Clean and orderly

The widespread focus on artificial intelligence and strong global equity market returns have left bond markets a bit under the radar in 2025. Yet fixed income returns have been consistent with the higher level of yields that we have been seeing since 2023. Bonds are delivering income returns and are well placed to provide diversification, should stock market volatility undermine equity returns. The one market that is different is Japan which is in a rates normalisation cycle of its own. I find more of interest in Japanese equities than I find to worry about a bond collapse in Tokyo. 

• Key macro themes – Mixed views on the outlook but current US data is soft
• Key market themes – Balance and diversification after a year of volatility

Yield and returns 

This year has been a decent one for fixed income markets. As of 30  November, index returns have mostly been above end-2024 yield levels. Short-duration credit strategies have delivered an 11-month total return slightly above end-2024 yields, while longer-duration US dollar fixed income has done much better because of yields declining through the year. Higher interest rates are not on the cards in the US or Europe. Short-duration strategies look set to again deliver total returns close to current yields – that is, 4.0%-4.25% for US dollar and sterling investment-grade fixed income, and around 2.60% for European short-duration strategies. In all cases, this should exceed cash returns.

Income 

For UK investors, bonds have provided mixed returns in recent years. Government bonds (gilts) have had to endure macroeconomic headwinds such as persistent inflation and concerns over fiscal policy. However, income returns are improving. The all-maturity gilt index has generated a 2025 total return of 4.8% to the end of November, with 3.2% of that coming from income. The rest came from the impact of marginally lower gilt yields on bond prices (which is at odds with the media’s “gilt panic” narrative). On the UK corporate bond side, the one-to-three-year index has delivered 5.8% so far in 2025 with the intermediate maturity part of the market (seven-to-10-year maturity) posting a 7.75% total return. It might not have felt like the year of the bond, but returns have been very much in line with prevailing market yields (expected returns). We have seen similar trends in the US markets, while European fixed income performance has been more limited.

UK returns 

On a three-year rolling basis, total returns from UK gilts turned positive in the last couple of months. The drawdown in the market since 2020 has been painful (30% at its worst). Investors have been significantly better off in equities during that period. Returns from strategies based on the FTSE All-Share or a World ex-UK index (in sterling) were around 15% more than returns from gilts (based on an annualised rolling three-year return). However, gilt returns are picking up, driven by higher income, and will be helped by Bank of England rate cuts. Despite the ongoing dissection of the Budget, gilt supply is not going to increase too much.

The negative correlation between bonds and equities is not always evident in high-frequency data, but for investors focused on medium-term portfolio performance, it is important. Since 2008, the three-year return correlation between the All-Share and gilt indices has been -0.16. When there were periods of negative equity returns in 2008, and just before and during the pandemic, gilts delivered positive returns. The equivalent correlation in the US market, between three-year S&P 500 and US Treasury total returns, has been -0.4.

We have said all year that fixed income is back to doing what it should: delivering income and providing a hedge against adverse volatility in risk markets. Equities have dominated global market returns this year, but the argument for a higher share of bonds in portfolios going forward is strong and supported by improved performance. Given valuations in credit and equities, rates are not the biggest risk out there.

Stable returns in 2026 

Current yields should support income returns next year – they sit around 5% in the US and UK corporate investment-grade markets, and around 3.5% in the euro investment-grade market. High yield should deliver even more attractive income. Total returns obviously depend on price volatility, which is a function of changing rate expectations, inflation and fiscal risks, and credit concerns. There would need to be a significant deterioration in market confidence for negative price returns to overwhelm the income. For example, given a UK corporate bond index duration of six years, yields would need to rise by around 80 basis points (bp) to get a flat total return over the coming 12 months.

But Japan? 

