With government deficits under the spotlight, fixed income investors need to think globally and take an active approach to allocations.
Read this article to understand:
- Why, despite recent headlines, government bonds have been far more resilient than in 2022, supported by relatively high starting yields
- The signs that bond markets are starting to pay much closer attention to fiscal deficits
- Why recent developments argue in favour of both a global and active investment approach
Bond markets have been under pressure this year, amid a fresh bout of inflation after the war in Iran pushed up energy prices. While the drivers of the conflict echo similarities to the 2022 geopolitical led energy shock, this time around bond markets have been notably more resilient.
Although investors continue to assess the longer-term implications for inflation of this year’s jump in energy prices, one of the most important differences from 2022 was the yield available to investors at the start of the year.
At the beginning of this year, yields were already significantly higher following a cycle of global tightening of monetary policy. As a result, investors have been earning a much larger income stream, helping offset the impact of rising yields and associated capital losses.
Whereas the global bond benchmark, hedged into sterling, returned minus 12 per cent during 2022, it returned minus one per cent in the first nine months of this year.
Figure 1: A higher starting yield means bond investors have more cushion
Note: Shows Barclays Global Treasury index, GBP hedged.
Source: Bloomberg, as at 30 September 2026.
While this year’s rise in yields may have held back performance, looking forward it would appear to offer bond investors a source of comfort. The global bond benchmark currently yields close to five per cent when hedged back into sterling with the index having a duration of around 6.5 years.
These figures suggest yields would have to climb by around another 75 basis points over the next year for an investor to experience a negative total return. Were they to fall by the same margin, investors could expect to receive a total return of around ten per cent.
Government bonds are likely to remain an important building block within many investors’ portfolios, notwithstanding mounting worries over many nations’ ability or willingness to get deficits under control.
Their liquidity and ability to protect capital and provide stable income, means they are an important means of diversifying equity and credit risk.
Why global?
For investors considering allocating to the asset class, an increasingly important factor to consider is which markets to invest in. Familiarity might lead many to favour bonds issued by their domestic government.
However, investors have historically been able to achieve superior risk-adjusted performance by taking a global approach compared with allocating to a single-currency benchmark.
Figure 2 shows that over the past 20 years the risk-adjusted performance of the global benchmark compares favourably with all individual developed markets.
Figure 2: Sovereign bond realised risk and return over 20 years
Past performance is not a reliable indicator of future results.
Note: All index returns have been hedged into sterling. Global index is Barclays Global Treasury index, GBP hedged. Annualised volatility is based on daily volatility for each individual market.
Source: Aviva Investors, Bloomberg, as at 30 June 2026.
Diversifying across global bond markets, thereby reducing exposure to country-specific risk, may be even more valuable at present.
That is firstly because central banks have in recent years been prioritising the control of inflation, moving away from the ultra-loose monetary policy regime that characterised much of the post-financial crisis era. This has led to bigger differences in monetary policy expectations and this remains a crucial driver of relative bond market returns.
Secondly, there is evidence bond investors are paying increasingly close attention to countries’ fiscal positions. Term premia – the extra financial compensation investors demand to hold a long-term bond instead of investing in a series of short-term ones – have been rising.
Prior to 2022, investors were prepared to fund almost any level of government borrowing, often at exceptionally low or even negative yields, particularly in countries that issued debt in their own currency. This reflected a widespread belief that central banks would continue to absorb excess bond supply, limiting upward pressure on yields.
That is no longer the case. Figure 3 has been created by regressing the term premia of eight different developed bond markets – Germany, Sweden, Switzerland, UK, Australia, New Zealand, Canada and Japan – over rolling six-month periods against respective national deficits.
Figure 3: Deficits impacting bond yields?
Past performance is not a reliable indicator of future results.
Note: R², also known as the coefficient of determination, shows the extent to which the variance in countries’ term premium may be explained by the size of deficits. The term premium is calculated by subtracting ten-year yields from 30-year yields and adding back 33 per cent of the relevant five-year yield to allow for upward sloping yield curve.
Source: Aviva Investors, Bloomberg, as at 30 September 2026.
The chart shows that a decade ago, and for most of the following six and a half years, there was very little evidence the size of a country’s deficit and its term premium were linked. But the relationship between the two has strengthened appreciably since 2022.
This relationship between deficits and term premia can be visualised in a different way. The best-fit line in Figure 4 shows a clear link between current term premia and different countries’ 2025 deficits – the higher the deficit, the higher the term premium demanded by investors.
The US market is shown for illustrative purposes but was a notable omission from the regression. If fiscal deficits were the only factor driving bond markets, US Treasury yields would be significantly higher.
For now, the dollar’s global reserve currency status makes the US a special case, but the chart suggests should global appetite for dollars ever fade, US bond yields could rise appreciably.
Figure 4: Individual countries’ term premia vs 2025 fiscal deficit
Past performance is not a reliable indicator of future results.
Note: The term premium is calculated by subtracting five-year yields from ten-year yields and adding back 20 per cent of the relevant two-year yield to allow for upward sloping yield curve.
Source: Aviva Investors, Bloomberg, IMF, as at 30 September 2026.¹
With central banks no longer in a position to contain yields, and investors suddenly acutely aware of each country’s fiscal position, there are clear dangers of being overly exposed to individual bond markets as UK investors discovered in 2022.
While almost all bond markets declined following the invasion of Ukraine, UK Gilts suffered especially heavy losses. In October of that year the British government announced the biggest (unfunded) tax cuts in half a century against a backdrop of rising inflation.
Why active management matters
Although higher yields should help cushion government bond markets, and while a global benchmark provides diversification, there is a strong case for combining a global allocation with an active investment approach.
In an environment where markets are becoming increasingly sensitive to fiscal sustainability, it would not be surprising to see widening divergences in returns both between countries and across yield curves.
Fixed income indices are typically weighted by the amount of debt outstanding. That means benchmarks tend to be dominated by the most indebted issuers.
Passive funds that track a benchmark are unable to distinguish between countries with improving fundamentals and those facing mounting fiscal or inflationary pressures.
Selective country allocation, duration positioning and yield-curve management seem likely to be increasingly important tools for capturing opportunities while managing downside risks.
Rather than accepting benchmark exposures, active managers can position portfolios more effectively
Rather than accepting benchmark exposures, active managers can position portfolios more effectively by reducing exposure to countries where risks are rising and allocating more capital to markets offering better risk-adjusted opportunities.
Why Aviva Investors?
At Aviva Investors, we seek to exploit the opportunities created by differing economic cycles, policy paths and valuation anomalies across global bond markets.
Our investment process combines top-down macroeconomic analysis with relative-value assessment across countries, maturities and yield curves, helping us identify where bonds appear mispriced relative to fundamentals.
Central to this approach is our collective investment culture. The close collaboration across our fixed income team allows us to draw on a wide range of perspectives when assessing investment opportunities and risks across the broad global opportunity set. These insights are translated into a diversified portfolio with a focus on optimising risk-adjusted returns.
In a world where fiscal sustainability, inflation dynamics and term premia are becoming increasingly important drivers of returns, we believe this combination of global expertise, collaborative decision-making and disciplined portfolio construction should help to deliver resilient long-term outcomes for investors.
