Outlook Bond Outlook: Strong yields offer upside as risks linger

Halfway through the year, bond markets are contending with the twists and turns of war in Iran, shifting labour market dynamics and heightened risks to economic growth.

“Bond markets have been influenced by the inflationary impact of higher energy prices,” says Chitrang Purani, fixed income portfolio manager. "But I’m increasingly concerned about how the war could weigh on economic growth as certain consumers have little buffer to absorb another inflation spike.”

While bond returns this year have been muted, this view suggests that ample starting yields could lead to a stronger second half as elevated rates either persist or drift down to boost total returns.

“We remain in this period of elevated yields, which is a great setup for forward returns,” says Damien McCann, fixed income portfolio manager. “You’d have to go back about 17 years to find another period where forward return expectations are as attractive as they’ve been in recent years.”

Interest rate strategy comes into focus

Inflation concerns dominated bond market sentiment in the first half of the year, with the US Consumer Price Index (CPI) rising from 2.4% in February to reach 4.2% in May, its highest level in three years. This has led the market to reprice Fed expectations toward seeing a rate hike more likely than a cut.

But several factors could help inflation stay more contained, especially when compared to past inflationary episodes. Money supply growth and bank lending are running at significantly lower levels than in prior surges, suggesting less fuel for sustained price pressures. The consumer also appears more constrained as the savings rate remains low and wage growth is tepid. These dynamics point to a more limited and potentially self-dampening inflation impulse.

History also shows that oil-driven inflation shocks have not translated into a consistent long-term path for Treasury yields. Yields have often risen in the near term, but over a one-year horizon there does not appear to be a clear cause-and-effect relationship between the initial oil shock and where yields ultimately settle.

Inflation pressures within the core PCE Index — the Fed’s preferred inflation measure — remain muted. At the same time, real consumer income growth and spending growth have declined, while a key measure of consumer confidence dropped to an all-time low in May. We are watching inflation and labour market developments closely to monitor for changes in underlying consumer strength. We believe these factors may lead the Fed to stay on hold rather than hike rates over the next several quarters.

“Higher oil prices are pushing up the cost of living for consumers already under pressure from weak wage growth, depleted savings and softening economic sentiment,” says Timothy Ng, fixed income portfolio manager.

Against this backdrop, we find it favourable to extend duration within bond portfolios. The recent rise in rates, with 10-year Treasury yields hitting above 4.6% in May, has translated into strong starting yields and attractive valuations. The position also serves as a potential hedge against further economic softening.

Beyond geopolitics, longer term forces such as artificial intelligence may also support lower rates across a range of outcomes. Strong productivity gains could help dampen inflation, while potential disruption to labour markets or risk sentiment could accelerate the need for a Fed response. Additionally, a Fed helmed by chairman Kevin Warsh is anticipated to lean more dovish.

If economic prospects fade and the Fed resumes cuts, that could lead to a steepening of the Treasury yield curve as short-term yields fall and long-term yields rise.

Strong fundamentals provide selective opportunity across credit sectors

The outlook for credit reflects a combination of attractive starting yields and largely resilient fundamentals. Elevated yields provide meaningful income support, and although spreads are tight, they can be justified by strengthening fundamentals. In this environment, we are finding value in a diversified and flexible approach to credit investing.

“The outlook for credit quality remains strong, and we expect that strength to continue,” says McCann. “Overall, this is a supportive environment for credit returns.”

With widening dispersion, broad-based exposure is less attractive. Rather, yield and spread differences across sectors and within rating cohorts are creating opportunities for issuer selection.

Investment grade (BBB/Baa-rated and above) corporates remain supported by strong corporate balance sheets and disciplined capital allocation. Net leverage levels have held relatively steady, reflecting a measured approach to financing, including around merger and acquisitions activity.

One key area of interest is debt tied to AI and data centre investment, where large issuers with well capitalised balance sheets, resilient cash flows and high credit ratings are helping drive what may be a record year for investment-grade issuance.

“Most of the AI financing has come from the hyperscalers,” McCann says. “The resulting supply has widened spreads just enough to create opportunity in very high quality credit.” Areas such as pharmaceuticals, utilities and managed care also stand out, where factors ranging from new product launches to wildfire mitigation efforts and stronger underwriting may support further spread compression.

We have high conviction in the securitised debt universe, where valuations remain attractive relative to corporates and fundamentals remain positive. Although our outlook on mortgage-backed securities has faded somewhat in recent quarters as valuations look less attractive, other parts of the sector have our attention. A slow-motion recovery in commercial real estate is creating opportunities in commercial mortgage-backed securities as refinancing conditions improve and help drive sales transactions and price discovery. Asset backed securities are benefiting from robust structural protections that are helping insulate investors from mixed consumer balance sheets.

Within the high-yield universe, fundamentals also appear relatively solid. Leverage has risen only modestly from recent lows while cash balances and interest coverage ratios remain healthy. The impact from tariffs has been manageable, and elevated operating costs have largely flowed through to consumers. High-yield spreads may look a little tight relative to other sectors, making security selection key in industries such as media and commercial real estate. Across the sector, an improvement in credit quality and a short duration help explain why spreads are tight relative to history.

Private credit has seen notable withdrawals, rising defaults and AI-related disruptions, but the headlines often overlook the sector’s diversity across lending structures and risk profiles. Selectivity and an up-in-quality bias may aid investors in capturing better risk-adjusted income while the broader market faces late-cycle pressure. Opportunities can be found in direct lending to upper middle market companies, where larger companies may be better able to absorb relatively elevated financing costs, and asset-based finance, where loans are secured by hard collateral such as equipment and may offer higher recovery rates in a downturn.

In emerging market debt, robust yields paired with healthy fundamentals are creating compelling opportunities. A number of sovereign issuers offer higher real yields and relatively lower debt levels than many developed markets, including the United States. Positioning is highly differentiated by region, with greater conviction in parts of Latin America and a more cautious stance towards areas that are more sensitive to energy prices or geopolitical risk. Local currency bond markets also stand out, offering both income potential and a possible hedge against a weaker US dollar.

Overall, the case for credit is less about chasing spread compression and more about obtaining income from fundamentally sound issuers in an elevated rate environment.

Income and ballast in a shifting landscape

Elevated yields have strengthened the opportunity set in fixed income, creating a more favourable entry point. Duration positioning and an emphasis on diversification and flexibility across credit sectors can help investors target attractive returns. Should economic conditions weaken, bonds are also in a position to play their historically critical role in providing diversification from equities and other risk assets.

That ballast may prove especially valuable as markets navigate geopolitical uncertainty and downside risks to growth in the second half of the year.