Fixed Income Review & Outlook
- Inflation accelerated following the conflict in Iran as higher energy costs filtered through the economy.
- Under new leadership, the Fed maintained a hawkish stance, prioritizing inflation over employment.
- Higher starting yields provide a stronger cushion against rising rates than in prior inflation cycles.
Inflation Returns, but the Bond Math Has Changed
It has been four months since the U.S. and Israel initiated joint strikes on Iran, leading Iran to effectively shut down the Strait of Hormuz. While a series of ceasefires, an eventual reopening of the strait, and optimism about a long-term deal have brought oil prices back down to pre-war levels, the effects of the 100-day war on U.S. consumers, the economy, and bond markets could linger for the remainder of 2026 and beyond. It turns out that when you take one-fifth of the world’s energy supply offline, not only do oil prices spike, but inflation filters into downstream products beyond energy.
Headline inflation (Consumer Price Index) reached 4.2%, its highest level in three years. If you take out food and energy prices, core inflation (Personal Consumption Expenditures Index) climbed to 3.4% by the end of May. Adding to price pressures is the continued infrastructure spending to support artificial intelligence ambitions. This inflation is inelastic, and as such, the Fed lacks a tool for this issue as well. Still, the Fed’s focus has clearly shifted to price stability over the labor market, which has proved remarkably resilient.
Against this backdrop, markets underwent a meaningful repricing of interest rate expectations. After beginning the year expecting up to two rate cuts and then pricing them out as the Iran war began, futures markets ended June assigning a high probability of at least one hike by year-end. While we believe energy-driven inflation alone is unlikely to warrant higher policy rates, the rapid shift in market expectations shows how fickle sentiment can be when risks surface.
Bond markets now reflect this changed outlook. Treasury yields moved higher, particularly at the front end of the curve, where the 2-year Treasury rose 35 basis points (bps) for the quarter and 67 bps year-to-date. Comparatively, longer-term yields rose slightly but remain well anchored. The 10-year Treasury yield rose 12 bps to end the quarter at 4.42% while the 30-year Treasury spiked before ending the quarter near where it started at 4.97%. Credit markets reflected this period of adjustment, with the Bloomberg U.S. Aggregate Bond Index returning 0.67% and the Bloomberg U.S. Corporate Bond Index returning 1.40% for the second quarter. Year-to-date, the Aggregate Index is up 0.62%, and the Corporate Index is up 0.86%. The Bloomberg MBS Index rose 0.58% for the quarter and 0.99% year-to-date, as higher starting yields have met volatility at the long end of the yield curve, subsequently driving higher mortgage rates.
The last time year-over-year inflation rose above 4%, we were having a much different conversation. Yields across much of the fixed income market were near historic lows, leaving investors with limited income to offset the price impact of rising rates. Today, while inflation has reemerged as a primary concern, investors enjoy substantially higher yields and a stronger foundation for future returns.
The Dawn of a New Era at the Federal Reserve
As market expectations for monetary policy oscillated, the Fed welcomed a new Chair, Kevin Warsh, on May 22. Many investors expect Chair Warsh to push for a more accommodative policy stance, but that will have to wait. In his first Federal Open Market Committee meeting in June, Warsh reinforced the Fed’s commitment to restoring price stability, acknowledging the prospect of increases to the Fed Funds rate. This continuity from the Powell era was noteworthy in that it signaled to global markets and consumers that the Fed’s credibility is intact and that they are taking the inflation threat seriously.
Equally notable was Warsh’s communication style. Unlike recent Fed Chairs, he offered little forward guidance on his policy outlook, instead emphasizing that markets should respond to incoming economic data rather than to a predetermined policy path.
With markets interpreting the press conference and the updated Summary of Economic Projections as more hawkish than expected, short-term rates moved higher. But the fact that longer-term Treasury yields remained contained reflected market confidence in the Fed’s commitment to tackling inflation.
Looking Ahead: Outlook for Bond Markets
Regardless of the Fed’s near-term plans for its policy rate, fixed income investors should pay attention to the broader forces that will shape bond markets over the remainder of 2026 and beyond.
Inflation
Whether inflation broadens beyond energy will be an important factor shaping the Fed’s path forward. Oil prices have retreated from their wartime peaks, but secondary effects could still show up in services or wage growth, which would create a more persistent inflationary environment. Higher oil prices alone would not likely be a reason for the Fed to move, but a broader acceleration into goods and services is another story. For now, we believe the Fed can afford to remain patient.
The Labor Market
The labor market also bears close watching. Employment has remained surprisingly resilient, allowing the Fed to prioritize inflation over concerns about growth. Should labor conditions weaken meaningfully, the policy outlook could change quickly. AI’s impact on jobs remains a wild card.
Private Credit Market
There continue to be signs of stress in portions of the private credit market. Redemption requests remain elevated across some vehicles, with managers continuing to utilize gating provisions to manage liquidity. While these structures are operating as designed, the ongoing restrictions serve as a reminder that higher yields often come with liquidity and valuation uncertainty.
Valuations
Valuations across credit markets remain top of mind for us. Credit spreads are offering historically low premiums over Treasuries, reflecting investors’ very favorable outlook. We want to see at least some of the downside risk priced into securities and, as such, are shying away from areas of the market where we believe the risks outweigh the rewards.
We will continue to see strong issuance, particularly as it relates to the AI datacenter buildout. Industrial issuers are benefiting from exceptionally strong demand, even as significant borrowing for AI infrastructure increases supply. We don’t view the supply or demand of AI-related issuance as a problem; rather, we stress the importance of credit research to ensure these companies remain able to pay their debts. Particularly with spreads at such snug levels. The best opportunities right now may be the least exciting: high-quality, highly liquid securities, and a readiness to act when valuations improve.
As we head into the second half of the year, preserving this flexibility will be just as important as generating income. In our view, the combination of elevated yields, a Fed that appears likely to remain on hold at a minimum, and upward yield adjustments creates a compelling opportunity for bond investors.
High-quality fixed income, which yields between 4.0% and 5.0% today, is well-positioned to serve its traditional role in a portfolio: a steady source of income (at levels above cash alternatives), diversification from other sources of risk, and capital preservation. Even if the Fed remains on hold for an extended period or raises interest rates, the higher starting yields today will not repeat 2022, when hiking upward from near-zero rates led to significant bond price depreciation.
Bond Concepts: Understanding Credit Spreads
When investors purchase a corporate bond, they are taking on credit risk, the possibility that the issuer may be unable to meet its interest or principal repayment obligations. To compensate investors for taking on this risk, corporate bonds typically offer a yield greater than that of a so-called “risk-free” U.S. Treasury bond. That difference in yield is known as the credit spread.
Credit spreads constantly fluctuate as investors reassess economic conditions, issuer fundamentals, and other risks present in the capital markets. During periods of economic uncertainty, where risk increases, spreads tend to widen as investors demand more compensation. In these environments, corporate bonds typically underperform Treasuries, with lower-quality issuers often experiencing the greatest price declines. During periods of optimism, spreads tighten as investors become more comfortable taking on credit risk. Credit performs well in this scenario.
Today, we are firmly in the “optimism” environment. In fact, over the past 25 years, investors were more optimistic (spreads have been tighter) only 5% of the time.
For investors, credit spreads provide an important gauge of market sentiment and potential return opportunities.
For advisors, credit spreads can serve as a useful framework for discussing risk and portfolio positioning with clients. Today’s historically tight spreads suggest that credit analysis and risk management may be more important than simply owning everything in the market or pursuing higher yields with lower-quality bonds.