A shifting macro regime is testing the traditional role of government bonds

High-quality government bonds have traditionally been viewed as a portfolio ballast, providing steady income, dampening volatility and offering diversification through negative correlation to risk assets. However, the current market environment challenges these assumptions.

Over the past two decades, central banks anchored interest rates through quantitative easing, suppressing volatility across fixed income markets. This created a low-yield, low-dispersion environment where passive exposure to government bonds was often considered sufficient.

Today, the regime has shifted. Sovereign bonds have become one of the most volatile segments of fixed income, with yields increasingly sensitive to inflation surprises, fiscal deterioration and geopolitical risks. Correlations with risk assets have become less stable, undermining their diversification benefits. As a result, the long-held appeal of government bonds as a reliable stabiliser has diminished.

In this environment, active management in sovereign bonds is increasingly important. It helps investors navigate volatility, harness dispersion, and work towards restoring a more stable negative correlation to risk assets, aiming to re- establish the role of sovereign bonds as a defensive anchor in portfolios.

A shifting macro regime is testing the traditional role of government bonds

Sovereign bond markets have entered a new regime, and investors must rethink their approach. Volatility in government bonds has reached levels not seen in the past two decades. Since 2007, the average volatility of G7 sovereign bonds was 3.25%. Following the onset of COVID19, that figure rose to 5%, peaking at just below 7% in 2022—more than double the long-term average. This heightened and persistent volatility has contributed meaningfully to overall portfolios risk. With rates volatility likely to stay, we believe there is a need for more deliberate and active management of sovereign bond exposures.

Correlations between sovereign bonds and risk assets have also become less reliable. At times, government bonds have moved in tandem with equities during market stress. Long dated bonds have shown significant moves within a short period of time. In April, US 30-year Treasuries lost nearly 10% in just 48 hours. In that same window, US equities (the S&P500) fell 7–10%, underscoring an unsettling breakdown in traditional diversification, and undermining the downside risk management attribute investors typically rely on.

Meanwhile, cross-market dispersion has returned. Yield paths across major sovereign markets have increasingly diverged in response to local inflation trends, fiscal positions and political risks. During the EU’s recent fiscal expansion announcement, German Bund yields surged while US Treasury yields fell amid domestic fiscal concern. This renewed dispersion presents a broader and more dynamic opportunity set, one that lends itself to selective and active positioning.

These developments challenge long-held assumptions about sovereign bonds’ role in portfolios. With volatility elevated, correlations unstable and dispersion rising, interest rate risk should be actively managed. For portfolio constructors, this is a timely opportunity to reassess passive allocations and consider how active management can re-establish the strategic value of government bonds in diversified portfolios.

Our solution: A flexible and tactical approach to government bonds

In an environment marked by volatility, dispersion and uncertainty, flexibility is essential. Our Global Government Bond High Quality (GGHBQ) strategy is designed to actively manage interest rate and currency risk—aiming to deliver steady returns, reduce overall portfolio volatility and provide diversification through negative correlation to risky assets.

The Strategy invests solely in developed market sovereign bonds and currencies, with no exposure to credit or emerging markets—seeking to preserve its role as a defensive anchor during market stress.

A defining feature is its wide duration band. This allows us to mitigate interest rate risk when yields are rising, and extend duration when yields are falling. While both directions matter, the ability to take duration off the table is key to making the Strategy less vulnerable than the benchmark in a bond sell-off. This is vital for investors relying on sovereign bond allocation for downside risk management.

In our view, preserving capital during bond market drawdowns matters more than outperforming in bond rallies because sovereign bonds are generally expected to be the stable core of a portfolio.

Better diversification when it counts

Negative correlation has long been considered a “free lunch”—a built-in benefit that made sovereign bonds a reliable hedge against equity market stress. But in recent years, that relationship has been broken, with government bonds at times moving in tandem with equities and eroding their defensive role.

The Strategy seeks to preserve this diversification benefit, supported by its ability to actively manage interest rate risk and adjust duration exposure when needed. Since inception in September 2019, it has maintained a negative correlation of -0.15 with global equities (MSCI World Net Total Return USD Index), compared to +0.46 for the benchmark (FTSE World Government Bond Index Hedged USD), which has shown a persistent positive correlation since 2021.

Resilience in equity sell-offs and rising yields

The Strategy aims to deliver resilient outcomes across a range of market conditions, providing diversification during equity sell-offs, while preserving capital when yields are rising.

