Bonds have not provided the protection investors typically expect since the outbreak of the Iran war. Yet several fund managers now say the balance could swing back in favour of debt instruments if inflation starts to damage economic expansion.
World equities, after an early sell-off when the conflict began, have recovered and sit around record highs, supported by enthusiasm for artificial intelligence and corporate earnings. By contrast, sovereign bonds have come under sustained pressure amid concerns that the conflict will sustain or lift inflation, pushing government borrowing costs to multi-year or even record highs in some jurisdictions.
Despite that pressure, investors have not abandoned bond markets entirely. Data from Lipper show a net $12 billion moved into developed-market government bond funds since the war began, representing all fund inflows so far this year. Still, the performance of core safe-haven debt has been weak: since late February, 10-year U.S. Treasuries have produced a negative return of 1.5%, which equates to an annualised loss of 5.4%. German 10-year Bunds have delivered a negative 2.4%, or a negative 8.7% on an annualised basis. By contrast, the S&P 500 has returned 9% since the start of the war - or 39% when annualised - according to LSEG data.
Sentiment measurements underline the divergence between bond and equity positioning. The latest Bank of America survey of global fund managers found investors were the most underweight in bonds since June 2022, and that covering short positions in fixed income now would be considered a contrarian move.
Even with recent volatility among AI and technology stocks, many portfolio managers judge equities to be expensive. The arrival of additional high-profile, rapidly valued companies could further stretch equity valuations, while the ascent in bond yields has made fixed income appear cheaper than it has in many years.
"If you look around the globe, fixed income markets look very attractive; and this is also true in jurisdictions that have historically not been overly attractive like Europe and Japan," said Konstantin Veit, a portfolio manager at PIMCO. "It’s hard to make the case that equities look very compelling," he added.
Yields that have climbed sharply underscore that assessment. German Bund yields sit near 15-year highs at about 3.1%, while Japanese 10-year debt yields are around 2.6%, a level not seen in nearly 30 years.
Geopolitical developments tied to energy flows are a key wildcard. If the Strait of Hormuz - a pivotal chokepoint for global oil shipments that has been effectively closed during the conflict - were to reopen, current market bets on further rate increases could be challenged and that could favour bonds. Conversely, if the strait remains closed long enough to threaten global growth, bond markets could also benefit as investors price increased downside to economic activity.
HSBC Private Bank strategists noted in their mid-year outlook that inflationary pressures are already visible in global data and that there is a risk of second-round effects through supply chains and input costs. They added that growth risks appear less fully priced, which implies bond yields could decline once inflation fears have peaked.
THE DYNAMIC FLIPS IF THINGS GET TOUGH
A further escalation of the conflict, or a prolonged closure of the Strait of Hormuz - which handles roughly 20% of the world’s daily fuel needs - could send oil prices well above $100 a barrel, amplifying concerns about the negative economic fallout from an energy shock.
"While the diversification on bonds has been disappointing so far, we do think that it will improve and materialise when it really matters," said Andrew Sheets, global head of fixed income research at Morgan Stanley. He added that if oil spiked to his firm's commodity team bear-case range of $130-$150 a barrel, yields would likely begin to fall as markets grew more concerned about the effect on growth.
BONDS MAY RE-EMERGE AS HAVENS IN SUPPLY-CHAIN SHOCKS
Oil is not the only route through which geopolitics could reshape asset correlations. Heightened tensions around Taiwan or renewed U.S.-China frictions that disrupt flows of crucial inputs - including rare earths or semiconductors - could directly hit corporate margins and prove damaging to equities, particularly the technology sector.
"If you have a geopolitical event that will impact the production of semiconductors, that’s going to impact massively financial markets," said Yoram Lustig, head of global investment solutions, EMEA at T. Rowe Price, noting the tech sector would be on the front line in such a scenario.
The outlook for interest rates remains central to how both bond and equity markets perform. The bond market has largely priced in a firmer path for rates, while the stock market may not have fully accounted for that risk. PIMCO’s Veit warned that a truly aggressive Fed hiking cycle would likely be an environment where risk assets, including equities, underperform - though he said that is not his firm's base case for U.S. rate policy.
For now, the market stands at a crossroad. Bonds have so far failed to act as the defensive asset many investors expect during the current geopolitical shock, but several managers believe the asset class could reclaim that role if inflation pressures translate into slowing growth or if geopolitical events inflict material damage on energy supplies or critical input chains. The timing and triggers for such a shift remain uncertain.
Key sectors to watch include:
- Energy - sensitive to oil-price shocks and Strait of Hormuz developments.
- Technology - vulnerable to semiconductor supply disruptions and valuation re-rating.
- Fixed income - influenced by rate expectations and inflation-growth trade-offs.