Bonds Are Offering Returns Again – Why Fixed Income Belongs Back in the Multi-Asset Portfolio

The phase when we were just getting to know bonds is over

An entire generation of investors became familiar with bonds during a period when they failed to deliver the very thing they were designed to provide: a return. Between March 2019 and December 2021, German government bonds – including those with maturities as long as ten years – yielded negative returns. Globally, at times Bonds with a total value of over 15 trillion euros below zero (source: BNYDMVU Index). The Eurosystem’s bond purchases had drastically reduced the freely tradable supply of German government bonds. For some issues, the free float (i.e., the portion of bonds freely available for trading on the exchange) fell to just 30 to 40 percent of the outstanding volume. Anyone holding duration in this environment was betting on yields to continue falling (Source: Central Banks, Debt Managers, and the Unique Characteristics of the Bund Repo Market).

This was not a normal state of affairs, but rather a historical anomaly: key interest rates near zero, forward guidance, a price-inelastic buyer in the form of the central bank, and an inflation rate that had been structurally below the target of just under 2% for over a decade.

This situation has come to an end – not cyclically, but structurally. The ECB’s balance sheet is shrinking rather than growing. The underlying fiscal stance in Europe has shifted: Germany’s infrastructure and defense package, increased NATO commitments, and joint EU bond issuance mean a sustained increase in duration in the market. This means there are more long-term bonds on the market, with a correspondingly higher interest rate risk. These additional bonds must be purchased by investors. Because many of these investors pay close attention to price and yield, this can lead to a situation where long-term interest rates must tend to remain higher in order to generate sufficient demand.

And inflation has not only risen but has also become more volatile – energy, supply chain fragmentation, demographics, and geopolitics are all pushing in the same direction.

The result: The yield on 10-year Bunds stands at 3.52%, while the Euro Aggregate Index yields around 3.92% (as of September 15, 2026, yield to worst). The real yield on 10-year Bunds (German government bonds) stands at 1.28%, the highest level since February 2010. Anyone who had spent the past fifteen years on a deserted island would not consider this yield level a sign of a crisis, but rather a return to normalcy.

That is precisely the point that gets lost in the debate: For bond investors, this isn’t bad news. It’s the prerequisite for bonds to once again do what they’re supposed to do in a portfolio.

Bonds Are Still Bonds

A bond’s total return comes from two sources: current income and price changes. During the period of extremely low benchmark interest rates, only the second source was at work. Investors weren’t compensated for holding long-term bonds – they were compensated for yields continuing to fall. This is a momentum trade disguised as a bond investment, not a fixed-income investment.

The coupon is back in effect today. And that fundamentally changes the math behind risk.

First: The carry acts as a buffer

Over a 12-month horizon, a bond’s total return can be roughly broken down into

If we simplify this further and equate the current income with the current yield, the break-even point for a parallel rise in interest rates is:

With an index yield of 3.92% and a modified duration of just under five years, this roughly corresponds to an interest rate increase of about 80 basis points over twelve months before the positive current income is eroded by the duration effect.

For the 10-year federal bond, the break-even rate – factoring in the roll-down effect – stands at around 47 basis points on an annualized basis. By comparison: At the end of 2021, when the Bund yield was around minus 0.19%, the same break-even rate was negative – yields would have had to fall for investors to break even at all. Back then, a normal interest rate movement was enough to wipe out a decade’s worth of returns. Today, bonds are once again offering current income that can cushion a certain rise in interest rates. At the end of 2021, this buffer was minimal or nonexistent.

Second: Higher yields and coupons reduce interest rate sensitivity

Duration is not a constant; rather, it depends on a bond’s yield level and cash flow structure. A direct comparison of two 10-year German government bonds illustrates just how much the market environment has changed.

The new German government bond issued in June 2021, maturing in August 2031, carried a 0% coupon and was issued with a yield of -0.19%. Virtually the entire value of the bond was therefore tied up in the principal repayment at maturity. As a result, its price reacted particularly strongly to changes in market interest rates. As a zero-coupon bond, its modified duration at issuance was approximately ten years.

In contrast, the most recent 10-year federal bond issued in July 2026, maturing in August 2036, pays a coupon of 3.0%. This means investors receive regular payments back during the term of the bond. Put simply, this shortens the average time it takes for investors to recoup their investment – and thus reduces the so-called duration. With a current yield of around 3.5%, its modified duration is approximately 8.4 years.

Investors today not only receive significantly more current income; the interest rate sensitivity of a newly issued 10-year German government bond is also noticeably lower than it was during the zero-interest-rate environment.

Third: The initial yield is a strong anchor for medium-term returns

For high-quality bonds, the initial yield has historically accounted for a large portion of the annualized five-year return. This is less a short-term forecast than a consequence of bond mathematics: Investors receive regular coupon payments, can reinvest them, and at maturity, the bond is typically redeemed at 100. This ensures that the initial yield level determines a significant portion of the total return over longer time horizons.

And that is why 2022 is only comparable to today to a limited extent. 2022 was not proof that bonds no longer work – it was the unwinding of the anomaly. The nominal yield was close to zero, the real yield was deep in negative territory, and the term premium had to be rebuilt from scratch.

