Rising bond yields may point to a structural inflection 

The rise in US bond yields is significant because they serve as a barometer for asset prices globally and are used as a yardstick of the risk-free rate. After declining from 1985, bond yields appear to have undergone a secular shift upwards.
 
Turning trend in bond yields?

Multiple factors are driving bond yields higher 

The adjustment in yields have not proceeded in a linear fashion, and there are likely to be cyclical rallies from time to time (like those we saw recently). However, we note multiple factors that are driving bond yields structurally higher, and that investors need to be cognisant of. These include:

• There is growing consensus that inflation will be higher for longer and inflation expectations are also rising. (We have long argued inflation will be higher for longer. Refer to previous insights from our Angles & Perspectives Q2 2023 and Q2 2022.)
• Concern about the US fiscal position may also be putting upward pressure on yields. US national debt is approaching US$36 trillion (with nearly US$29 trillion held by the public), the federal budget deficit for 2024 is estimated at US$2 trillion, and total interest on the debt is expected to exceed US$1.1 trillion this year. Furthermore, President Donald Trump’s policies are also likely to be inflationary, as we highlighted in this video and the November 2024 PSG Angle.
• Changes in bond yields are not only driven by changes in interest rates, but also by changes in the risk and term premiums (the additional return investors require to tie up their funds further into the future). Recently, the term premium has started to rise, reaching its highest point in over a decade. In addition to factors already mentioned, escalating political risks may be driving the term premium higher.

An additional source of concern is that historical correlations with equities may be undergoing an adjustment as well, with the rolling 3-year correlation between US stocks and bonds having reached their highest level ever (based on analysis going back to 1976). This may mean that bonds are no longer the reliable portfolio diversifier they were for so many years.

Higher bond yields may signal trouble for equity markets too 

As the world’s benchmark for the ‘risk-free’ rate, changing bond market dynamics could potentially impact equity markets too.
 
Currently, the dividend yield of the S&P 500 Index is below its 20-year average while valuations look very extended after the market had another very strong year last year. To our minds, therefore, it could indicate that risk levels in US equity markets are high.
 
Navigating the challenges ahead 

Looking ahead, we believe it will be crucial to ensure portfolios are suitably diversified. Importantly, investors will need to move beyond ‘lazy’ diversification tactics of the past, as:

• the US plays an outsized role in global market indices
• market valuations are stretched
• bonds may not offer the level of portfolio protection that they have in the past, and could even be a source of pain for investors, as they were in 2022
• inflation protection will be crucial

We believe our proven 3M investment process is especially well suited to help investors navigate the current environment. As price-sensitive investors, we have a preference for finding overlooked gems in unloved sectors of the market, meaning that we have a natural tendency to avoid overpriced sectors of the market. We prefer to take a longer-term approach, and have taken lessons from past periods characterised by elevated inflation levels. In the current environment, we are seeking out industries characterised by supply-side constraints that enjoy pricing power, the energy sector and commodities, which are more likely to reward investors in a higher inflation world. Importantly, we are excited about the investment opportunities we are finding outside the popular areas of the market. In looking beyond what is popular, our portfolios provide valuable diversification benefits to our clients – and offer a unique advantage during a period when many market participants have settled into similar positioning built around the common consensus.