In 2025, capital markets were given a test of their resiliency. Tariffs rewrote trade relationships; artificial intelligence reimagined capital spending and corporate borrowing; fiscal deficits reached new heights; the Federal Reserve (Fed) maintained a Fed Funds rate above inflation throughout the year. And despite all of that, fixed income rewarded investors by delivering the reliable income, capital preservation, and diversification benefits it has been known for.
The question for 2026 is not whether uncertainty remains. It is whether investors will navigate it with confidence and logic.
2025 In Review
If 2024 was defined by curve inversion and tightening financial conditions, then 2025 was the year when investors were reminded how quickly pricing can reset and how emotional markets get when the economic narrative changes.
The reset came in April. Treasury yields and credit spreads spiked as the market tried to digest the Trump administration’s “Liberation Day” tariff announcement. The move was abrupt and short-lived, spreads reflected a bond market suddenly concerned about the potential impact to growth and inflation. High yield felt the impact most directly. The energy sector was also volatile. In a familiar pattern, the moment of fear did not last long. As investor angst faded, spreads tightened again, retracing most of the widening that occurred in those early April sessions.
Credit spreads had entered 2025 near the bottom of their historical range, around the 6th percentile. In other words, over the past 25 years, investors have received less extra yield over Treasuries only about 6% of the time. Despite the brief April widening, they crept back toward historically tight levels, largely ignoring the uncertainty that still surrounded economic policy, inflation, and consumer spending.
The Federal Reserve spent most of 2025 in a balancing act. Tariffs raised the risk of a one-time price shock. Labor markets began to soften. Inflation never convincingly approached 2%. The Fed resumed its easing campaign in September, with a total of 75 basis points (bps) of cuts in its final three meetings of the year to take the federal funds target to 3.50 to 3.75 percent.
Despite this easing, not all points on the yield curve moved lower. Consistent with the trend we have written about at length, the intermediate part of the curve saw the greatest price appreciation. Bonds at the long end of the curve (ten years and out) responded to longer-term dynamics, including large and persistent fiscal deficits and inflation that has sat above target for more than four and a half years. As such, investors demand greater term premium. By year-end, the ten year Treasury traded within a range of 4.00-4.25 percent and the curve steepened meaningfully. The term premium between the ten year and two year reached about 65 basis points, its highest level since early 2022. After years of inversion, that alone felt like progress.
The artificial intelligence buildout entered a new phase as well, shifting into a debt-financed infrastructure cycle. Hundreds of billions of dollars in data center, semiconductor, and power delivery commitments led to a surge in issuance in both public and private markets. Investors must carefully evaluate what type of productivity gains, employment effects, and free cash flow profiles might emerge from that spending, and whether those effects justify the capital structure being created.
Despite the volatility, fixed income rewarded investors in familiar ways—yield, income, and diversification. The role of fixed income in a diversified portfolio remains entrenched.
A Cautious Fed Facing Conflicting Mandates
The economy held up in 2025 because the consumer remained resilient, companies loaded inventories ahead of tariffs, and capital spending on AI infrastructure accelerated. Looking ahead, the market and the Fed are now focused on the labor market. The latest nonfarm payroll release showed slowing labor demand and an unemployment rate of 4.6 percent, already above the Fed’s projections. Meanwhile, above-target inflation seems an afterthought.
The biggest challenge for monetary policy is that the Fed’s dual mandate is pulling in opposite directions. Can officials support growth and a healthy labor market without reigniting inflation? Can inflation move lower without sparking a recession? The December Fed meeting made clear that the committee is not unified in responding to these challenges. Several dissenting votes flagged how uncertain the path forward will be.
The market currently expects two or three additional cuts in 2026. The Fed’s dot plot implies one, with Fed Chair Powell already sugging that policy is within the broad range of neutral. We think the Fed will be patient. The committee can afford to sit out the first part of the year and evaluate incoming data.
Credit market
While credit markets recovered from initial fears of tariff policy, we continue to believe investors should be mindful of downside risk. High yield and long duration credit offer little cushion at current valuations. Chasing the highest yielding bonds often means taking equity-like risk and reducing diversification benefits. High quality investment grade still earns 4 to 5 percent. We prefer that profile to high yield or low BBB.
Issuance related to AI has shifted the risk profile of large parts of the corporate bond market. The capital promises tied to infrastructure buildout have resulted in significant new issuance. The projects themselves will support economic activity, but investors must question whether the cash flow outlook justifies the leverage. It is too early to claim victory on productivity or profitability. Investors should treat AI credit narratives with humility. In the prior years, equity pricing carried the story. In 2025, debt markets began financing the same optimism. The two are not the same. Bonds demand cash flow.
Within corporates, Financials look more attractive than Industrials, Utilities, and parts of Telecom and Media. Mortgages also remain relatively attractive in a curve-steepening environment.
Municipal bonds were stuck in neutral for most of the year as massive supply collided with hesitant demand. Tax-adjusted yields can be compelling when spreads allow concessions.
Outlook
The outlook for fixed income in 2026 remains constructive as starting yields will be a better buffer for negative price movements than, say, in 2022. Carry can offset volatility. Low correlations to equities can diversify sources of return.
As we saw post-financial crisis through 2018, spreads can remain tight for a long period. At current valuations, we stress selectivity. Moving into lower quality for minimal added yield may expose a portfolio to equity-like risk. We prefer investment grade and high quality positioning and see opportunities for active managers to move in and out of sectors as risk reprices. Flexibility matters because uncertainty from both monetary policy and political policy remains unusually high.
While we expect positive economic growth in 2026 and a stabilizing labor market, inflation remains the biggest unknown. Monetary and fiscal policies will keep upward pressure on prices, and if inflation spikes, there is a good chance rates will move higher in response. Investors should be cognizant of the impact on portfolios.