So there was hardly any current income to cushion price losses. A portfolio without an income cushion entering an inflation shock is defenseless against losses. A portfolio with a 3.92% star return is not. A repeat of 2022 is possible – but it would have to start from a completely different baseline, and that significantly changes the distribution of outcomes.

The Multi-Asset Context

So, let’s get to the real question: What role does this asset class play in a diversified portfolio?

Duration is a conditional hedge – with a positive carry today

A common objection is that bonds have lost their diversifying effect. This objection is usually based on two measurement errors.

The first mistake is the average correlation. Bonds are generally considered a relatively safe haven and less volatile than stocks. Therefore, a hedging instrument should not be evaluated based on how it performs on average across all market conditions, but rather on how it performs when the risk event actually occurs. Historically, there has been virtually no correlation between European government bonds and stocks during quarters when stocks have posted gains. However, in quarters when stocks have lost more than 5%, the relationship turns distinctly negative. Thus, when stocks fall significantly, bonds help stabilize the portfolio.

It is also true that this hedge is conditional – bonds do not always fulfill their stabilizing function. Duration provides protection against growth and monetary policy shocks because interest rate expectations fall under such conditions. It does not protect against supply-side and inflation shocks. That was precisely the case in 2022. However, this does not mean that bonds no longer function as a hedge in principle – only that they provide better protection against certain risks than against others.

The second mistake is confusing bonds with duration. Anyone who invests in a broad bond index is also exposed to credit risk – corporate bonds are a risky asset. The yield on a euro-denominated investment-grade bond is divided into a government bond component and a spread component – that is, the yield level of government bonds and the premium that the respective corporate bonds command over them. The first component helps when growth slows; the second component widens precisely at that time.

For Europe, there is an additional nuance: Euro-duration is not homogeneous. German Bund duration is (still) the purest example of this growth/disinflation hedge in Europe. Government bonds from other eurozone countries with weaker credit ratings carry a spread component that widens in a risk-off environment and, during periods of stress, behave like a risk asset themselves. When people in Europe talk about using duration as a hedge, they are referring to core government bonds. The BCEG9T Index was used to calculate the German Bund yield.

Another objection warrants a serious response: If higher fiscal deficits and rising issuance volumes structurally raise yield levels, will bonds still be able to deliver returns at all during the next downturn? The answer involves two distinct levels. Structural forces raise the level of yields and the term premium; they do not prevent cyclical movements during a recession.

In the U.S., deficits widened steadily from the 1970s through 1983 – yet government bonds still delivered attractive risk-adjusted returns during the downturns of 1980 and 1981–82 because recession, disinflation, and expectations of falling key interest rates dominated. Both can be true at the same time: higher average yields over the decade and significantly falling yields during the recession.

And this is where the key difference lies compared to the zero-interest-rate regime: The hedge now once again offers a positive carry. During the zero-interest-rate phase, holding duration was associated with a negative current yield and an expected real return below zero. Investors thus accepted ongoing opportunity costs in order to hedge against growth and monetary policy shocks. Today, the situation is different: With yields at around 3.5%, Bund duration once again offers a positive current yield. This does not guarantee a positive total return, but it does create a buffer against moderate interest rate hikes. For portfolio construction, this is a qualitative difference: A hedge with negative carry is costly if you have to wait a long time to recoup your investment. A hedge with positive carry is much easier to hold in the portfolio over the long term.

Stocks are relatively expensive – and the cushion is getting thinner

The second half of the argument lies on the other side of the portfolio.

If we compare the earnings yield of European stocks (5.9% based on expected 12-month earnings in the STOXX Europe 600) with the return of the Euro Aggregate Index (3.92%), there remains a relative valuation gap of about 2%. For a globally diversified equity portfolio – whose weighting is effectively determined by U.S. stocks – the comparison is even less favorable: In the U.S. market, the gap has narrowed to 0 basis points.

The point isn’t that stocks will fall. The point is that the buffer has become thin. Stock investors can lose money in two ways: through a revaluation – where the multiple compresses without any change in earnings – and through a slowdown in growth that directly affects earnings. Investors bear the full brunt of both risks. As a result, the earnings yield on European stocks is currently only about two percentage points above the yield of the Euro Aggregate Index.

Conclusion: Fixed income is once again an integral part

The argument is explicitly not that bonds will outperform stocks. Rather, it is that bonds are once again fulfilling two functions simultaneously – functions they had lost for a decade: When the global economy is healthy, they provide a sufficient, predictable return – and when conditions deteriorate, as growth and monetary policy take a turn for the worse, they offer protection for the equity side of the portfolio. The star yield provides the current income while also creating a buffer that makes it easier to maintain duration as a permanent hedge in the portfolio.

However, portfolio allocations have not yet reflected this shift in market conditions. Equity allocations in both institutional and retail portfolios remain near historic highs, and there is a clear reason for this: Investors who have faced increasingly low – and at times negative – bond yields for many years and experienced one of the steepest drawdowns in broad bond indices in decades in 2022 are not going to change their behavior over a few basis points. But portfolio construction should be guided by the current market regime, not the one in which one grew up.

Bonds are yielding a bit again. This isn’t a forecast, but rather a characteristic of the current situation – and the current situation is the only thing you can actually be sure of in this business.

 

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