Two key questions that bond investors should not ignore

The rates perspective

Stormy weather ahead — can bonds provide shelter?

We started the year with expectations of rates remaining elevated and growing evidence of increased divergence across bond markets, as investors and policymakers reacted to increasingly local growth/inflation dynamics. Markets have pondered the possibility of rates staying “higher for longer” on several occasions since the inflation shock of 2021 – 2022, only to look for signals of any easing to prompt market rallies, such as in the last quarter of 2023 and last summer. The question then is: will this time prove to be any different? And what can a bond allocation offer in a broader portfolio?

Vigilantes are back, capital flows could follow

There has been no shortage of exogenous shocks in the first half of this year. The US administration’s approach to tariffs escalated progressively, culminating in the “Liberation Day” announcement in early April. Further escalation ensued, upending decades of trade policy, until a temporary reprieve was announced. In this context, longer-dated bonds, rather than equity markets, acted as the disciplinarian, forcing the administration to rethink its approach. This could mark the return of the “bond vigilantes”, with fixed income markets imposing a degree of restraint on governments whose fiscal outlook is increasingly deteriorating. Even if some of the tariffs are walked back through trade deals, there is an increased probability of more economic nationalism and repatriation of capital. We could start to see capital outflows from US financial assets into global fixed income, which should imply higher risk premia and higher long-term bond yields for the US. In the rest of the world, this could be a strong technical factor to support non-US financial assets, with European, Japanese and Chinese fixed income potentially benefiting from US outflows. 

Storing up trouble 

We continue to expect heightened volatility in rates markets around longer-dated maturities. Yield curves across developed markets have now normalised but could see further steepening due to persistent inflation and high government spending. Growing concerns about debt sustainability could lead to higher term premia across developed markets, especially the US — a dynamic illustrated by Figure 1, which shows that, at the time of writing, the average term premium across developed markets had risen above 1.0% the first time in 11 years. 

The euro area is a good example of this tension: the European Central Bank appears biased to continue its rate-cutting cycle, while the sustained increase in defence spending — especially, in Germany — and deteriorating fiscal outlooks in some countries (notably France) could push long-term bond yields higher. Equally, the Japanese yield curve has steepened significantly in the last year with 30-year bonds reaching yield levels not seen this century, even if monetary policy remains stubbornly loose. Contrary to other markets, we expect to see a flattening of the Japanese curve should the Bank of Japan opt to hike policy rates, in response to a potential trade deal with the US and persistent, domestically generated inflation.

Finding the right safe-haven asset

In times of macroeconomic turbulence, rates should act as an anchor, rallying just as riskier assets depreciate. Investors have been sceptical of bonds’ total return and their correlation to equities since the annus horribilis of 2022. Recent market turmoil suggests that bonds have regained their historical role, providing portfolios with income and downside protection. However, quite where this anchor can be found could be changing. Over the course of April, global investors implicitly challenged the notion of the US Treasury market as the main diversifier asset in times of exogenous shocks. The Moody’s downgrade may further cement the view that alternative assets, such as European, Australian and Japanese government debt (as well as select currencies) can deliver the required diversification within a broader portfolio. In summary, bonds are demonstrating once again that they can be a safe-haven asset during heightened volatility, but an active approach is likely warranted as local conditions increasingly trump the global cycle in driving market returns.

The credit perspective

How to navigate the rapids in a year of market crosscurrents

Did the first half of 2025 feel like a whitewater rafting trip that you didn’t sign up for? If so, you’re not alone. What looked like a calm river paddle has turned into a wild ride that could have easily capsized markets and submerged the global economy. Yet the US economy especially has stayed afloat: unemployment is historically low, and consumers are still paddling. Corporate fundamentals in the US and beyond remain solid, with healthy cash flows, limited new debt issuance, and muted merger activity. 

That said, we’re not floating through calm waters. The US Federal Reserve (Fed) hasn’t eased much, and monetary policy remains tight in the US, while most other central banks have started to loosen the lines. Spreads are wider than they were in January, but still not what I’d call generous. In this environment, I’m staying cautious on risk while watching for better entry points downstream.

Looking beyond the US

I don’t expect a sharp loss of confidence in US markets, but I do think investors may start shifting their focus away from the US into other markets with more attractive potential (Figure 2). I'm leaning more heavily into non-US credit — specifically global high yield and emerging markets corporates — to build a more resilient portfolio in today’s choppy waters.

CDX HY: higher-yield credit default swaps. CLO Aaa: collateralized loan obligations rated Aaa. CMBS Aaa: commercial mortgage-based securities rated Aaa. CoCo: European contingent convertibles. Converts: global convertible bonds. CRT: credit-risk transfer bonds. EMC HY: emerging market corporate high yield. EMD: emerging market debt. EU HY: European high-yield credit. iTraxx Crossover: higher-yield credit derivatives. MBS: mortgage-backed securities. RMBS NPL: non-performing residential mortgage-backed securities. US BL: US bank loans. US HY: US high-yield credit. US short HY: shorter-duration US high-yield credit. US IG corp: US investment-grade corporate bonds. US IG long corp: longer-duration US investment-grade corporate bonds.

Where are we spotting more favourable conditions?

• European financials: Well-capitalized, largely insulated from US trade dynamics, and poised to benefit from German fiscal spending, European banks look sturdy in turbulent waters.
• Emerging market corporates: Companies with limited US exposure, especially in sectors like utilities and telecoms, offer steady cash flows and low leverage. We’re finding solid ground here.
• Convertible bonds: With tighter high-yield spreads, converts offer asymmetric upside. Their bond floors provide protection in risk-off environments, while their equity linkage gives them strong potential in bullish scenarios. They also add exposure to tech and life sciences, sectors underrepresented in most fixed income portfolios.

Where are we cautious (for now)?

• Long-dated IG corporates: Spreads are tight, and rising term premia due to increased Treasury issuance could weigh on returns. Add in potential margin pressures from tariffs, and we’re cautious here.
• Emerging market sovereigns: Fundamentals are solid, but the upside seems limited. We’re focused on a select group of high-conviction improving credits.
• CMBS: The waters are choppy in CMBS. We’re avoiding known hazards — lower-grade offices and regional malls — but in a few well-positioned areas, like high-end New York office buildings and hotels, we see a clear opportunity.

Running the rapids ahead

This year calls for the skills of a seasoned raft guide — adjusting as soon as conditions change, reading the currents, and ready to strike when the right course emerges. A flexible, global approach can help navigate the waves while turning uncertainty into an edge. By staying nimble and broadening their horizon, investors can aim not just to stay afloat — but to move ahead with agility and purpose in the second half of 2025.