The bond market is well positioned to provide investors with attractive income potential and relative stability, should equity markets swing lower in the second half of the year. Given slowing US economic growth and cooling inflation, bonds should offer a smoother ride for investors amid high uncertainty over US trade and immigration policies, rising debt levels and worsening conflicts in Ukraine and the Middle East.

“Economic conditions are steady but softening, with labour markets and consumer spending gradually slowing,” says Chitrang Purani, fixed income portfolio manager. “Ongoing uncertainty around tariff levels — as well as the time it takes to reach these agreements — will continue to weigh on business and consumer sentiment. It could also negatively impact economic data during the second half of this year.”

Building a bond portfolio that balances seeking return against minimising exposure to elevated market volatility is important to Purani. “I currently favour an up in quality tilt toward credit exposures across bond sectors and issuers, as you’re not getting paid appropriately to take on riskier investments. The market has priced in a very optimistic outlook, and while recession is not my base case, it’s crucial for bond portfolios to serve as a ballast when volatility hits.”

Meanwhile, inflation risks continue to plague markets — and the Federal Reserve. At the June 2025 meeting, the Fed extended the pause on rate cuts and left the target range unchanged at 4.25% to 4.50%. The latest projections show rates to end the year at 3.9%, which suggests modest rate cuts for the remainder of the year.

Waking a sleeping giant

Moves in the rapidly growing $28 trillion US Treasury market have emerged as a flashpoint for policymakers and investors.

Yields on the 10-year Treasury, arguably the most important interest rate in the world, reached 4.39% as of 18 June 2025, compared to 4% in early April. The upward march came even as yields on shorter dated Treasuries declined, steepening the yield curve.

“Investors are balancing concerns of higher inflation and a potential downturn, both stemming from a tariff policy that continues to evolve,” says Tim Ng, fixed income portfolio manager. Expectations of a growing US federal budget deficit amid potential tax cuts and other spending plans also play a role in keeping long-term yields high. 

“There’s room for the curve to further steepen in several scenarios,” explains Ng, who is maintaining flexibility considering recent market swings. “While the worst of trade policy uncertainty may be behind us, I want to be positioned to take advantage of any major shifts in valuations.” 

Investors count on bonds to zig when stock markets zag. That is exactly what happened during the policy-induced stock market volatility. Specifically, when the S&P 500 Index fell 18.7% from the record high set on 19 February 2025, to the recent low on 8 April 2025, the Bloomberg US Aggregate Index gained 1%. The return of this time-honoured relationship – which disappeared in 2022 during the Fed’s rate-hiking spree — is crucial as Trump’s policy initiatives raise the risk of a recession. Specifically, should economic conditions weaken abruptly, the Fed can lower interest rates beyond expectations and provide a tailwind for bond returns since bond prices increase as yields decline. 

Elsewhere, Germany’s fiscal pivot via new infrastructure and defence spending commitments is likely to provide a meaningful boost to eurozone growth over the medium term. In the immediate term, trade uncertainty makes the growth outlook more challenging, however. This, in combination with a stronger euro, is likely to bear down on inflation in the region, which should make it easier for the European Central Bank (ECB) to cut rates more rapidly.  In our view, the ECB is likely to err on the side of doing more rather than less to help ease upward pressure on the euro and to minimise the output loss from higher tariffs. 

The most extreme steepening seen has been in Japanese Government Bonds (JGBs). The selloff is being driven by concerns about increased supply at a time of weaker demand in a market where the Bank of Japan (BoJ) is buying fewer long dated bonds as part of its quantitative tightening plan. We think the dislocation temporary and anticipate the BoJ will now pause hiking rates and potentially take measures to address the supply demand imbalance. 

Securitised credit offers competitive income potential

In a world where waves of volatility are likely, exposure to securitised assets including agency mortgage-backed securities (MBS) could benefit portfolios given their higher quality and attractive nominal yields and spreads compared to corporate credit. The appeal of agency MBS is further bolstered by the sector’s liquidity and relative resilience in past downturns.

