Impact of high sovereign debt on bond markets

In recent months, the sovereign bond market has been sending warning signals to investors: sovereign-corporate spreads are tightening and volatility is rising. In our latest Ahead of the Curve webinar, Arif Husain, Chief Investment Officer and Head of Global Fixed Income, Ken Orchard, Portfolio Manager and Head of International Fixed Income, Chief US Economist Blerina Uruçi, and Samy Muaddi, Head of Emerging Markets sat down with moderator and Portfolio Specialist Amanda Stitt to discuss the market’s growing concern with sovereign debt sustainability.  

The headlines may be scary, but are they justified? Amanda Stitt began by asking the panel whether the path of US and other sovereign debt really is as unsustainable as some have suggested, and whether that was something to be worried about.  

Setting the scene, Blerina Uruçi pointed out that the last two decades have essentially seen a doubling of the US debt-to-GDP level, with unusually high domestic deficits of 6.5-7% for more than four years, with debt service now accounting for almost half the deficit. This is quite unusual given that the unemployment rate is at a historic low of around 4%, a level that would normally be associated with a much lower primary deficit. 

“The good news is that there is no empirical evidence out there to suggest that this kind of debt is unsustainable for an economy that is as diversified and dynamic as the US, which has reserve currency status in the global financial markets, and deep and liquid markets – but the trajectory is concerning,” she said. 

“There’s a long-term political unwillingness to deal with the deficit. We have seen fiscal largesse without tax offsets under the Democrats, and tax cuts without spending reform under the Republicans. Both approaches are leading to a larger, not, smaller deficit.”

Reasons to be nervous

Arif Husain was more pessimistic. “The issue is a global problem the issue is a global problem. The US is running high deficits, the UK, France, Italy and Japan are running high deficits, even Saudi Arabia is going to be issuing debt. That debt needs to find a home and ultimately yields have to go up.”

Ken Orchard pointed out that the quality of demand for sovereign debt is at least as important as the quality of supply. “For years, the buyers of government debt were price insensitive. The Fed was buying, the ECB and Bank of Japan were buying, and defined-benefit pension providers were Impact of high sovereign debt on bond markets September 2025 buying – and they bought whatever the interest rate. Now we’re seeing a rise in defined contribution plans and the buyers are banks or asset managers like us that are much more price sensitive – we don’t buy because we have to, we buy for attractive returns.” 

Blerina added that with a market dynamic clearly pointing to higher – and possibly much higher – bond yields, monetary policy becomes the critical issue. “Whatever the official mandate of the central banks, experience shows they won’t hesitate to use the balance sheet to stabilise markets if they become dysfunctional. And in the US, this is the big question mark for investors in 2026 and 2027. What is the vision of this administration for the Fed and how it works with the Treasury?”

Look to emerging markets

Samy Muaddi said that he sees debt sustainability through an emerging market investment lens. “Emerging markets have gone through this many times, and with that experience the first factor I would look at is the operational independence of the Fed. I would separate political independence and operational independence – it’s the latter you should focus on. Secondly, watch for high-quality US corporate bonds beginning to ‘trade through’ sovereign debt. That has often happened in emerging markets, and if we see that in the US that would be a sign of unsustainability.

The panel also explored the role of the dollar in an era of rising US debt and shifting US monetary policy. “What really matters is the fiscal and monetary policy mix,” said Ken. “I think the big question for the dollar is going to be what happens if the Fed cuts interest rates dramatically or started buying a lot of treasuries, then they would be running loose fiscal and loose monetary policy at the same time and I suspect that would be very detrimental for the dollar.”

Amanda asked the panel to comment on the relative attractiveness of sovereign instruments in this era of rising concern over debt levels in the US and beyond, coupled with uncertainty over policy. “Government bond markets are really like an ugly block at the moment, and the key is to find the best houses on this ugly block,” said Arif. “I think the countries that are going to do better are the ones that can mobilise big pools of domestic savings and whose governments are willing to actually raise taxes – as may happen in the UK, for example.”

"Government bond markets are really like an ugly block at the moment, and the key is to find the best houses on this ugly block."
Arif Husain CFA^©, Head of Fixed Income and Chief Investment Officer

Don’t forget the deficits

That means that investors should continue to look at both debt and deficits, said Ken. “There are some countries with very high debt levels, but in fact their deficits are not too bad. Japan and Italy are two examples. Italy actually ran a primary surplus last year and it’s likely to run a primary surplus this year. So, despite the fact debt is very high, it’s fairly stable.”

Yet sovereign bond volatility has become a fact of the market, and Samy said he believed that investor portfolios have been slow to catch up with this changed environment. “The new reality is that Treasury volatility has converged with the volatility of other assets, and while there are now lots of other safe assets you can own, such as short-dated global corporates, I don’t think most asset allocation platforms have adjusted to that reality.” 

Ken ended with a reminder that for all the uncertainties surrounding sovereign debt levels and the growing volatility of sovereign bonds, governments still hold the cards. “At the end of the day, developed market governments have the power to tax and they have the power to regulate – and that is something the corporation doesn’t have.”