From the desk of the CIO: Are yields high enough?

By James Foot, CIO, APAC

Key points

• Bond yields are rising
• Markets are pricing in higher interest rates
• Competition for capital is hotting up.

AI remained a major focus for investors in August, helping technology stocks perform strongly as companies continued to invest and earnings improved. But attention also shifted to bond markets, where government bond yields rose following their decline in July.

So, what could higher yields mean for investors?

A useful rule of thumb is that the yield available on a bond today can provide a reasonable starting point for thinking about its longer-term return potential.

One of the main drivers has been higher energy prices, which have pushed inflation higher and increased expectations that central banks may need to raise interest rates.

The conflict involving Iran has contributed to the rise in energy prices by disrupting energy supplies from the Middle East, including through the Strait of Hormuz.

Higher energy costs can feed into inflation across the global economy. However, we expect the impact to be relatively modest and temporary, partly because the way energy is produced and consumed has changed significantly over time. While an extended conflict could keep inflation elevated for longer, political and geopolitical conditions can also change quickly.

The key question for investors is whether yields have risen far enough to make bonds attractive again, both for their income and for the diversification they can provide if economic growth weakens. We believe the evidence is increasingly pointing in that direction.

Markets now expect interest rates in Australia to reach 5% mid next year, which would be the highest level since 2008. Rates are already above current and expected inflation. If rates were to reach that level, it could slow economic activity and, in turn, ease some inflationary pressures.

At the same time, rapid investment in and adoption of AI could help businesses become more productive and competitive. Over time, greater productivity could help keep costs and wage pressures under control, potentially providing a broader offset to inflation. The race to build AI capabilities has created enormous demand for capital, with significant investment flowing into data centres, computer chips, servers and other infrastructure.

It’s difficult to know when this investment cycle will peak. However, no investment boom continues at the same pace forever. Eventually, the need for new infrastructure is likely to slow. As demand for capital eases, one of the pressures pushing interest rates and bond yields higher could also fade.

Large government deficits and rising debt levels are another concern for bond investors. Higher long-term bond yields partly reflect the increasing cost governments face when refinancing their debt, particularly as older, cheaper debt matures. Demand from some traditional buyers, including central banks, has also declined.

The important question is whether government debt remains manageable over the long term. Defaults by major developed-market governments have historically been rare. Governments also have a range of tools available to manage their finances, and changes in government can bring changes in spending and tax policy. This means today’s budget deficits should not automatically be assumed to continue indefinitely.

After years of relatively low yields, government bonds are offering investors more attractive income and stronger potential returns after inflation.

At current yields, we believe they also provide a greater margin of safety, meaning investors are being better compensated for the risks they are taking. And because high-quality government bonds can perform differently from shares when economic growth disappoints, they may once again play a valuable role in a diversified portfolio. In short, higher yields are making government bonds increasingly attractive as a source of income, potential real returns and portfolio diversification.

Since its original publication, this piece may have been edited to reflect the regulatory requirements of regions outside of the country it was originally published in. This document is issued by Morningstar Investment Management Australia Limited (ABN 54 071 808 501, AFS Licence No. 228986) (‘Morningstar’). Morningstar is the Responsible Entity and issuer of interests in the Morningstar investment funds referred to in this report. © Copyright of this document is owned by Morningstar and any related bodies corporate that are involved in the document’s creation. As such the document, or any part of it, should not be copied, reproduced, scanned or embodied in any other document or distributed to another party without the prior written consent of Morningstar. The information provided is for general use only. In compiling this document, Morningstar has relied on information and data supplied by third parties including information providers (such as Standard and Poor’s, MSCI, Barclays, FTSE). Whilst all reasonable care has been taken to ensure the accuracy of information provided, neither Morningstar nor its third parties accept responsibility for any inaccuracy or for investment decisions or any other actions taken by any person on the basis or context of the information included. Past performance is not a reliable indicator of future performance. Morningstar does not guarantee the performance of any investment or the return of capital. Morningstar warns that (a) Morningstar has not considered any individual person’s objectives, financial situation or particular needs, and (b) individuals should seek advice and consider whether the advice is appropriate in light of their goals, objectives and current situation. Refer to our Financial Services Guide (FSG) for more information at morningstarinvestments.com.au/fsg.  Before making any decision about whether to invest in a financial product, individuals should obtain and consider the disclosure document. For a copy of the relevant disclosure document, please contact our Adviser Solutions Team on 02 9276 4550.