We use cookies that are necessary to make our site work as well as analytics cookie and third-party cookies to monitor our traffic and to personalise content and ads.
Please click “Cookies Settings” for details on how to withdraw your consent and how to block cookies. For more detailed information about the cookies we use and of who we work this see our cookies policy
Necessary cookies:
Necessary cookies help make a website usable by enabling basic functions like page navigation and access to secure areas of the website and cannot be switched off in our systems. You can set your browser to block or alert you about these cookies, but some parts of the site will then not work. The website cannot function properly without these cookies.
Statistic and marketing cookies:
Statistic cookies help website owners to understand how visitors interact with websites by collecting and reporting information
Marketing cookies are used to track visitors across websites. The intention is to display ads that are relevant and engaging for the individual user and thereby more valuable for publishers and third party advertisers. We work with third parties and make use of third party cookies to make advertising messaging more relevant to you both on and off this website.
Fixed income to benefit from Fed easing – but is a soft landing baked in?
Sandro Croce
CIO, Fixed Income
Philipp Burckhardt, CFA
Fixed Income Strategist and Senior Portfolio Manager
key takeaways.
As the Federal Reserve returns to easing mode and a soft landing looks likely, fixed-income markets could benefit from investors exiting money markets to seek yield
Given macro risks, we prefer corporate credit in relative terms over sovereign debt despite tight spreads. We also see opportunity in emerging-market hard-currency debt
Transition finance typically focuses on labelled bonds, but a broader, forward-looking approach to net-zero alignment can expand the opportunity set and reduce sector bias
Tightness is a challenge in corporate credit, but our research shows spreads are well-aligned with default expectations and technical factors may see tights persist.
In the Q4 issue of Alphorum, our fixed-income quarterly, we offer food for thought on what the unusual menu of contributing factors – including extremely tight credit spreads amid macro uncertainty, potential tariff impacts, and signs of both softening and sticky inflation in the US economy – means for fixed income. Meanwhile, our sustainability experts explain the benefits of going beyond labelled bonds to employ an issuer-level approach to transition financing.
Portfolio positioning: uncertain US policy impacts support credit over sovereigns
Despite ups and downs, bonds have performed well overall so far this year. In a world of diminishing dispersion, a focus on fundamentals and nimble approach has made it possible to avoid losers, seek out value in single names, exploit regional divergence in sovereign bond markets and adjust duration exposure to exploit technical factors.
With the Federal Reserve (Fed) returning to easing mode and economic indicators pointing to a soft landing as the most likely scenario, fixed income could continue to benefit as investors exit money market funds in search of yield. However, the current US administration’s seemingly erratic approach magnifies uncertainty for investors.
Trade policy is now clearer, but tariffs remain on the menu and could yet leave a bad taste. For some investors, uncertainty has now moved to the quality of data, making it tricky to interpret. Is core US inflation on the rise again? Do low US non-farm payroll figures mean the labour market is cooling, or have the Trump administration’s anti-immigration policies changed the paradigm?
A more structural issue may prove to be that of Fed independence in the face of an interventionist president. For now, though, the bank continues to set its own path, resuming its cutting cycle and insisting its focus is on the full employment element of its remit. Meanwhile, the desynchronisation of monetary policy among other major economies creates the potential for pockets of opportunity in sovereign fixed income.
With a lot of ingredients in the mix and Donald Trump continuing to stir the pot, we prefer credit in relative terms over sovereign debt (in spite of tight spreads). We see opportunity in emerging-market hard-currency debt, which benefits from a weaker dollar, strong technical and a positive shift in flows.
Read the Q4 issue of Alphorum to explore our fixed-income views
Government bonds: headwinds dictate a neutral overall stance
Signalling a shift to focus on the full employment aspect of its mandate, Fed Chair Jerome Powell maintained that inflation from recent shocks should be “relatively short-lived”. At 4.125%, the fed funds rate remains in modestly restrictive territory, but the median projection now implies two more cuts before the end of the year.
Market expectations of a firm easing cycle from the Fed have been supportive of short-term US Treasuries. However, investor appetite for sovereign bonds remains subdued, and long-term bonds continue to face multiple headwinds – including structurally lower bond purchases by pension funds.
Fiscal largesse is a common issue across major sovereign markets. An unusually late Autumn Budget in the UK, near-record high term premia in Japan, and the downgrade of French sovereign debt can all be tied back to governments’ failures to balance the books. On a more constructive note, US tariff revenues appear to be exceeding initial estimates.
Following a real-yield driven nominal rally at the front end of the US Treasury curve in Q3, real-term valuations are now less compelling. We have therefore downgraded our US Treasury valuation score from attractive to neutral and moderated our stance on duration.
Macro uncertainty and challenging technicals mean we are now neutral on sovereign fixed income as a whole, while continuing to seek out tactical opportunities in markets where steepening pressures are starting to create value, such as in UK Gilts. Meanwhile, we continue to see US inflation-protected securities as an attractive inflation hedge – particularly in the light of attacks on the Fed’s independence from a US administration keen to reduce rates.
