Fixed income in the new macro world order

In the Q2 2025 edition of our fixed income quarterly, we consider how the Trump administration’s attempts to reshape the macroeconomic world order are impacting bond markets. Download the full report, or read our summary below.

Portfolio positioning: safety first amid shifting sands

In the wake of Liberation Day, the world has become more uncertain and conflictual, driving instability and volatility. Whether or not the tariffs persist, they have accelerated a shift away from globalisation towards strategic autonomy.

For central banks, this creates a potential dilemma between dealing with rising inflation or addressing slowing growth. We expect the Federal Reserve may first need to act decisively on inflation, before pivoting to stimulus as growth and the labour market softens.

Given the considerable uncertainty at geopolitical, regional and national levels, a complex range of factors could impact bond markets. We stay patient while remaining flexible in our allocation, keeping nimble to avoid the downside risks and watching for upside opportunities amid the volatility.

As recession risks increase, so does the likelihood of rates coming down, which would make government bonds more appealing – we particularly like US Treasury Inflation-Protected Securities. In the meantime, we favour domestically focused businesses in the higher quality end of credit. European instruments are starting to offer quite appealing valuations that could be worth capturing once the dust settles.

Systematic research: taking the cost out of liquidity in shock scenarios

With sharp selloffs like the one immediately following the tariff announcements comes the risk of sudden liquidity events, as negative sentiment triggers a ‘dash-for-cash’. This can be particularly damaging to carry-focused strategies that get squeezed as the often-crowded trade gets unwound. Can carry-based allocations be positioned to better deal with the threat of a sharp downturn? Our latest research finds an answer

High-yield (HY) derivatives such as credit default swaps (CDSs) show lower volatility than cash-bond equivalents, largely due to their behaviour during liquidity shocks. In Figure 1 we compare the performance of CDS-based HY with both the cash-bond based HY index and HYG, the US HY ETF, which should represent the most liquid access to cash-bond based HY. As shown, cash bonds and HYG experienced a drawdown of over 30% at the height of the global financial crisis in 2008, whereas CDS-based HY saw a more modest drawdown of only 10%.

FIG 1. Performance throughout liquidity shocks – HY bond index vs HY ETF vs CDS-based HY¹

This CDS-based approach to HY can also avoid the long-term liquidity cost of ETFs. Given most ETFs are benchmarked to a liquid variant of standard corporate-bond benchmarks, we compared the performance of US and European HY ETFs gross of fees against both their stated benchmarks and the standard benchmarks. We found that while ETFs perform broadly in line with their stated benchmarks, this represents substantial and relatively systematic underperformance of over 0.5% annually in the past 15 years versus the standard benchmarks.

These findings demonstrate that where carry is appealing but political volatility threatens tail events, accessing HY markets through CDS indices delivers strong liquidity without the higher cost that leaves ETFs hamstrung.

Read also: Bonds, ETFs or CDS – in high yield, which is more resilient to liquidity shocks?

Sustainability: why decarbonisation is ultimately Trump-proof

Global emissions continue to rise, highlighting the challenges of decarbonising the global economy. However, both total and per-capita emissions have been falling in the West and Japan over the last 25 years; rising emissions in developing markets, particularly China and India, are the reason for the overall increase (see Figure 2).

FIG 2. Western emissions are declining despite the continuing global increase²

Decarbonisation is an economy-wide phenomenon that creates both risks and opportunities. To participate effectively in the transition, investors need to take a cross-sector approach that looks beyond firms’ current carbon footprints to understand their future emission trajectories in the context of their specific industries and regions.

Unlike many low-carbon strategies, LOIM’s TargetNetZero franchise pursues real-world decarbonisation, reinforcing the diversification, resilience, low tracking error and style-agnostic nature of these core portfolios. We aim to identify companies with solid investment fundamentals that capture the market returns of this major economic transition while mitigating risks.

Ultimately, despite the political challenges posed by the Trump administration, the transition to a decarbonised economy remains fundamentally resilient and robust, in our view. Factors including the cheaper cost of solar, onshoring, energy security, market dynamics, data-driven demand, consumer preferences and the need for economic and geopolitical leverage will combine to ensure continued progress on decarbonisation.

Government bonds: ample room for further abrupt repricing

In the US, announcements and reversals on tariffs, chaotic policy rollouts and lack of a coherent narrative have already hit consumer and business confidence, threatening a slowdown. Meanwhile, in Europe, Germany has taken decisive action to spend up to EUR 1 trillion on infrastructure and defence, while the European Union’s less convincing ReArm Europe plan aims to enable defence spending of up to EUR 800 billion.

Government spending plans point to a deteriorating technical picture for sovereign bonds in Europe, adding EUR 50-100 billion per year to historically high net supply³. Price-sensitive private investors will need to absorb the additional supply – and be compensated through higher term premia and a higher risk-free rate.

In the US, the Treasury plans to keep auction sizes unchanged while awaiting clarity on legislative plans, particularly a potential extension of the Tax Cuts and Jobs Act that would cost around USD 4.6 trillion over the next decade. Tariffs and efficiency drives are unlikely to generate anything near that amount, making additional debt funding likely in the future.

Factors including tariffs, policy uncertainty, slumping consumer and business confidence or a weakened US labour market could trigger abrupt repricing over the coming months. We see good value and some optionality in the front-end and belly of the curve, while steepening could also present tactical opportunities further out.

Overall, we maintain a constructive stance on sovereign fixed income going into Q2 2025. However, we will closely monitor events over the coming months and stand ready to move tactically, as volatility is expected to remain elevated.

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Corporate credit: bumpy roads and slipping orbits

In credit, companies who import raw materials and components have tended to stockpile resources ahead of tariffs driving up prices. However, over time, firms will refocus their capex budgets and amend their supply lines to reflect the new reality.

Investment-grade businesses generally operate globally, helping them to withstand shocks, while large domestically focused firms such as utilities and many banks will be less affected by tariffs. Real estate also benefits from a domestic focus and continues to offer attractive carry given its proven resilience.

Already challenged by sluggish electric vehicle (EV) take-up and cheap Chinese imports, the automotive sector faces the additional burden of a 25% tariff on all foreign car imports into the US – including from the factories of US carmakers in Canada and Mexico. We remain invested in selected names, but see automotive as perhaps the most beleaguered sector in corporate credit.

Elsewhere, the threat from Elon Musk’s Starlink provoked a selloff of European satellite operators SES and Eutelsat⁴ in January. Price volatility may continue, but the need for strategic autonomy in defence and other areas should be supportive. SES’s planned acquisition of Intelsat2 is a positive move, and is part of a pattern of mildly increased M&A activity recently.

Overall, while we don’t see significant areas of weakness at this stage, favouring quality and employing a thorough but nimble bottom-up approach focused on local markets will be important to avoid negative surprises.