Bond markets: An investor’s Swiss army knife

Fixed income markets provide investors with an abundance of tools to adapt portfolios in the face of heightened economic and policy uncertainty.

The market is not homogenous – bonds come in a variety of differing guises; there are fixed income assets that mostly reflect the interest rate outlook; there are others that are more correlated with equity markets.

There are also assets of varying maturity, allowing participants to use fixed income to hedge liabilities and manage required future cash-flows.

Bond interest payments are either linked to short-term floating rates or are fixed for varying periods. And fixed income derivatives (contracts) allow hedging of interest rates, credit, and foreign exchange risk to provide more confidence of return for a core portfolio.

There is also the ability to access cash-flow returns from credit activities like mortgages, automobile and consumer loans, and bank lending through structured credit instruments such as asset-backed securities and leveraged loans. In short, the fixed income markets have something for everyone.

Higher income

Since 2022, central banks have increased interest rates to levels closer to those that prevailed before the 2008/2009 financial crisis than those experienced in the period following it. While zero rates and quantitative easing pushed bond yields down and in turn boosted total returns, bond markets were less able to generate meaningful income returns - a core attraction of the asset class.

Today, however, income returns are increasing, reflecting the rise in yields since the lows reached in the 2020-2021 period. In the year to 31 March 2025, the US investment grade corporate bond index returned 4.7% of income.¹

For an equivalent European index, it was 2.5% and for US and European high yield indices, income return over the same period were 6.8% and 5.0% respectively. The average coupon on European investment grade bonds has increased from a low of 1.45% in 2022 to 2.6% currently.

Companies are paying more interest to borrow in the bond market, and investors are getting higher income returns. This provides solid foundations for total returns for fixed income portfolios and provides a more diversified source of performance in multi-asset strategies. Interest rates will move lower over the next few quarters, but income returns from bonds should be resilient for some time.

Policy influence

Higher rates have become a vital component of fixed income returns since 2022. However, the outlook for rates reflects economic and policy uncertainty. It seems likely the US’s tariff policy will trigger slower economic growth, which would normally spur on central bank monetary easing. Indeed, this is our central case.

However, tariffs might also lead to higher inflation. This will not necessarily prevent central banks from cutting, but it may contribute to steeper yield curves – which normally happens during recessions.

For investors concerned about inflation, we would look to inflation-linked government bonds as an opportunity to help protect portfolio values. Break-even inflation rates have moved lower since US President Donald Trump announced his tariff plans on 2 April but a portfolio of short-maturity inflation-linked bonds will benefit from any upward shock to consumer price indices as tariffs are passed on to consumers.

For government bonds more broadly, a steepening of yield curves should encourage investors to look at longer-duration strategies. However, presently, there is little compensation from higher yields for taking on a lot of duration risk – certainly for more active fixed income participants.

The current spread between two-and-10-year US Treasuries is close to 50 basis points (bp). However, in a recession it would not be uncommon to see spreads of between 250 and 300bp. In Europe, the German government curve is steeper as the European Central Bank is more advanced in its monetary easing cycle. But even here, curves have been significantly steeper in the past.

Risk management

Long-duration government bonds are attractive assets for long-term investors needing to manage reserve assets or have a need for high-quality assets to match long-duration liabilities. However, for return-seeking investors they have disappointed in recent years, with an unattractive risk-return payoff.

This is unlikely to materially change in the immediate future given the fiscal stability concerns in developed economies. A sign of this is the widening of the gap between government bond yields and swap rates, which suggests higher fiscal risk premiums.²

This has become evident in the US Treasury, UK gilt and European bond markets. However, long- duration government bonds are useful for expressing short-term tactical views on the macroeconomic cycle – slower growth tends to push interest rate expectations lower and a 50bp move in 10-year bond yields is worth a lot more in performance than in a two-year bond.

Fixed income markets are framed by the two dimensions of rates and credit. The market offers a variety of ways of getting access to rates and credit returns and hedging adverse movements in both.

Given the uncertain outlook, limiting a portfolio’s sensitivity to both might be a choice for investors today. Short-duration, high-quality credit assets should provide a return above falling cash rates with less sensitivity to volatility in interest rate expectations or credit deterioration.

Returns can be enhanced in bond portfolios by having more exposure to credit; cash-flows from corporate bonds, loans and other credit assets. The key is to understand the level of credit risk. For good quality investment-grade bonds, we continue to have a favourable view on fundamentals – companies have managed their balance sheets very well in recent years and retain a strong ability to meet their interest obligations.

Moreover, markets remain open with strong demand for corporate bonds from a range of investor types including retail and more traditional insurance and pension fund buyers who primarily need to match cash-flows.

But any period of economic weakness is likely to result in credit spreads moving wider as investors demand higher risk premiums in the face of challenges to corporate profits and cash-flow. This is most likely to be seen in the high yield markets.

Historically there is a strong correlation between moves in equity indices, such as the S&P 500, and high yield credit spreads. Any further decline in equity markets - in response to growing signs of economic weakness - is likely to mean wider spreads. 

What’s next?

Our view is the quality of the US high yield market has improved in recent years. At this point we would not expect spreads to reach the extremes seen in previous economic downturns. Yet some widening is likely, and this would likely be both short-lived and provide the opportunity for locking in much higher returns from a high yield portfolio.

For example, in February 2016, when spreads reached 887bp, subsequent total returns from US high yield were 23% over one year and 33% over three.

Again, the fixed income market is not homogenous. The risk spectrum extends from cash-like floating rate instruments with higher levels of credit quality, to leveraged assets which have payoffs like small-cap equities.

This gives incredible choices for investors to generate portfolio income, to hedge against a rise in inflation and to benefit, opportunistically, from investing in cheap assets when economic conditions have gone through a deterioration.

Historically, most attractive risk-adjusted returns have come from credit assets and their incorporation of rates, term premium and credit spread. In the short term, such assets may re-price to reflect the uncertain outlook. However, should this be the case, medium-term returns will be attractive given the yield levels prevailing today.

More than ever, the diversified sources of return, and risk levels, available in bond markets are vital tools which should be extremely beneficial to investors.