Global bond markets have repriced to a world where US growth and inflation pressures look firmer than previously expected, the conflict in the Middle East appears more protracted than hoped, and oil supply disruptions look set to endure.
Strong US employment, steady economic growth, and firmer US price pressures (especially in the services sector) have all reduced expectations for US policy easing and increased expectations of further Fed tightening. The Federal Reserve delivered a hawkish hike in September, with a unanimous decision to raise rates 25bps, while projections point to a median two-hike path and rates on hold in 2027, with upward economic projections for PCE and core PCE inflation. We expect the Fed to raise rates again in December.
In the Eurozone, the European Central Bank (ECB) recently raised rates, and its updated staff projections suggest that inflation pressures will prove more persistent than previously thought. Headline inflation is forecast at 3.0% in 2026, 2.5% in 2027, and 2.1% in 2028. Compared with the June projections, the forecasts for 2027 and 2028 were revised up by 0.2 and 0.1 percentage points, respectively. Core government bond yields have recently traded at some of their highest levels since the global financial crisis. We now expect the ECB to raise rates again in December.
For investors already allocated to bonds, rising yields and falling bond values can seem unsettling. But from a longer-term perspective—and for investors sitting on excess cash—we believe now may be a good time to review fixed income allocations and consider rebalancing.
Higher starting yields can offer a larger cushion
For much of the past decade, bonds offered slim income opportunities in many markets. Starting yields were extremely low, leaving little yield “cushion” to offset periods of market volatility. Today, the situation is very different.
While bond prices remain sensitive to movements in interest rates, investors are now entering the market with substantially higher yields. That income stream is once again doing much of the heavy lifting. Across investment grade, high yield, and emerging market bonds, coupon income is helping cushion the impact of rising yields and reducing the likelihood of losses over a 12-month investment horizon.
Despite a significant reassessment of monetary policy expectations, rising government bond yields, and concerns about inflation, many credit sectors have continued to generate positive total returns because income has more than offset bond price declines. The relationship between yields and returns has become considerably more favorable for long-term investors, in our view.
Higher yields also mean investors have a larger yield cushion. Breakeven calculations indicate that many fixed income sectors can absorb a meaningful rise in yields before total returns fall below zero. For example, spreads on euro investment grade and high yield debt would have to rise roughly 90 and 180 basis points for total returns to fall to zero, while the comparable figure for EM corporate bonds (JPM CEMBI Index) is roughly 150 basis points.
Although forecasts for bond price appreciation have moderated as rate expectations have risen, expected 12-month total returns across several major bond sectors remain positive and potentially more appealing than holding excess cash.
Why and how to diversify across bonds
In a world of persistent inflation risks, geopolitical uncertainty, and shifting monetary policy expectations, diversification remains essential. Rather than concentrating exposure in a single bond segment, investors can build more resilient portfolios by combining high-quality government bonds, investment grade corporate credit, selected high yield exposure, and emerging market debt.
We view fixed income as Attractive, and we see select opportunities across regions and market segments. The recent sharp rise in yields has created tactical opportunities to add some duration in high quality bonds. Medium- to long-duration, high-quality bonds have scope for price gains and can provide valuable diversification in an economic downturn.
In the Eurozone, the combination of upward-sloping yield curves (where investors are rewarded for taking more interest rate risk) and attractive all-in yields may present some tactical opportunities to extend duration in high-quality European government bonds.
We especially like the most financially sound Northern European issuers. We also see selective opportunities in countries where fiscal and political uncertainty continue to support attractive risk premiums relative to fundamentals.
In credit, stronger investment-grade issuers offer attractive carry across medium tenors, while exposure to higher-risk credit should remain relatively short-dated. We remain more cautious on the longest-dated bonds, given fiscal sustainability concerns and the growing extent of AI-related debt issuance. Investors should calibrate both credit risk and duration to their objectives and investment horizons—for example more income-focused investors may prefer shorter maturities to reduce duration risk.
The investment case for emerging market credit
Emerging market credit remains one of the most compelling opportunities within global fixed income, in our view. We believe the asset class offers attractive income, diversification benefits, and increasingly resilient fundamentals. Many sovereign borrowers have strengthened external balances, while corporate issuers generally maintain conservative leverage and solid earnings momentum.
Supportive technical conditions have also underpinned performance. While spreads are near historically tight levels, return potential continues to be supported by relatively high all-in yields.
