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Head of Investment Strategy, Sustainability and Research, CIO EMEA
key takeaways.
Shifting asset class correlations are changing the role of sovereign bonds in multi-asset portfolios, and they are no longer as reliable as portfolio diversifiers
Fiscal and political risks have pushed bond yields up, most notably in Japan, but improved external financing positions suggest risks of any sovereign debt crisis are low
Geopolitical shifts are reshaping global demand for government debt; as central banks diversify into gold, sovereign bonds may see higher domestic ownership and depend more on domestic demand
In several countries, sovereign bond yields now compare favourably with equity earnings yields. This underscores their value for investors with a domestic focus. We highlight selected investment opportunities.
Developed market sovereign bonds have long served as diversifiers of choice in multi-asset portfolios. They offered a degree of protection in periods of uncertainty, strong returns during their 1990-2010 golden age as global yields declined, and portfolio stabilisation through a negative correlation with equities. Today, investor sentiment and confidence in their role is less certain. We look at how investors can reassess core sovereign bonds in multi-asset portfolios and capitalise on investment opportunities as they emerge.
Correlations between bonds and equities are no longer reliably negative. The equity-bond relationship, predominantly negative before 2022, has turned more positive since then. Even gold, which is often touted as an uncorrelated asset, has correlated positively with equities more often than not. Developed-market sovereign bond fundamentals, including budget deficits and public debt levels, have seen some erosion over the last two decades. And geopolitical shifts continue to reshape global demand for sovereign bonds.
Correlations between bonds and equities are no longer reliably negative
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No sovereign debt crisis on the horizon
Political risks have also driven up sovereign bond yields in France, and have now driven significant rises in Japan. Yet despite a deterioration in fundamentals, investors should not fear any default or sovereign debt crisis. Sovereign debt crises do not occur because a budget deficit threshold or debt-to-GDP ratio has been breached. They happen when governments can no longer finance debt domestically. This is a function of the share of government debt held at home versus foreign holdings, and of a country’s net foreign asset position. Current accounts play a big role in the latter and in many economies, these have improved over the last 15 years.
For highly indebted countries, current account deficits above 5-6% of GDP are typically the point at which debt risks start to rise. Currently, no developed market nation is in this danger zone. The UK has improved its current account deficit in recent years and France has a small current account deficit. Many European countries and other highly indebted countries like Japan or China are running current account surpluses. Among the major economies, only the US sits closer to the danger zone, though it is still far from crisis. Regarding ownership of government debt, the US stands out with around 40% of its Treasury bonds held by foreign investors, compared with only about 13% for Japanese government bonds (JGBs).
Assessing the risk of a sovereign debt crisis as low does not exclude potential losses on sovereign bonds. JGBs are a case in point. After years of yield curve control as a means for the Bank of Japan (BoJ) to combat deflation, Japan has now seen a sharp catch-up of government bond yields as the central bank engineers a reflationary environment. As yields have risen to their current levels, the value of JGBs has fallen, and this trend could persist in the months ahead. Estimating the fair value of sovereign bonds is never easy. A simple gauge is to combine long-term inflation expectations with potential real GDP growth. If inflation settles around 2%, potential growth hovers around 1% and the Bank of Japan keeps raising its policy rates, the 10-year JGB yield may find its equilibrium closer to 2.5-3.0%, rather than below 2%.
Japan has now seen a sharp catch-up of government bond yields as the central bank engineers a reflationary environment
The picture is more balanced in the US, where current 10-year US Treasury yields align with a 1.9% growth outlook and long-term inflation of 2.3%. 10-year UK Gilts tell a similar story with yields at 4.5%, broadly in line with an outlook of 1.2% for growth and 3% for inflation. But even here, risks of rising yields remain. For example, a conflict in the Middle East would push oil prices higher, accelerating inflation, and raising US, UK and European government bond yields in response. That would put pressure on returns. We believe real assets, especially gold, will continue to offer superior diversification benefits versus sovereign bonds across most risk scenarios.
Geopolitics and shifts in government bond holdings
What is increasingly evident is that sovereign bond holdings are likely to shift as a result of tense international relations and as governments move to reduce their exposure to foreign political leverage. The decline in China’s holdings of US Treasuries from a high of USD 1.3 trillion in 2013 to a record low of USD 680 bn in November 2025 is a good illustration. In the original five BRICS countries – Brazil, Russia, India, China and South Africa – central banks are adjusting their reserve policy in response to a less cooperative geopolitical context, particularly in relations with the US. Russia’s central bank has entirely divested from US Treasuries. As geopolitical tensions rise, not only between the US and strategic competitors like China, but also with traditional allies such as Europe or the UK, more developed central banks including the European Central Bank, Bank of England or Swedish Riksbank, may well join the efforts of their BRICS counterparts to raise the share of gold in their reserves to the detriment of foreign government bonds. In this context, sovereign bonds will instead see higher domestic ownership.
Sovereign bond holdings are likely to shift as a result of tense international relations and as governments move to reduce their exposure to foreign political leverage
Domestic and international investment opportunities
In several countries, sovereign bond yields now compare much more favourably to domestic equity returns than over the past decade. For example, we have argued that 10-year UK Gilts offer value to UK investors with a 4.5% yield versus the 5.4% earnings yield on the FTSE 100, bringing the equity risk premium – or the excess return over government bonds – to a low of around 1%. The Japanese equity risk premium is equally at a 10-year low of 3.1%, down from its average of 6.5% over 2016-2026, highlighting the much improved value of JGBs versus Japanese stocks from a domestic investor’s perspective. In the US, the S&P 500 earnings yield is lower than the 10-year US Treasury yield, stressing the value of holding US sovereign bonds for a domestic investor.
The Japanese equity risk premium is at a 10-year low of 3.1%
Overall, our current moderate pro-risk stance in portfolios means we hold global government bonds at underweight levels. Yet we see several developed market sovereign bonds offering positive real yields. UK Gilts, US Treasuries, Australian and now increasingly Japanese sovereign bonds are appealing long-term ‘buy and hold’ options from a domestic investor’s perspective. Within our sovereign bond exposures we prefer Gilts, which we believe will offer an attractive combination of income and capital gains this year. In the US, Treasury Inflation-Protected Securities (TIPS) offer a shield against inflation surprises, for example if rising oil prices were to push up price pressures. From an international investor’s perspective, and considering short-term opportunities, JGBs offer an attractive yield pick-up over US Treasuries, UK Gilts, German Bunds and Swiss government bonds – when hedged in US dollars, pound sterling, euros, and Swiss francs.
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