The green transition is likely to make life challenging for bond investors, particularly over the next five years or so. As the IIF argues, net zero will impose very substantial costs on economies, with a significant part of the burden being carried by governments.
We can debate exactly how much it will cost and how the debt will be apportioned, but it seems clear that it will only make already high government debt to GDP ratios swell further. Government deficits had rocketed in response to the pandemic and are proving very slow to come back down. Add in the costs of new energy infrastructure and other climate mitigation and adaptation measures, and the debt burden will begin rising once more, leading to a rise in risk premia for many fixed income assets.
A large US government deficit – it was near 6 per cent of GDP in 2023, against a post-war average of 2.2 per cent – is already making the US Federal Reserve’s job of controlling inflation increasingly difficult. Markets are not only overly optimistic about how quickly and how far interest rates will fall but also seem to be in denial about the costs of building a sustainable economy: the green transition means the era of zero interest rates is in the past.
So how should bond portfolios adjust to world embracing net zero?
Higher bond yields and steeper yield curves certainly present new challenges.
Investors will have to manage the duration and curve exposure of their fixed income portfolios much more actively. Given that traditional bond benchmarks have an inherently long bias, this implies a more benchmark agnostic approach.
At the same time, investors should also expect an increase in the dispersion of returns across individual markets given central banks’ differing attitudes to inflation and the differing costs of net zero.
Central banks’ efforts at reconciling weak growth – not least as fossil fuels begin to be phased out – sticky inflation and net zero targets could well shorten interest rate cycles. It would also tend to lead to higher interest rate volatility than investors grew used to during the past two decades. At the same time, central banks’ experience with quantitative easing could see them use these alternative means of providing liquidity where financial market accidents threaten – think the Credit Suisse and Silicon Valley Bank failures – even as they keep key real interest rates at positive levels.
Investors should also expect an increase in the dispersion of returns across individual markets given central banks’ differing attitudes to inflation and the differing costs of net zero.
In light of sticky inflation and fiscal laxness, investors would be wise to add a 0.5 percentage point premium to what they demand from 30-year Treasury bonds above what 10-year Treasuries yield. At the same time, European investors would do well to add a small premium for the risk that the European Central Bank will allow inflation to run slightly hot – reflecting higher energy costs in Europe – for a while, suggesting 10-year German bund yields of on average 2.5 to 3 per cent for the rest of the decade.
