Fixed Income Positioning for a Shifting Rate Environment

We recommend a phased approach to duration extension throughout 2025, beginning at neutral and moving to overweight as the rate cutting cycle gathers pace and the trajectory of inflation becomes clearer. Starting the year at neutral duration — relative to benchmark — provides participation in any early-cycle rally while limiting exposure to inflation data surprises or central bank communications that delay the cutting timetable.

The sweet spot of the yield curve for duration extension is the intermediate (3-7 year) maturity range. This portion of the curve offers the best combination of yield income and duration sensitivity to rate cuts. Very long-duration bonds (15-30 years) offer higher sensitivity to rate moves but expose investors to greater term premium uncertainty, fiscal deficit concerns, and supply indigestion risk as governments continue to fund large deficits.

US Treasuries and German Bunds are our preferred vehicles for core duration exposure given their superior liquidity, depth, and safe-haven characteristics. The ability to exit positions at minimal cost in risk-off scenarios is particularly important for fixed income allocations that serve a portfolio hedging function. We also see value in UK gilts for investors who can absorb slightly wider bid-offer spreads in exchange for a yield pickup relative to Bunds.

Investment-grade corporate credit offers an attractive yield premium over government bonds with manageable credit risk. Corporate balance sheets in aggregate are in reasonable health — leverage ratios have declined from the peaks reached during the pandemic stimulus period, and the maturity wall for refinancing is more manageable than many feared heading into the rate hiking cycle. The credit cycle has not yet turned, and a soft-landing macro scenario supports continued solid corporate credit performance.

Within investment grade, we favour financial sector bonds — particularly senior unsecured debt from well-capitalised large banks — where spreads offer a premium over industrials that we believe more than compensates for the sector's structural complexities. Bank capital ratios are at historically high levels, and regulatory frameworks have improved systemic resilience significantly since the global financial crisis. Subordinated bank debt (AT1s and Tier 2 instruments) offers higher yields but requires careful credit selection.

We are more cautious on BBB-rated corporate debt, particularly in sectors with high debt loads and limited pricing power. The compression of spreads in recent months has reduced the margin of safety in weaker investment-grade names, and a deterioration in the macro outlook could trigger significant spread widening and potential downgrade to sub-investment grade. Selectivity is more important than ever at the lower end of the investment-grade spectrum.

High yield credit spreads are near the tight end of their historical range, reflecting investor appetite for income in a declining rate environment and a broadly resilient economic backdrop. While absolute yields remain attractive in an historical context, the spread component offers limited compensation for the meaningful increase in default risk relative to investment grade, particularly if the economic soft landing does not materialise.

We recommend limiting high yield exposure to short-duration instruments (1-3 year maturities) and higher-quality BB-rated issuers. This positioning captures a meaningful yield premium over investment grade while limiting sensitivity to spread widening and reducing the risk of holding impaired positions if the credit cycle turns. Avoiding the CCC-rated tail of the market — where stress is most concentrated — is particularly important in the current environment.

Emerging market hard currency bonds represent an interesting subset of the higher-yield universe. Select investment-grade and crossover-rated sovereign and quasi-sovereign issuers in stable, commodity-producing economies offer spreads that compare favourably to developed market high yield, with improving fiscal fundamentals in several countries. However, dollar strength, geopolitical risks, and idiosyncratic country risk require careful market selection and position sizing.

Our geographic preferences in fixed income reflect our central bank outlook. Europe — particularly the eurozone — is our most constructive allocation given the ECB's more aggressive easing path relative to the Fed. European government bonds and investment-grade credit are positioned to benefit from both yield decline and spread compression as monetary conditions ease and economic growth gradually recovers.

US fixed income remains the global benchmark and a core allocation for virtually all diversified portfolios. While the Fed's slower pace of cutting limits near-term price appreciation potential, the absolute yield levels available in US Treasuries and investment-grade credit are attractive for income-oriented investors. The dollar's reserve currency status and the depth of US credit markets provide liquidity assurance that is difficult to replicate in other markets.

For non-dollar investors, currency hedging costs are a critical input to fixed income return calculations. The cost of hedging dollar exposure back to euros or sterling has moderated from the elevated levels of 2022-2023, improving the attractiveness of hedged US fixed income allocations for European investors. We recommend actively managing currency hedge ratios rather than taking a static approach, given the potential for significant currency moves driven by central bank divergence.