A strategic buy point for fixed income
While the investment outlook remains clouded by uncertainty, such times often create opportunities
AGAINST an unnerving backdrop of economic uncertainty and fraying geopolitical ties, markets have seen plenty of volatility over the last few years. Across most developed markets, things seem to keep pointing to one outcome: a “muddle through” scenario characterised by low to moderate growth with mildly sticky inflation, especially at the core level.
This may seem like an odd time for bold asset allocation calls. But current conditions present a compelling case for fixed income, even more so when compared to cash and equities.
Fixed income vs cash, equities
In the world of bonds, yield is destiny. Today’s bond yields are attractive, as the market’s yield over a decade is often highly correlated to the subsequent, realised return.
Yields on global investment-grade bonds are more or less at their highest levels since the global financial crisis across several major markets. This suggests that bond returns over the coming decade are likely to be head and shoulders above the 2010 to 2022 period.
Following the 2022 bond market sell-off, many investors tend to be content with holding cash. After all, in recent years, money market yields have rivalled long-term fixed-income yields, with the benefit of price stability. The problem is, the “safety” of price stability can mask the uncertainty regarding long-term return potential.
If past rate-cutting cycles are any guide, investors who stay in cash will be at risk of seeing their interest earnings fall over time, while those investing in bonds will have locked in an income stream at today’s attractive rates.
BT in your inbox
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
While equities have enjoyed a strong run, several metrics indicate that stocks are somewhat overvalued versus bonds. For example, looking at the last few decades, the difference between the yield on Australian seven to 10-year government bonds and the earnings yield on the MSCI Australia index (the inverse of the price-to-earnings ratio) is currently at an above-median level.
Valuation is hardly a timing tool, granted. But historically, a “bonds are cheap” reading from this valuation metric (that is, bond yield minus earnings yield above historic median) has presaged periods when the absolute and risk-adjusted returns on bonds have rivalled and even exceeded those of equities.
Another important consideration is the shock-absorber potential of fixed income in a diversified portfolio.
Historically, how bonds perform in an equity drawdown depends on where we are in the rate cycle. If the central bank is hiking rates, equities and bonds can decline in tandem, as was the case in 2022. However, if central banks are on hold or cutting rates – as they are now – bonds tend to perform well during equity market corrections, typically outperforming both cash and stocks.
Shifts in economic data and yield-curve dynamics
In contrast to the first half’s broken yield-curve dynamics – when short-term yields fell and long-term yields rose – things have changed in the home stretch of 2025. Yes, yield curve steepening seems likely to continue, but long yields are now moving along with short rates and clearly seem past their peak in the US. This has bullish implications for other Western markets, given the influence of the US market on cross-market correlations.
Negatives can be positives
Two negative developments may bring about the only thing bond investors like as much as high yields – falling yields. The first is the potential for a US Federal Reserve capture scenario where the management motif at the Fed takes a markedly more dovish tack, resulting in a short-rate decline of 100 basis points or more relative to prior expectations.
While we can debate the longer-term inflationary impact of such a scenario, the short-to-intermediate term implication would likely be a lower and steeper yield curve, turbocharging the bond bull market over the intermediate term.
The second negative-positive development is the downshifting in the US employment picture. With the fourth quarter – and a partial shutdown of the federal government – underway, the latest US ADP employment numbers exposed a job market that may be contracting, rather than expanding.
Forget about Fed capture; a sustained labour downshift could easily prompt Fed funds pricing to drop from the current expected terminal rate in the 3 per cent area – estimated to be in the neutral range – into the more accommodative 2 per cent realm. In addition to the bullish implications for the entire US yield curve, this shift also brings marginally bullish ramifications at the very least for other Western and emerging markets.
Where opportunities lie
Within fixed income, global hedged allocations have typically delivered comparable outcomes to domestic fixed income over the long term, but with less volatility. With the potential for adding value through active management, global fixed-income portfolios have a much wider field of opportunity compared to narrow, single-country fixed-income portfolios.
The global investment-grade universe offers compelling opportunities, with some of the highest spreads for the credit risk available in the high-rated collateralised loan obligation tranches. Despite historically narrow spreads, corporate bonds should continue to do well, in particular those with intermediate maturities, given the phase of the credit cycle.
Emerging markets present select opportunities across the credit spectrum, especially in hard currency bonds. Although spreads are narrow, the market’s credit quality has improved in recent years and the average maturities have shortened, suggesting a potential for heightened returns.
Similarly, European corporate bonds currently have wider credit spreads compared to US corporate bonds, presenting opportunity in both high-grade and high-yield.
Hedged investments in smaller countries with strong fundamentals, like Switzerland and New Zealand, offer attractive interest rate fundamentals. Some emerging markets, such as Thailand, stand out due to their low economic growth and inflation, which can create a stable environment for bond investments.
What could go wrong?
Despite these opportunities, risks remain. Distribution tails are thick, not only on the downside in a world of fraught geopolitics and trade tensions, but similarly on the upside if a Fed capture scenario ensues – that is, possibly positive over the near to intermediate term, but risky longer term. Hence, we remain vigilant.
Yet, these potential developments are lower-probability scenarios and, ultimately, we are guardedly optimistic regarding our base case – global muddle-through scenarios – which should be well enough for the fixed-income markets.
The bottom line is, while the investment outlook remains clouded by uncertainty, such times often create opportunities. With cash rates potentially declining, the current configuration of economics and valuations argues against either carrying excessive cash balances or allowing equity allocations to passively swell to above strategic targets.
A solid case for fixed income has emerged at this point as a strategic asset class, offering the potential for a reasonable income stream with a buffer against downside volatility in equity markets.
The writer is chief investment strategist and head of global bonds, PGIM Fixed Income
Copyright SPH Media. All rights reserved.
