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Escalation in the Middle East, persistent inflation and renewed rises in key interest rates are shaping global bond markets. Across all segments, a structural shift is becoming apparent: once again, a large share of expected returns now comes from ongoing coupon payments, with significantly less coming from capital gains. Bonds are therefore once again fulfilling their traditional role as a reliable source of income in portfolios. “This means carry strategies are moving more strongly into focus, while sensitivity to further interest-rate rises remains high,” says Thorsten Fischer, Managing Director and Head of Portfolio Management at Moventum AM.

The escalation of the conflict between the US, Israel and Iran is keeping global financial markets on edge. Rising energy prices, more expensive fertilisers, higher transport costs and increased prices for industrial intermediate goods are fuelling inflationary pressure – with noticeable consequences for monetary policy and yields worldwide.

“In the United States, the phase of rapid disinflation has, for the time being, come to an end,” says Fischer. Headline inflation rose to 4.2 per cent in May, while core inflation increased to 2.9 per cent. Producer prices, which normally feed through to consumer prices with a slight lag, also rose noticeably, accelerating to 6.5 per cent in May. Higher prices are increasingly weighing on real consumer demand, particularly as, for the first time in several years, prices in the US are rising faster than wages. This creates a balancing act for the US Federal Reserve: interest-rate cuts, which were still considered likely at the start of the year, have now been completely priced out of market expectations. Instead, a prolonged “higher for longer” interest-rate environment is emerging.

Yields on the US Treasury market are therefore structurally elevated. A robust economy, persistent fiscal deficits and the resulting high issuance volumes are keeping yields at an elevated level – with the long end of the curve remaining particularly vulnerable to higher term premia. Fischer therefore considers short to medium maturities more suitable for the current environment.

In the US high-yield bond segment, risk premia currently stand at around 300 basis points. Although this is higher than the lows seen in recent months, it remains moderate by historical standards. With yields of around seven per cent, the absolute income level remains attractive given the associated risk. Stable corporate balance sheets and an economy that has so far proven resilient are supporting the segment. “However, the risk-return profile is becoming increasingly asymmetric,” explains Fischer. If inflationary pressure persists for longer, rising financing costs and an economic slowdown could increase default risks.

US investment-grade bonds now yield more than five per cent, once again offering a meaningful level of ongoing income and representing “a genuine alternative to money market investments or dividend yields”, according to Fischer. One key difference compared with the previous zero-interest-rate phase is that investors no longer have to rely on falling interest rates to generate additional capital gains. Returns are once again determined primarily by regular coupon payments and so-called carry – that is, the ongoing income a bond provides when held to maturity or in a stable market environment.

The inflation trend has also turned in the eurozone: headline inflation stood at 3.2 per cent in May, while core inflation was 2.5 per cent. The phase of rapid inflation normalisation appears to be over for now. “The eurozone’s high dependence on energy makes it particularly vulnerable to geopolitical price shocks,” says Fischer, “while its economy reacts more sensitively to rising energy prices than that of the US.” Shortly after the outbreak of the US-Iran war, the market had already completely priced out any interest-rate cuts by the European Central Bank and had begun to price in rising key interest rates. The ECB followed this expectation at its June meeting, raising its key interest rate for the first time in three years – to 2.25 per cent.

In euro government bond markets, differentiation between individual countries is once again coming more strongly to the fore. “Countries with higher debt levels and expansionary fiscal policies – including France and Italy – remain more vulnerable to spread widening,” says Fischer. Germany and other core countries are acting as stabilisers. For German government bonds, this results in an overall neutral picture: the yield on ten-year bonds, at around three per cent, is currently well above the level seen during the zero-interest-rate phase and once again offers ongoing coupon income.

European high-yield bonds are yielding around 5.9 per cent, with spreads at approximately 270 basis points. Here, too, the income structure has changed. A significantly larger share of the total return now comes from the interest component itself. These higher coupons act as a buffer against moderate widening in credit spreads. Fischer points out that the European high-yield market traditionally has a more defensive sector structure and a higher proportion of BB-rated issuers than its US counterpart: “A stability advantage in an uncertain environment.”

In the European investment-grade segment, risk premia stand at around 55 basis points, with yields at approximately 3.5 per cent. European IG bonds are therefore developing, much like their US counterparts, increasingly into a defensive building block that can compete with dividend yields in a multi-asset context. In Europe, too, however, the potential for further spread tightening is limited, suggesting a focus on short to medium maturities.

The message is the same on both sides of the Atlantic: the paradigm in which falling interest rates and narrowing spreads drove bond prices belongs to the past. The key drivers of returns are ongoing coupon income.