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 notice
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.
Optional 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 in 2026: expect a soft landing, but be ready for alternative scenarios
Sandro Croce
CIO, Fixed Income
LOIM Fixed Income team
key takeaways.
Our base case for 2026 is a soft landing. But unemployment, the risk of disappointing ROI on AI, a politicised Federal Reserve, fiscal easing, geopolitics or a market correction could all interfere
In what is definitely a carry environment, we favour the belly of the sovereign curve, selectively adding credit spread exposure. We also like emerging markets
Recently proposed changes to the European Union’s Sustainable Finance Disclosure Regulation, including the addition of a ‘transition’ category, are broadly positive for our TargetNetZero strategies
Despite a smaller fallen angels universe, the segment continues to demonstrate robust performance, and offers strong opportunities for alpha potential.
In the Q1 issue of Alphorum, we set out our base case for fixed income in 2026, while also flagging a range of risks and uncertainties and exploring alternative scenarios. We also take a deep-dive into fallen angel performance in light of short supply in recent years, and consider the implications of changes to the EU’s Sustainable Finance Disclosure Regulation for our TargetNetZero strategies.
Portfolio positioning: long-end risks favour the belly of the sovereign curve
While the K-shaped economy theme will continue in 2026, some underlying weakness in the US economy should be offset by spending on AI. At its December meeting, the Federal Reserve (Fed) presented the view that employment, inflation and growth are normalising. We largely concur, and believe a meaningful correction is unlikely. With Fed Chair Powell indicating he sees policy rates as in the upper range of neutral, we predict rates will decline more slowly than the three cuts to reach 3% in Q3 2026 expected by the market.
There are, however, plenty of risks to this base-case scenario, ranging from rising unemployment, inflationary fiscal easing or a dovishly politicised Fed to a market correction, heightened geopolitical noise or a slowdown in AI capex. That creates the potential for alternative bull and bear scenarios, or even overheating – which, combined with a politicised Fed cutting rates below neutral, would amplify the possible range of eventual outcomes.
Read the Q1 issue of Alphorum to explore our fixed-income views
In Europe, any changes to the current 2% ECB policy rate will be very much data dependent, with rate-change risk more symmetrical than in the US. New fiscal spending, particularly in Germany, will boost demand, but EU economies are less well positioned to benefit from AI and face headwinds for key industries, including autos. The risk of economies within the bloc underperforming means pricing in rate hikes in 2026 may prove somewhat optimistic.
With expectations of lower policy rates no longer a driver for price appreciation, bond market returns will mostly come from income/yield. However, fixed income remains attractive given still relatively high rates, steeper curves and spreads that, while low, remain reasonably appealing based on the strength of fundamentals.
Issues including concerns regarding debt sustainability mean we tend to favour carry from the belly of sovereign curves, selectively adding credit spread exposure for the extra carry it provides, always based on a clear understanding of company fundamentals. While inflation-linked bonds are an allocation that has yet to pay off, we still see them as a relatively cheap option against a tighter-than-expected labour market and sticky inflation in the US. Meanwhile, a lack of net issuance by emerging market (EM) corporates and a generally quite benign economic backdrop make EM bonds attractive.
Overall, we see a positive environment for active fixed income in early 2026, and look forward to capturing fresh opportunities as they arise.
Government bonds: despite headwinds, tactical opportunities abound
With policy rates largely normalised and limited scope for central bank easing, government bond performance globally is likely to remain range-bound in the near term. Investing in sovereign fixed income markets will therefore be about anticipating and reacting to evolving dynamics rather than expressing a strong overall conviction. However, on a tactical level, regional repricing and curve dynamics will continue to present tactical opportunities for the active and attentive investor.
Curve steepening has been evident recently, with the 2-year/10-year and 10-year/30-year yield spread trading close to multi-year highs across the G4 economies. With fiscal largesse a common theme, we continue to favour markets such as Australia that demonstrate strong fundamentals coupled with attractive yields. Meanwhile, the rebuilding of term premia amid still-quite-high rates creates tactical opportunities in markets like the UK, where long-dated forwards offer compelling value as long as political risk is closely monitored. In other regions, like the eurozone, we are reluctant to call an end to the steepening theme. Meanwhile political pressure has left the Bank of Japan behind the curve, in our view.
After years of record net/net supply, debt management offices in countries including the UK, the US and Japan are adjusting issuance to reflect waning long-end demand. However, eurozone supply will run contrary to the general trend, with German defence and infrastructure spending helping to set fresh records.
Looking ahead, we remain neutral on sovereign fixed income, as monetary policy is unlikely to be a major driver of returns and the segment may continue to struggle to outperform cash in the coming months. However, with yields trading above the 70th percentile of historical ranges over the past two decades, we continue to see value in developed market rates, and foresee tactical opportunities where rate-hike probabilities appear overstated.
FIG 1. The period of synchronised monetary policies is definitely over1
Corporate credit: tune out the noise and focus on fundamentals
Like the year before it, we expect 2026 for corporate credit to be characterised by long periods of quiet, punctuated by unexpected but temporary periods of volatility. With spreads very tight but no obvious signs of a major correction, we expect credit markets in 2026 to be largely about carry, and probably largely lacking in excitement — and that’s no bad thing.
