the outlook changes — ideally a combination of falling oil, moderating inflation and neutral or falling rates.  At that point long-dated bonds work as both an income asset and portfolio protection again.

When bond market credibility is questioned, investors buy gold

There is a natural companion to this story. A government bond is, in the end, a promise on written on a piece of paper. If you trust the government to pay you back, it is valuable. If you don’t, it is just paper — think of the old imperial Russian or Chinese bonds that you can find in antique shops or framed for decoration: they were worth nothing after those revolutions. When faith in governments' ability to manage their debt is tested, investors reach for something finite and physical that has held its value for thousands of years: gold.

Central bank gold demand by quarter, tonnes. Source: World Gold Council / Metals Focus.

​Central banks – primarily in emerging countries like Russia, India and China – have stepped up their gold buying sharply from the third quarter of 2022, when Russia's reserves were frozen, and have bought at a much higher pace ever since. Purchases dipped early in 2026 but rebounded in the second quarter, still well above pre-2022 levels. The driver is those central banks wanitng to diversify their balance sheet reserves away from the US Dollar given geopolitical tensions.  This could be a multi-year structural shift rather than a passing trade.

This is why gold and other genuine diversifiers are an attractive investment. In a world of stretched government finances, assets that behave differently from both equities and bonds are attractive for “true” (uncorrelated) diversification.

Conclusion

Government bond yields are high because governments are borrowing heavily, and that looks set to continue. It is a reason for concern, but not panic.  It’s why our portfolios keep bond exposure short-dated and tilted towards emerging markets, and it’s why they also hold alternative assets such as gold alongside bonds as a structural diversifier.  Our portfolios are ready to add duration should the outlook for inflation and interest rates start pointing down, not up.

In the meantime, let’s hope for the bond markets’ sake that Governments get a handle on their finances: and that means cutting their spending or raising your taxes.

Captain Binface’s witty idea of “cutting taxes for you and raising them for everyone else” sounds like an ideal solution of how this could be done comfortably. Sadly, it is nonsensical good joke.