Corporate credit: practicing the lost art of sitting still
After many a summer in corporate credit, one thing we’ve learned from experience is that sometimes the best course of action is, in fact, to consciously take very little action. We predicted 2025 would be a year of carry, and so it has proven. Despite an uncertain and often volatile environment, trusting our investment decisions and knowing when to sit tight has resulted in healthy performance.
Evidence regarding the direction of travel of the US economy remains inconclusive. From a credit perspective, if consumer spending continues to drive demand for products and services then firms have little to immediately worry about – the danger, of course, is that any correction, should it come, is likely to be more painful.
The apparent resilience of the global economy is to be celebrated. However, given high levels of uncertainty, the lack of anything resembling a risk premium across most of the credit market is a challenge. Spreads have become so tight that in many cases the cost of making a trade outweighs the benefits.
In this environment we prefer to focus on bottom-up research and analysis of individual companies, standing ready to act if events conspire to create opportunity. A recent example was the drop in price of Danish firm Orsted’s1 bonds after the Trump administration put a stop order on its major US offshore wind project. But our confidence in the 50% state-owned company meant we were happy to increase our exposure.
Other things on our radar this quarter include real estate (generally still attractive) and cyberattacks – a growing issue for companies’ bottom lines and therefore also an issue for us. Like a swan gliding across water, any lack of apparent activity in credit belies the hard work by the team going on below the surface. While analysis may not immediately result in buying or selling, none of this work is ever wasted.
Interest in transition finance has grown in recent years, with investors increasingly keen to participate in the shift to a more sustainable global economy. Fixed income investors can allocate capital towards the climate transition in two key ways, each with distinct implications for portfolio construction and impact.
In fixed income the focus tends to be on labelled securities. Use-of-proceeds instruments are popular for their transparency, particularly ‘green’ bonds directed at financing projects targeting positive environmental outcomes. Other options include sustainability-linked bonds, which have no restrictions on the use of proceeds but link financial terms to sustainability performance; and transition bonds, which are use-of-proceeds bonds for projects offering incremental benefits in hard-to-abate sectors. However, the available universe for labelled bonds is relatively small and poorly diversified.
Climate-aligned investment offers a robust, forward-looking alternative to labelled bonds that incorporates a much wider range of issuers – including companies in hard-to-abate sectors. Instead of focusing on specific securities, it involves analysis of an issuer’s overall strategy and trajectory to identify companies decarbonising their business in line with net-zero goals.
Our Implied Temperature Rise (ITR) metric assesses the credibility of firm’s decarbonisation plans, expressing it in degrees representing the global warming that would result if every actor in the economy managed its emissions with the same level of ambition as the company in question. Meanwhile, our Alignment Framework classifies businesses into three categories: sustainable investments, grey investments (companies with positive exposure to the transition but facing broader sustainability challenges that are limited and yet to be addressed) and red investments.
Our research shows that by applying our ITR and Alignment Framework in an issuer-level approach, investors can construct portfolios that meet climate objectives while offering stronger diversification and effective risk control.
While carry in corporate credit is still attractive to market bulls, bearish investors point to extremely tight spreads amid widespread policy uncertainty as strong evidence of market complacency. We decided to dissect the underlying drivers of this scenario, then take a regime-based approach to understand the investment implications.
Ultimately, bond spreads are compensation for the probability of default. Absent a large exogenous shock, in credit markets this is driven by the fundamental health of companies. By overlaying current spreads for BB and CCC grade corporates on Moody’s 12-month trailing default rates and forecasts (used as a snapshot of the current fundamental picture), we found that spreads and default rates are actually well-aligned.
At the same time, credit market positioning is long, but not overly stretched in historical terms. So, while softening market data might see defaults surprise to the upside, technical factors look a stronger market driver than macro factors in the short term.
We consider high cash allocation key, since the availability of cash is more likely to encourage a buy-the-dip mentality if minor selloffs increase the relative attractiveness of credit valuations. Additionally, if central bank cuts continue as expected in the US, the relative proposition of being invested in credit assets becomes increasingly attractive.
We would contend that market participants are using areas of the investment landscape other than spreads – chiefly hedging activity via options markets – to cover the materialisation of negative scenarios. Calculating the difference in implied volatilities between call and put options in the S&P 500 index shows the uncertainty level priced into risk assets sits at around the 70th percentile level of figures seen over the last 20 years, according to our analysis.
Together, these technical factors imply a cautious investor base, not a complacent one, suggesting that tight spreads can be expected to continue.
subscribe to investment insights and strategy updates
Preference Centre
view sources.
+
[1] Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
important information.
For professional investors use only
This document is a Corporate Communication for Professional Investors only and is not a marketing communication related to a fund, an investment product or investment services in your country. This document is not intended to provide investment, tax, accounting, professional or legal advice.
