But in recent years, a massive component of this market – developed market government bonds – hasn’t been a great investment for people who buy and hold them within a portfolio.

It’s worth remembering that while bonds suffer in times of rising interest rates, interest-rate risk – or longer-dated government bonds – performs well during periods of slower growth and weaker inflation.

That’s why we need to examine bond yields, how the risk versus reward balance has shifted, and the implications for debt in an economy experiencing a soft landing.

What the yield curve tells us

One of the most important tools for understanding the bond market is the bond yield curve – a graphical representation of the interest rates for bonds of different maturities.

Typically, the yield curve slopes upward, indicating that longer-term bonds have higher yields than bonds with shorter maturities. This upward slope reflects the higher risk and uncertainty associated with longer-term investments, and investors demand higher yields to compensate for these risks.

However, an inverted yield curve – one in which short-term yields are higher than long-term yields – has been the trend for some 24 months. Under normal circumstances, an inverted yield curve is seen as a predictor of economic recession.

Is this time different?

After more than two years of yield-curve inversion and no recession in sight, many investors have asked what happened and why the recession predictor hasn’t done its job so far.

There are many reasons, but one of the most important is that recessions typically do not occur when central banks, such as the Federal Reserve (Fed), tighten monetary policy or invert the yield curve.

Recessions happen much later. It is often only once the central bank has stopped raising interest rates and has started cutting them that a recession begins. That’s also when we stop seeing the inversion in the bond yield curve.

Recession or no recession?

In recent months, investor concerns have shifted from inflation to the risks associated with slower growth. In financial jargon, a hard landing has replaced no landing as the key investment risk.

There are undoubtedly recessionary signs. For example, economic growth is slowing in many developed countries, and unemployment is rising in the US. That said, rising US unemployment is partly driven by a growing labor supply from immigration and higher workforce participation, as opposed to companies cutting staff. Meanwhile, US corporate profitability is still robust, mortgage delinquencies are low, and measures of household net worth are close to record highs.

That’s why our economists believe, for now, that the US economy will manage to escape recession and achieve an elusive soft landing – with inflation back in check without the need for a painful economic contraction.

What a soft landing means for bonds

Inflation has fallen back to levels that the Fed is comfortable with. Last month, the Fed cut interest rates by half a percentage point – its first cut of many. The subsequent fall in short-term yields ended two years of yield curve inversion.

Meanwhile, inflation has been falling elsewhere, which allowed central banks worldwide to shift into rate-cutting mode even earlier than the Fed – although individual circumstances will dictate the pace of monetary easing.

We think the risk-reward balance has shifted back in favor of bonds. In a soft landing scenario, the safest fixed income assets will likely maintain their value.

But suppose our economists are wrong, and the US economy does slip into recession. In that case, investors can expect a substantial increase in the value of their holdings in developed market government bonds.

Bonds help diversify risk again

Bonds have traditionally played an important role in helping to diversify risk. Fixed income tends to correlate negatively with equities – when one falls, the other rises, and vice versa.

That relationship broke down in 2022 when the shock of sustained interest rate hikes caused both asset classes to collapse simultaneously.

That said, the negative correlation dynamic is back and performing its role as a portfolio diversifier. In a falling interest rate environment, and as investor focus returns to growth expectations, slower growth means lower equity and higher bond prices –  stronger growth means rising equities and falling bonds.

This is one of those rare instances in which being negative can be a positive within the bigger picture.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

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