How portfolio positioning can protect investors from rising government bond yields

Government bond markets have come under renewed pressure as investors reassess inflation risks against a backdrop of geopolitical uncertainty, rising energy prices and concern about elevated government borrowing.

The latest moves have been driven in part by escalating tensions between the US and Iran, which has increased concern about energy supply and the risk that inflation remains stickier than central banks would like.

These events are inherently difficult to predict, but the market implications are exactly the kind of risks we have been considering in portfolio construction for some time.

While policymakers have stopped short of signalling a fresh tightening cycle, they have increasingly emphasised data dependence over forward guidance.

This creates uncertainty because investors are left testing how tolerant central banks might be of above-target inflation and whether policy may need to stay tighter for longer. The result has been higher yields across global government bond markets.

Pressure building across the yield curve

Some of the most eye-catching moves have been at the shorter end of the yield curve, where yields remain heavily influenced by expectations for future central bank interest rates.

However, the more significant impact on investor returns has been felt further along the curve, where longer-dated bonds have sold off as inflation expectations and risk premiums have risen.

This dynamic is playing out across many major regions. In Europe, investors continue to debate the prospect of policy tightening this month. In the UK, the market is particularly sensitive to developments in energy prices given the economy’s exposure to imported energy costs and the inflationary consequences that can follow.

The UK gilt market also faces uncertainty about the extent of government borrowing and spending in the run up to Chancellor John Healey’s first Budget at the end of October.

Energy exposure proving valuable

Oil prices have fluctuated significantly as markets assess the impact of geopolitical developments. This has provided support for energy-related companies and reinforced the benefits of maintaining exposure to the sector within diversified portfolios.

Within our portfolios, the dedicated exposure to US energy has provided a useful counterbalance. Energy businesses can be supported by stronger commodity markets, giving portfolios an additional return driver when inflation concerns and geopolitical risks are influencing markets.

This is a good example of why we build portfolios to be robust across different scenarios, rather than relying on one narrow market outcome.

Our recent move into shorter-dated US real yields, through TIPS, has also been helpful. Inflation-linked bonds can provide exposure to realised inflation, but they are still sensitive to moves in real yields.

Keeping that exposure to shorter dated bonds has therefore been important, helping reduce interest rate sensitivity while retaining a degree of inflation linkage. This reflects a deliberate positioning decision for a more uncertain inflation backdrop.

The return of supply-side inflation

Recent bond market moves are notable, but remain far less severe than the volatility seen in 2022.

However, they do reinforce a broader structural shift. Inflation is increasingly being driven by supply-side developments rather than purely by demand. Geopolitical events, energy markets, trade policies and supply chain disruption are therefore playing a larger role in shaping inflation outcomes than many investors became accustomed to during the decade following the global financial crisis.

A different investment backdrop

Since the pandemic, supply chains have become more vulnerable and the global economy has become more fragmented. The world has shifted away from the highly-globalised environment that helped keep inflation subdued for much of the previous decade. Investors are instead navigating a landscape shaped by trade disputes, tariffs, geopolitical tensions and conflicts across multiple regions.

For investors, the key implication is that inflation may prove more uneven than markets became accustomed to during the previous decade. Diversification remains critical in this environment. Shorter-duration fixed income, shorter-dated inflation-linked bonds and selective equity allocations such as energy show how AJ Bell’s portfolios have been positioned with these risks in mind, helping clients remain exposed to long-term growth opportunities while reducing reliance on any single market outcome.

Past performance is not a guide to future performance and some investments need to be held for the long term.