More defensive than the benchmark in equity drawdowns

• Since the inception of the Strategy, in all six quarters of equity declines, the Strategy delivered better downside risk management than the benchmark. In several of these periods, the Strategy not only outperformed the benchmark but also delivered positive returns while both the benchmark and equities (S&P500) fell, demonstrating its effectiveness as a diversifier during these periods.
• A notable example was Q1 2020, during the COVID19 market shock. The S&P 500 fell -19.6%, yet the Strategy returned +4.55%, outperforming the benchmark’s +3.97%. This highlights the Strategy’s defensive strength during one of the sharpest equity drawdowns in recent history.
• More recently, in April 2025, when the benchmark was whipsawed by the initial safe-haven rally followed by a sharp sell-off, the Strategy captured the early upside but actively adjusted as markets turned. The Strategy recognised that the “Liberation Day” rally had become overbought and vulnerable to concerns about inflation and fiscal risk, helping it avoid the subsequent drawdown and outperform the benchmark. This ability to navigate both legs of volatility has underscored its role as a diversifier during this period of market stress. Stronger capital preservation vs the benchmark in rising yield environments
• Traditional sovereign bond benchmarks have struggled in periods of rising yields. Historically, the Strategy has consistently delivered stronger downside risk management than the benchmark, thanks to its ability to reduce duration risk.
• This was particularly evident in 2022, one of the worst years for government bonds in decades. While the benchmark fell -12.86%, the Strategy limited losses to just -1.33%, aided by a significantly shorter duration stance.
• In addition, the Strategy also outperformed in other key rising yield periods, including Q1 2021, Q3 2023, first half of 2024 and Q4 2024. Notably, the Strategy delivered positive returns while the benchmark experienced drawdowns over these periods.
• While there has been an isolated instance of underperformance in 2023, when the Strategy extended duration early, the drawdown occurred alongside a strong equity rally, when the need for downside risk management was less acute.
• These outcomes highlight the value of active duration management in managing risk against drawdowns and suggest that the Strategy could serve as a more defensive, flexible alternative to traditional sovereign bond exposure.

Seeking to enhance portfolio outcomes through active duration risk management

The Strategy has historically delivered lower volatility than the broader sovereign bond benchmark during periods of stress. While its wide duration band can create higher tracking error, this flexibility is deliberate – allowing us to actively adjust or remove duration exposure to better manage interest rate risk and reduce overall portfolio volatility when it matters most. While volatility of the Strategy temporarily spiked in early 2025, it reflected intentional, high-conviction positioning that contributed to meaningful outperformance relative to the benchmark during that period.

When incorporated into a diversified portfolio, the Strategy could improve overall portfolio outcomes. A 60/40 portfolio using the Strategy has shown stronger return and risk-adjusted results, with better resilience during drawdowns compared to a traditional 60/40 using the benchmark.

In today’s environment of heightened volatility and unstable correlations, sovereign bond exposure must be dynamic, not static. T. Rowe Price Global Government Bond High Quality is designed for this new regime, with the flexibility to manage duration risk, preserve diversification, and navigating shifting market conditions. Through active positioning across rates, curves, and currencies, it seeks to deliver more stable outcomes and a more defensive role in portfolios than traditional bond benchmarks. The post-global financial crisis era of low yields and dependable diversification is behind us. Interest rate volatility is likely to stay and bond allocations must evolve accordingly. Bonds still play a critical role in portfolios, but it is active management that makes them work.

 

 

Objectives and risks Objective

The Global Government Bond High Quality (USD Hedged) Composite seeks capital appreciation and interest income by investing primarily in bonds issued by high quality governments, government-related entities and government agencies located around the world and in global currencies. The strategy seeks to achieve attractive risk-adjusted returns across global bond markets, supported by an extensive macroeconomic research process. (Created September 2019)

Risks – the following risks are materially relevant to the portfolio:

• ABS and MBS - Asset-Backed Securities (ABS) and Mortgage-Backed Securities (MBS) may be subject to greater liquidity, credit, default and interest rate risk compared to other bonds. They are often exposed to extension and prepayment risk.
• Credit risk - a bond or money market security could lose value if the issuer’s financial health deteriorates.
• Currency risk - changes in currency exchange rates could reduce investment gains or increase investment losses.
• Default risk - the issuers of certain bonds could become unable to make payments on their bonds.
• Derivatives risk - derivatives may result in losses that are significantly greater than the cost of the derivative.
• Interest rate risk - when interest rates rise, bond values generally fall. This risk is generally greater the longer the maturity of a bond investment and the higher its credit quality.
• Issuer concentration risk - to the extent that a portfolio invests a large portion of its assets in securities from a relatively small number of issuers, its performance will be more strongly affected by events affecting those issuers.
• Security Liquidity - any security could become hard to value or to sell at a desired time and price.
• Prepayment and extension risk - with mortgage- and asset-backed securities, or any other securities whose market prices typically reflect the assumption that the securities will be paid off before maturity, any unexpected behaviour in interest rates could impact portfolio performance.
• Sector concentration risk - the performance of a portfolio that invests a large portion of its assets in a particular economic sector (or, for bond portfolios, a particular market segment), will be more strongly affected by events affecting that sector or segment of the fixed income market.

General Portfolio Risks

• Capital risk - the value of your investment will vary and is not guaranteed. It will be affected by changes in the exchange rate between the base currency of the portfolio and the currency in which you subscribed, if different.
• Counterparty risk - an entity with which the portfolio transacts may not meet its obligations to the portfolio.
• Geographic concentration risk - to the extent that a portfolio invests a large portion of its assets in a particular geographic area, its performance will be more strongly affected by events within that area.
• Hedging risk - a portfolio’s attempts to reduce or eliminate certain risks through hedging may not work as intended.
• Investment portfolio risk - investing in portfolios involves certain risks an investor would not face if investing in markets directly.
• Conflicts of Interest (CoI) - The investment manager’s obligations to a portfolio may potentially conflict with its obligations to other investment portfolios it manages.
• Operational risk - operational failures could lead to disruptions of portfolio operations or financial losses.
• Total Return Swap - Total return swap contracts may expose the fund to additional risks, including market, counterparty and operational risks as well as risks linked to the use of collateral arrangements.