What do current government bond yields and spread levels tell investors about bond markets?
Government bond markets are telling us a few things. Fundamentally, the presence of positive real yields indicates both concerns as to the deteriorating fiscal picture for most economies, but also the reasonably positive outlook for growth. In addition to the yield backdrop, the steepness of curves speaks to a bond market that doesn't view conditions as being overly tight and the cycle not at imminent risk. Notwithstanding the above, I would caution against reading government bond market entrails too much. While it is often credited with a leadership position for wider financial markets, the committee meetings where we all apparently decide to invert curves or similar before ‘inevitable' recessions are hard to get invitations for.
The picture for households and corporates is much better. Debt levels for both are at very healthy levels nearly four years into the hiking cycle. Corporates have responded to higher rates by deleveraging balance sheets and household stress from higher rates is largely absent. As such, we don't see the recent reduction in credit spreads as being unwarranted.
What do you see as the big opportunities and risks for investors in 2026? How are you responding to these in a particular strategy?
Divergence. The big, directional markets of the QE era and then into, and out of, the COVID era are well-and-truly behind us. In government bond markets we can see the theme play out in different fiscal outlooks for G7 countries as well as more divergence in policy rates. While we saw almost universal policy hikes, then cuts in and out of COVID, in 2026 we will see countries continuing to cut (UK, US), holding (Aus), and even looking to hike (Japan, Sweden). Such divergence in path and magnitude will create volatility and significant relative value opportunities. This is not a market which will reward a static and directional duration stance. Rather, valuations will distort and revert quickly, and returns can be generated which do not rely on directional calls and crucially, portfolio volatility can benefit from such an active approach.
In credit markets, while we don't claim in aggregate markets are super cheap, there remain pockets of value. Within investment grade, we like domestically focused companies with robust supply chains. We also like senior financials, notably those older vintage or ‘grandfathered' securities which no longe suit their issuers. In global high yield, we like short-dated exposures in higher quality names rated BB and B where we can exploit refinancing dynamics to generate additional return. Stock selection has always been important, but in a divergent world it becomes even more-so.
What is the potential risk to investors' capital if the consensus in wrong?
The main risk to markets as we see it is if the growth outlook worsens markedly. The real yields available in government bonds will offer a degree of protection – and we have seen bonds display their traditional ‘risk off' behaviour in recent risk wobbles – and as such we think a degree of fundamental, but actively managed, duration exposure is warranted, ideally in the belly of the curve. On the other hand, a traditional, vanilla long duration exposure in response to growth fears may not be as protective as hoped. We believe markets would very quickly look to the fiscal response demanded by voters and that could have grave implications for long bonds.
For credit markets, history tells us that growth concerns would hit the weakest parts of credit markets, notably subordinated financials and the lower reaches of the high yield market. As such, we largely eschew these parts of the market and focus on company level resilience and cash flow over yield. Again, and active, stock specific approach, rather than generically buying a credit index or market, is our preferred strategy.
We think bond markets are telling us that things are a little less certain than have been in the recent past. A year ago, pretty much everywhere we saw monetary policy as becoming more supportive in the form of rate cut expectations. In addition, there was a broad expectation that fiscal policy would continue to ‘normalize' from the understandably high levels of COVID-era spending. Today, while we await what will be likely the last cut from many central banks, the spectre of possible increases may soon be with us as inflation remains stubborn. On the fiscal side, we have seen a widespread change in the political ability to cut spending with limited room for tax increases, this leaves bond markets picking up the tab. Accordingly, we have seen volatility in market pricing of terminal (i.e. long term) interest rates as bond markets cycle through worrying about growth, inflation, and fiscal largess. Our preference is to remain active and lean into cross-market and relative valuation opportunities, as opposed to a ‘set and forget' highly directional asset allocation approach. Volatility throws up opportunities for the former and reduces the attractiveness of the latter approach.
Conversely, the picture for both households and corporates looks much better. Debt levels for both are at very healthy levels nearly four years into the hiking cycle. Corporates have responded to higher rates by deleveraging balance sheets and as such, we don't see the recent reduction in credit spreads as being unwarranted.
