Build core exposure to quality, short- and medium-maturity bonds
Benchmark government bond yields in USD, EUR, and GBP have risen again in recent weeks amid persistent inflation concerns and a re-escalation in US-Iran tensions. But we continue to think current pricing overestimates further interest rate hikes and expect yields to fall as the year progresses. In fact, energy prices and inflation expectations have come off from their year-to-date highs, but short-end rates remain elevated. This disconnect creates a timing opportunity—the outright level and recent cheapening of rates across fixed income now offer an appealing risk-return profile. Investors should use elevated yields to add quality short- and medium-maturity bonds, particularly in USD and GBP, while select longer-maturity European bonds also offer value, given differing central bank paths, cyclical positions, and fiscal and political dynamics.
After many years of strong equity performance, investors now have an opportunity to rebalance toward bonds, bring allocations back in line with long-term plans, and help manage potential equity risks.
Even in markets where yields remain low and inflation muted, we still think some allocation to high grade debt can make sense for adverse economic scenarios, in which government debt tends to rally and yields fall in anticipation of monetary easing.
Seek diversified exposure through select credit and equity income strategies
For a holistic and well-diversified fixed income exposure, especially for investors relying on their portfolio for income, we like select exposure to more growth-sensitive and higher-yielding bond market segments such as emerging markets (EM), high yield, or subordinated debt. Amid elevated geopolitical and sector-specific risks, investors should avoid overexposure to any single segment of the credit market.
EM credit has benefited from resilient global GDP growth and commodity strength. Additionally, many emerging markets have maintained restrictive monetary policy to keep inflation in check. This means real rates in the EM complex are high and should benefit from capital inflows from investors looking for diversification away from traditional markets. Despite some expected spread widening, we believe elevated yields and supportive central banks underpin a positive outlook for EM credit, which we rate Attractive.
We expect most of high yield credit’s total return to be rates-driven. For spreads, we see reduced risk of sharp widening and only forecast modestly wider HY spreads from here, thanks to strong demand for yield and solid corporate fundamentals.
Investors seeking more defensive ways to access higher-yielding bonds amid uncertainty may also look at select exposure to subordinated debt, including corporate hybrid bonds. These are a type of subordinated debt instrument issued by non-financial companies that blend the characteristics of standard corporate bonds (paying regular interest) and stocks (often no fixed maturity date and the ability to defer coupon payments).
Looking across asset classes, we believe equity income strategies (especially in Switzerland and Southeast Asia), yield-generating structured investment strategies, and multi-asset income approaches, which may also include derivative strategies, can support income objectives. However, investors should be willing and able to bear the unique risks of investing in options.
