Looking beyond the core: How to position fixed income portfolios

Investment implications

It is increasingly evident that the fixed income market is broadening out beyond core US fixed income opportunities. In this paper, we see value in maintaining a diversified portfolio, with the following views on key sectors:

Developed markets credit: We find the combination of a short duration profile and attractive total yields to be desirable qualities in the current environment. For this reason, we favor high-yield bonds—particularly US high yield. Fundamentals remain solid, and we do not see refinancing risk as a meaningful concern over the coming year. While spreads may be volatile in the months ahead, strong yield cushions should help offset this risk.

Emerging market debt (EMD): We remain constructive on emerging market debt, viewing the macroeconomic environment as supportive of further EM central bank rate cuts. Real yields remain attractive, particularly when taking a selective approach. The recent build-up of international reserves has made many EMs fundamentally more resilient. We favor a split allocation between local and hard currency debt, with a tilt toward the former.

Euro bonds: For US dollar (USD)-based investors, hedged benchmark Bund yields look increasingly compelling, offering opportunities even as we maintain a neutral stance on European fixed income. Our neutral view is premised on the European Central Bank (ECB) bringing its policy rate to a more neutral 2%, having already delivered eight interest-rate cuts. While moderating inflation could permit further rate reductions, the easing cycle is clearly in its mature phase. Meanwhile, large fiscal programs and a potential rebound from depressed growth levels may create headwinds for longer-term yields.

US Treasuries: We continue to see the most attractive risk-reward in the short-to-intermediate part of the yield curve, while remaining cautious on longer-term bonds. Fed policy expectations primarily drive the shorter end. Although the Fed does not appear to be in a hurry to cut rates, once it starts, the pace of cuts could be more aggressive than currently anticipated. Longer-term bonds are influenced by both Fed policy expectations and the term premium—the latter potentially limiting the scope for significant declines in longer yields.

Currencies: We see headwinds persisting for the US dollar. Structural factors, such as the rebalancing of flows, are likely not over, and Fed cuts could ultimately add to dollar downside, even though the bearish narrative has eased after recent declines. We believe it remains prudent for non-USD investors to consider hedging currency risk when building exposure to foreign fixed income products denominated in USD.