Finding fixed income yield without reaching for risk

Despite a recent pick-up in client demand for fixed income across both institutional and wholesale investors, allocations remain structurally underweight in bonds. We see the clearest opportunity at the front end of the yield curve.

Investment grade corporate bonds are yielding in the region of 5.5%, while global high yield sits north of 7%. Since starting yields remain the primary driver of forward returns, this makes the asset class more attractive than it has been for the best part of a decade, offering income and total return potential alongside diversification against equities and alternatives. 

This yield is available without extending duration, as curves, while no longer inverted, remain relatively flat by historic standards. Investors don’t need to stretch out to seven or eight years to find attractive yields. They can stay short, minimise volatility and interest-rate risk, and still capture a meaningful coupon at the front end. 

New decade, new opportunities 

Our macro team expects this decade to look very different from the last. The previous decade was defined by quantitative easing, extremely low yields and inflation struggling to reach target, particularly in Europe. This one is marked by geopolitical events and a more inflationary environment, with inflation now likely to run above target even in Europe.

For fixed income, that means yields staying structurally higher than investors have been used to over the past 15 years, and more volatility in government bond markets across the curve. 
 

These conditions create significant opportunities to be tactical, but calling the turns will be difficult. Careful entry and exit points will matter. 

At a high level, we currently see interesting opportunities in high-quality corporate credit, which remains attractive on a risk-adjusted basis. Investment grade private credit also looks attractive and is very different from lower-quality private credit, direct lending and middle-market loans. 

Emerging markets offer opportunities in countries with improving fundamentals and a supportive policy environment. We also see select areas of securitised credit worth holding, particularly high-grade collateralised loan obligations rated AAA, AA and single-A. 

Credit spreads are tight across most credit markets, including investment grade, high yield and pockets of private credit, while fundamentals remain extremely healthy. We favour areas where valuations remain reasonable.

Given current spreads, we prefer higher-quality credit. Our current focus is the short-dated BB and BBB crossover space, where we aim to capture an attractive level of yield per unit of risk. Short-call Tier 2 bonds and corporate hybrids can be relevant core allocations in this environment, provided they are kept short dated. 

Financials and banks remain attractive, with fundamentals still very strong at a time of considerable uncertainty in other sectors. At the margin, we prefer Europe and emerging markets to the US. US credit spreads are tight, with several negative technical drivers, including hyperscaler issuance. 

The role of duration amid evolving risks
 

Risks have evolved over the past 24 to 36 months, shifting from inflation to headwinds to growth, including events in the Middle East and the tariff shocks of the preceding year.  Broadly, though, the risks remain geopolitical. 

Equity valuations have largely shrugged off both tariff concerns and the conflict in the Middle East and continued to rise, making the risk asymmetric. An escalation in those conflicts is not our base case, but we do not believe markets have priced it in effectively. 
 

Another risk is fiscal. It has already fed through to rate volatility and elevated sovereign and Treasury yields in both Europe and the US. Deficits are rising on both sides of the Atlantic alongside increased spending, putting upward pressure on government bond yields. We expect this to persist over the next 12 to 24 months.  
 

Over a shorter horizon, rate rises will be a key factor. Markets are trying to price in one or two, although some investors expect none from the US. Anything that made the Federal Reserve more hawkish would probably weigh on equity markets and credit spreads. Our rates team believes the risk of US interest-rate rises has increased, but may now be overstated in market pricing. We expect another rise in Europe, while the Bank of England is likely to remain on hold. 

Looking ahead, the macro backdrop should stay supportive for fixed income.  We expect global growth to remain moderate but positive at around 3%, with the US near 2% and Europe closer to 1%. Inflation should trend lower, but unevenly. Europe, the UK and pockets of emerging markets are more exposed to energy prices, while the US is more insulated as a net energy exporter.  
 

Central bank policy changes are mostly priced in by the market, and we see a relatively benign credit outlook. Default rates may rise but should remain manageable. 
We expect credit spreads to end the year moderately wider, although the macro environment and demand from yield-focused investors should limit the move. The all-in yield offers substantial insulation against that volatility. 

Final thoughts
 

The single change we believe investors should consider making to their portfolios now is to step out of cash. Historically, cash has underperformed short-dated credit, and the excess spread over a money market or liquidity fund is driving more and more client conversations. 

This article was originally published in Investment Week.