Bonds in Brief: Making Sense of the Macro — June issue

What are we watching?

• AI buyer fatigue: Investor demand for AI-related credit remains strong, but the scale of anticipated financing needs raises questions about how much supply markets can ultimately absorb. Hyperscalers, data centres, utilities and other infrastructure providers are likely to remain frequent issuers for years to come. While demand has kept spreads contained, sustained issuance could eventually require wider spreads and greater concessions to attract capital. We are also monitoring whether increased competition among underwriters is leading to weaker structures, looser terms or a deterioration in underwriting discipline. In our view, the key risk is not the availability of capital, but whether investors are being adequately compensated as supply continues to grow.
• Inflation not out of the woods: While inflation has moderated from recent highs, investors may be underestimating the risk that price pressures prove more persistent than expected. Labour markets remain resilient, fiscal deficits are large and supply-side shocks — from energy markets to AI-related investment and infrastructure bottlenecks — continue to pose upside risks. Although recent geopolitical developments have eased immediate concerns around energy supplies, they have not eliminated them. In our view, inflation is likely to remain more volatile and sensitive to supply-side developments than during the decade preceding the pandemic, increasing the risk of periodic repricing in rates markets.
• Fiscal credibility and bond market pressure: Bond markets have so far absorbed rising government borrowing needs across many developed economies, but fiscal trajectories remain a key risk. Persistent deficits, rising debt-servicing costs and growing issuance requirements could contribute to higher term premia and greater volatility in sovereign bond markets. While fiscal concerns have surfaced periodically in recent years, the combination of structurally higher rates and larger borrowing needs suggests they are likely to remain an important market consideration.
• Geopolitical risks remain elevated: The reopening of the Strait of Hormuz has reduced immediate concerns around energy supplies and shipping flows, but many of the underlying geopolitical tensions remain unresolved. Investors may be placing too much weight on recent stabilisation and too little on the risk of renewed disruption. In our view, geopolitical developments are likely to remain an important source of volatility across energy, commodity, foreign exchange and rates markets.
• Institutional integrity: We have previously highlighted institutional integrity as an important risk to monitor, particularly amid intensifying debates around Fed independence. Recent US Supreme Court rulings expanded presidential authority over many independent agencies while preserving protections for Fed Governor Lisa Cook, reinforcing the Fed's unique status within the federal government. For markets, the decision may help ease concerns that monetary policy could become subject to direct political influence at a time when policy credibility remains an important driver of investor confidence.

Where are the opportunities?

• We continue to believe that total return fixed income strategies unconstrained by benchmarks are best positioned to navigate the later stages of the economic and credit cycle. Central banks’ divergent policy paths are creating dispersion in growth and inflation, further increasing the likelihood of market dislocations. Looking through the heightened geopolitical instability, we believe that structural tailwinds — fiscal stimulus, deregulation and robust AI-driven capital investment — keep the backdrop broadly constructive. However, elevated valuations across most sectors suggest that success will hinge on selectivity and discipline.
• Today’s uncertain market environment underscores the growing appeal of an allocation to core fixed income, be it aggregate or credit only. In our opinion, higher-quality fixed income continues to be attractive from both an income and capital-protection perspective, providing a combination of carry and significant potential upside in a risk-off environment. In our view, all-in yields remain appealing for investors looking to de-risk or diversify away from domestic government bonds, providing a potentially smoother return profile.
• European investors can seek to embed resilience and enhance income potential through either a bond allocation in local markets or by going global, particularly if they are concerned about the extent of their exposure to the US or USD-denominated assets. Doing so could also potentially provide a yield pick-up, as hedging costs mean USD-denominated investments have lower yields than EUR- or GBP-denominated equivalents.
• We think emerging market debt (EMD) offers potential as both a return driver and a diversifier in fixed income allocations, particularly for European investors. While EMD has historically been more cyclical and volatile than its developed market counterparts, there are reasons to be structurally positive as risks are increasingly originating from developed markets amid disruptive US policy dynamics. Many EM economies also benefit from muted default forecasts, reflecting solid fundamentals across growth, fiscal and external metrics. Despite heightened geopolitical uncertainty, we think select exposure to EMD could still make a positive contribution to a well-diversified portfolio, mainly through carry and USD weakness.
• In our view, high yield remains attractive from an outright yield-to-worst perspective but warrants a cautious approach given market uncertainty and current spread levels. The robust carry may make this a good equity substitute should investors want to de-risk. We advocate an “up-in-quality” issuer bias and careful credit selection but remain cautiously optimistic that this sector can continue to perform well.