Known unknowns in the macro environment that could affect corporate credit include the effect of tariffs on earnings, the degree of deterioration in consumer confidence, the impact of AI and firms’ vulnerability to cybercrime. However, with everyone now in on the act, ‘buying the dip’ no longer represents a financially enticing opportunity. Instead, credit investors will do better by identifying companies whose bonds offer value and who have solid enough fundamentals to withstand the various black swan events that are sure to come along.
In this environment, for us, BBB and BB grade credit – along with fallen angels – remains the sweet spot.
In general, fundamentals will progressively weaken as tariffs impact earnings, while interest costs will continue to rise as corporates are obliged to refinance the very cheap debt they raised a few years ago. In this environment, for us, BBB and BB grade credit – along with fallen angels – remains the sweet spot.
At a sector level, AI will continue to boost tech names but also the real estate, construction, energy and utility industries for data centre buildout and power. At the same time, specific sectors including automotive, chemicals, and consumer cyclicals will face headwinds in 2026.
The ongoing environment will allow us to exploit our company-level knowledge, buying only when price action is enough to make a particular bond attractive. Conversely, understanding a specific name’s fundamentals often gives us confidence to stay invested when negative news is ultimately immaterial to a company’s ability to repay its debt.
Sustainability: SFDR 2.0 proposes a ‘transition’ category
In November 2025, EU regulators proposed significant changes to its Sustainable Finance Disclosure Regulations (SFDR), initiating a two-year consultation process.
‘SFDR 2.0’ marks a shift to a category-based approach, reinforcing the need for evidence for sustainability claims while simplifying disclosure requirements. The three key sustainability-related investment categories are: ‘Transition (Article 7); ‘ESG Basics’ (Article 8) and ‘Sustainable’ (Article 9).
These categories are based on minimum criteria supported by clear guidance on the type of eligible investments. Funds will be able to categorise themselves pending regulatory oversight, but there will be a mandatory requirement for managers to audit and assure any sustainability-related information.
Under the proposed rules we would expect our TargetNetZero Fixed Income strategy to be categorised under Article 7. This is defined as suitable for “products making investments in companies and/or projects that are not yet sustainable, but which are on a credible transition path, or investments that contribute toward improvements – e.g., climate, environment or social areas”.
In principle, we welcome changes to the SFDR, particularly the addition of a ‘Transition’ category, which is a cornerstone of our sustainable investment philosophy. Other positive proposals include requirements for robust sustainability-related engagement strategies for portfolio companies, a credible portfolio-level transition target, and for 70% of a fund’s investments to be aligned with a portfolio’s sustainability objectives.
Under Article 7, investments in companies working on new fossil-fuel projects (other than power generation) are not allowed, and clear evidence of planned withdrawal from any involvement in coal, including for power generation, will be necessary. These exclusions will mostly affect traditional oil and gas companies that are rarely transition leaders, but may have some impact on the ability to maintain strong sectoral diversification within portfolios.
The next step in the process will be the publishing of more detailed rules specifying the operational and technical details that will underpin the revised regulation.
Systematic research: fallen angels in short supply but full of opportunity
Fallen angels – bonds that have been downgraded from investment grade (IG) to high yield (HY) – are a potential source of notable outperformance in fixed income. However, the asset class has experienced a noticeable lack of supply in recent years.
Ratings for corporates at BB and above have drifted higher persistently since the pandemic, creating more rising stars than fallen angels. As a result, fallen angels currently represent the smallest proportion of the broader HY universe in 20 years, by some distance.
Extending the fallen angel universe to include all underlying bonds of downgraded issuers almost triples its size, leading it to cover 15% of the broader HY universe rather than just 5%. That figure represents the largest relative uplift in the last 20 years, and highlights the importance of universe formation in making fallen angels an investible standalone asset class.
The good news is that analysis shows fallen angel universe size itself is less important than recent supply dynamics. In fact, while fallen angels experienced mixed performance versus HY from 2021 to 2023 as the universe shrunk, since hitting universe-size lows, they have outperformed HY.
Adjusting the HY universe to align its rating composition with the fallen angels universe shows that the latter have actually outperformed their direct rating peers in HY by around 10 bps annualised since 2021 (see Figure 2). This is further demonstrated by fallen angels’ comparatively heightened risk-adjusted returns, with a Sharpe ratio almost 10% above the HY universe. Digging down further uncovers a marked concentration of positive and negative performance in top and bottom deciles, offering strong opportunities for active alpha generation.
FIG 2. Compared to HY, fallen angels have offered attractive risk-adjusted return potential2
Overall, our research demonstrates that fallen angels have maintained their preferable performance patterns throughout the latest cycle. That said, the vast headwind of a sharp drop in universe size has sharply underscored the need for research-driven adaptations and interventions for fallen angels to translate into an investible asset class.
subscribe to investment insights and strategy updates
Preference Centre
view sources.
+
[1] Source: Bloomberg, LOIM, as of December 2026. For illustrative purposes only.
[2] Source: LOIM Calculations, Bloomberg indices at December 2025. Credit returns are returns in excess of duration-matched treasuries, thus removing the rate-return impact. The HY index used is ex-emerging markets to match the fallen angels index. Past performance is not a guarantee of future returns. For illustrative purposes only.
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.