Active coupon selection is an important factor in mortgage portfolios. Higher coupons offer compelling income opportunities with low sensitivity to rates even if interest rates and volatility remain elevated. In contrast, low coupons, which are more prevalent in the Bloomberg US Mortgage-Backed Securities Index, have higher interest rate sensitivity and lower nominal spreads and yields.

Many areas of securitised credit also look appealing, such as the senior tranches of subprime auto asset-backed securities. “The underlying loans have shorter maturities compared to mortgages, and lending standards have tightened over the past decade,” says Xavier Goss, fixed income portfolio manager. 

Some commercial mortgage-backed securities, particularly higher segments of the capital structure, also offer strong income with reasonable valuations. While some office properties still face challenges in the post-COVID era, multifamily housing, warehouses and other segments of the market have solid balance sheets, steady cash flows and strong demand.

Corporate bonds show continued resilience

Healthy corporate fundamentals and attractive yields should help corporate investment-grade (BBB/Baa and above) and high-yield bonds weather potential headwinds to growth.

“Corporate earnings are reasonable, though rising costs and weaker consumer sentiment muddy the general economic outlook,” says Tom Chow, a fixed income portfolio manager. “In periods of declining growth expectations, established entities with strong credit metrics, low refinancing risk and sizable equity cushions are better positioned to weather the storm,” Chow explains.

As simple as it sounds, yields are a proxy for future total returns. For example, looking at investment grade (IG) corporate yields, history tells us that the correlation between the starting yield and the total return over the following five years has been extremely high. Today, depending on the quality of issue, fixed income markets offer yields of between 4% and 8% across sectors. Locking in these yields offers good value over the long term. 

Companies with non-cyclical businesses are still capable of improving their financial profile and reducing refinancing risk. For example, within investment-grade rated companies, certain pharmaceuticals, such as Amgen, are reducing debt following recent acquisitions. In high yield, telecom company Charter Communications has recurring revenue streams, while security and defense companies including Axon Enterprises may be less affected by the economic cycle.

Today’s starting yields for higher income sectors such as investment-grade, high-yield and emerging markets debt offer attractive entry points for long-term investors. Even if spreads to US Treasuries widen to impact price, the income component should help support positive returns. Moreover, rate cuts expected from the Federal Reserve later this year could be tailwinds for bond returns, particularly for those with longer maturities.

Corporate defaults are expected to remain low relative to the historical average of roughly 3%. “Many high-yield companies refinanced debt ahead of tariff-induced volatility, so a ‘maturity wall’ is not a major, imminent concern,” Chow adds.

Importantly, the credit quality of the high yield market has improved significantly over the past decade. The highest rated cohort in high yield is BB, which now represents more than 50% of the US high yield market. 

EM opportunities 

Meanwhile, downward revisions to global growth, falling energy prices, and easing core inflation all point to a lower interest rate trajectory across emerging markets. Meanwhile, muted pressure for the US dollar to appreciate means that the balance sheet channel, which traditionally pressured EM central banks to maintain more restrictive monetary policy in risk-off environments, is less of a constraint. 

 “While the potential for a spike in risk aversion remains higher than normal with US foreign policy uncertainty, EM countries are in a relatively strong position to face any upcoming challenges, considering mostly solid fundamentals and supportive technical factors”, according to fixed income portfolio manager Kirstie Spence. 

The decline in foreign ownership of EM local currency debt combined with the rise in a domestic investor base in most regions protects against capital flight as local investors often have different goals and timelines compared to foreign investors and are generally a stickier source of demand. 

Meanwhile, if we see a broader move away from US-based assets, relatively low foreign participation in most EM regions suggests that there is capacity to accommodate foreign inflows.

Bonds are in better shape for a changing world

The US economy has proven to be resilient through high inflation and elevated yields, which remain near multi-decade highs, but ongoing trade negotiations and other policy initiatives complicate the economic outlook. Though most economists and investors do not expect a recession, they agree the chance of one has increased.

“Growth remains solid due to healthy labour markets and corporate profits in the US, but near-term risks to growth appear tilted modestly to the downside,” Purani says. “Over the long run, shifts in global economic and political alliances are likely to force changes to traditional economic growth drivers across regions, which may increase dispersion among winners and losers. This is an environment which supports the role of bonds as a portfolio ballast and highlights the potential value of active management.”