Capital Ideas^™ 
Investment insights from Capital Group

Higher bond yields are not solely a U.S. story. Across Europe, Japan and other major economies, governments are borrowing heavily to fund defense, energy security and infrastructure. Together, these pressures suggest global rates may settle above levels seen following the global financial crisis (GFC) and remain more volatile, creating a market environment that could reward active investing.

Against this backdrop, long-duration government bonds may no longer provide the same diversification benefits they once did. Instead, investors will likely need to be more selective across markets, maturities and issuers, and prioritize building portfolios that can adapt to a wider distribution of rate outcomes. The next decade may be defined by the tension between market forces pushing the cost of capital higher — including stronger investment demand, larger fiscal deficits and scarcer capital — and policy-related constraints, including financial repression, that may limit how far yields can rise.

Higher rates create a new investing landscape

Global bond markets face a structurally higher cost of capital than during the long post-GFC era of low inflation, quantitative easing and abundant global savings. In the U.S. 10-year Treasury yields recently crossed 5% and remain near a two-decade high. Reasonably strong forward growth projections, flexible policy tools and the breadth of U.S. Treasury bond ownership across domestic and global institutions may limit the upward potential for yields. But it is still likely that the U.S. will need to pay a higher premium to attract capital over time.  

Yields in Japanese government bonds have also recently surged to 30-year highs, driven by shifts in monetary policy, inflation fears and concerns around the country’s fiscal deficit. Looking ahead, repatriation of overseas assets to support domestic debt markets could strengthen the yen and alter long-standing carry trades, with spillover effects for global markets.

Europe presents a more mixed picture. Greater fiscal integration and joint issuance could support the eurozone as a whole, but individual sovereigns with high debt burdens or heavy reliance on foreign buyers may face renewed scrutiny. France and the UK look more exposed on that front, while Italy’s large domestic savings base may offer some buffer despite elevated debt ratios.

Yields reflect higher neutral rates, not just higher term premium  

Understanding the upward shift in yields requires separating higher neutral rates from a higher term premium. In developed markets including the U.S., Europe, the UK and Japan, much of the recent move in 10-year real yields stems from the market reassessing the neutral rate rather than simply demanding more compensation for bond supply. That matters because higher neutral rates have different asset implications than higher term premium. If yields are rising because the economy can sustain stronger productivity growth, the signal is not necessarily bearish for risk assets; it may reflect stronger nominal growth, investment demand and corporate cash-flow prospects.

Term premium — which reflects the extra compensation investors require to own longer duration bonds rather than continually reinvesting in shorter term bonds — is different. Term premium has already increased materially since 2020 and now sits within a pre-GFC range, but not necessarily at a level that signals excess. The post-QE world has fewer natural absorbers of duration. Central banks have retreated from balance sheet expansion, pension demand is less structurally sticky in places, government debt burdens are high, and corporate issuance linked to the AI and infrastructure cycle is rising. That argues against assuming term premium can sustainably return to the compressed levels of the mid-2010s through the early 2020s.

High debt raises resistance to market-driven borrowing costs

The tension is that high public debt makes governments less willing to accept borrowing costs that markets might otherwise demand. This increases the probability of explicit or implicit financial repression through debt-management strategies — such as shorter weighted-average maturity issuance, regulatory encouragement for domestic institutions to own sovereign debt, central bank balance sheet flexibility or yield-curve management — as well as greater tolerance for inflation that reduces real debt burdens over time. Governments are already trying to ease long-end pressure through issuance choices, and financial repression becomes more tempting as interest expense approaches nominal growth capacity.

This creates a two-sided risk for bond markets. Persistent inflation, larger funding needs, reduced central bank demand and more price-sensitive buyers can push term premium higher. But policymakers may also suppress long-end supply, mitigate disorderly rises in yields or allow inflation to handle some of the adjustment. The adjustment may therefore appear through currencies, inflation-linked assets, curve shape, swap spreads and cross-country relative value.

Investment implications: Owning the right risks

The central asset allocation implication is that broad index exposure may be less attractive than careful security selection. The 2010s rewarded exposure to long duration, U.S. growth leadership, falling discount rates and broad spread compression. The next phase may reward a more active mix of carry, curve discipline, inflation-aware positioning, relative value across countries and currencies, and bottom-up selection more than broad beta. In rates, that argues for curve expressions that isolate term-premium risk more precisely than outright duration.

For sovereign duration, the focus is on being selective. Starting yields are higher, carry is more meaningful, and duration could still help balance portfolios in a genuine demand shock. But duration should be owned deliberately, in markets where real yields compensate investors for inflation and fiscal risk, central banks have room to cut, and issuance or external balance dynamics are manageable. Curve exposure may be more attractive than outright duration where fiscal risk is concentrated at the long end.

We favor approaching credit through carry and idiosyncratic selection rather than relying on broad moves in credit spreads. Stronger nominal growth and investment spending can support corporate fundamentals, but tight spreads leave less margin for error. The most attractive credit opportunities are likely to be those where income is visible, refinancing risk is manageable and the issuer is relatively well positioned for a higher cost-of-capital environment. The riskier parts of credit markets are more vulnerable if term premium shocks tighten financial conditions abruptly.

Foreign exchange and regional allocations become more important. If U.S. exceptionalism fades at the margin and opportunities outside the U.S. broaden, non-dollar opportunities should improve. We favor a selective approach focused on exposures to undervalued developed-market currencies, select EM local markets, and countries where valuations, real yields and policy credibility are compelling.

The next cycle may look very different from the last

There is growing evidence that the world is leaving behind the post-GFC regime of abundant capital, weak investment demand and ultra-low real yields.  Should the recent massive and simultaneous growth in demand for public and private financing continue, it will likely expose the limits of capital availability, meaning its cost could face persistent upward pressure.

For bond investors, the defining challenge of the next decade may not be predicting the next move in yields, but instead identifying where capital is scarce, policy is credible and compensation for risk remains attractive. In a world of higher rates and greater dispersion, a focus on fundamentals and selectivity will be key.