Japanese government bond yields have ploughed something of their own furrow of late. The 10-year yield is near 1.9%, the highest since 2007. It reflects a more aggressive fiscal stance by the new prime minister, Sanae Takaichi, as well as higher inflation in Japan (core CPI was 3.0% in September), and further increases in the Bank of Japan’s (BoJ) key overnight interest rate. Long-term government bond yields have gone up in all major markets – the 30-year US Treasury yield is up 313bp since the beginning of 2021. The 30-year Japanese government yield is up about 274bp over the same period. But it is the steepening of the curve in Japan that is remarkable, with short-term rates remaining low. The 30-year minus two-year spread is now 240bp, twice that of the equivalent spread in the US. This has been driven by a sharp increase in inflationary expectations and concerns about supply and demand at the long end of the government bond market.

Modest rate bears 

I was in Japan last week. The consensus there expects the BoJ to raise interest rates to at least 1.0% in the next few months; some expect 1.5% by mid-2026 (market pricing is for 1.0% by end 2026). Inflation is a concern, but the local narrative was that it is very much a function of food prices, although policy makers are watching wage growth as well. On the fiscal side, there are more concerns. The natural demand for longer maturity government bonds is fading. Japanese financial institutions own a lot; they could buy more, given where yields are (3.4%). However, local investors are unsurprisingly concerned by the elevated level of government debt in a society that is ageing and where growth has been poor in recent years. Nevertheless, current yields compare favourably with foreign yields hedged into yen. On the fiscal side, there was mixed support for the government’s ¥21.7trn fiscal package. However, from what I have seen, the issuance implications are limited - at least next year - compared to what the market has been used to. Japan remains a very wealthy country with a huge current account surplus. Funding the government is not going to be a problem.

Should the yen be stronger? 

The other focus was the exchange rate. Theoretically, if fiscal policy is turning more expansive and monetary policy is tightening, the exchange rate should appreciate. Over the last year the dollar has risen by around 10% versus the yen. The fall against the euro has been even more marked. This will have contributed to inflation but also to the robust performance of Japanese equities (the Nikkei 225 is up 25% in local currency). A stronger yen going forward is possible given the direction of macro policies, which means Japanese investors will need to fully hedge their foreign bond portfolios. While the hedging costs are moving in Japan’s favour, it remains difficult to see hedged yields competing with Japanese government bonds. However, there was no indication of a desire to reduce foreign bond holdings, but there was, like everywhere else, a preference for higher yielding private credit exposure and for global equities.

Flows 

There is a narrative that higher domestic interest rates will create conditions for Japanese investors to repatriate capital from overseas markets and for foreign investors to close the yen carry trade. Both lead to a stronger yen and possible increased volatility in foreign bond markets. According to estimates, Japan’s net international asset position is around $3.3trn. This figure has remained stable despite changes in the Japanese yen/US dollar exchange rate. Marginal shifts in the net investment position could occur if local returns are more attractive, but arbitrage would soon restore balance. I find the more cataclysmic versions of this story just too dramatic –Japanese investors have never expressed any intention during my visits to Tokyo to engage in such massive asset allocation shifts. As for the yen carry trade, so far three-month Japanese rates have moved from a low of 5bp in 2022 to 89bp today. Is that enough to derail a huge volume of leveraged short yen trades, sufficient to wreak havoc on global markets? I remain yet to be convinced.

Long stocks, short bonds the Japan way  

It used to be a bit of a joke that being long Japanese equities and short Japanese government bonds was the so-called widow maker of all trades. It does not look like that to me today. Japanese equities are interesting, as Japanese companies are well integrated into the global technology and automation supply chains. Equity market performance in 2025 has been broad-based across industrial sectors and financial companies. For the MSCI Japan universe of stocks, earnings growth is expected to be close to 10% in the next year, with the market trading on a 12-month forward price-earnings ratio of 16 times. That is above the long-term average, in line with other markets, but at a much lower premium than for US markets. When it comes to balancing away from the Magnificent 7-heavy US market, Japan has a lot going for it.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, AXA IM, as of 2 December 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.