Investment Outlook
Fixed income shock absorbers? The Gulf conflict has upended energy costs, shattered inflation and central bank expectations, and heightened growth uncertainty. How can fixed income investors respond?
The Tipping Point
- The Inflation pass-through from higher energy prices is expected to be rapid. The Federal Reserve’s (Fed) dual mandate allows more room to manoeuvre than other central banks. Treasury Inflation-Protected Securities (TIPS) can provide inflation protection—but also perform if growth slows and rate cuts return to the fore.
Higher energy prices are already evident in the US CPI numbers. The central banks’ “transitory” messaging delivered during 2022’s Ukrainian energy shock damaged their credibility and will not be repeated. Rhetoric has already turned hawkish. But aggressive policy tightening will be difficult to justify in a supply-driven shock, particularly one occurring at a later stage of the economic cycle. The Fed’s employment mandate further supports a steady policy stance.
In fear of inflation
Inflation concerns have pushed US 2-year breakevens to their widest since March 2023, when the domestic Consumer Price Index (CPI) reached 5%. By contrast, longer-term inflation expectations remain contained. The 5-year, 5-year forward inflation rate has declined to 2.3%, its lowest since October 2022.1 This figure may reflect a belief that the Fed will not repeat its 2022 policy errors, or optimism over a swift resolution to the conflict. Either way, longer-dated bonds seem to be pricing limited inflation risk.
Figure 1: 10-Year US breakevens unmoved by oil prices
The path ahead
Developments in the Gulf conflict will determine whether inflation expectations reprice higher.
- Quick resolution: Damage to vital energy infrastructure will elevate energy prices even after a ceasefire. But CPI will decline as the oil price ‘hump’ passes through. Long-end breakevens are unlikely to materially widen.
- Prolonged conflict:Further escalation could push energy prices higher and eventually pressure long-term inflation expectations. However, demand destruction from higher oil prices would eventually limit further tightening.
Treasury Inflation-Protected Securities (TIPS) can provide partial protection in either scenario. Early year gains were reversed in March as the market priced out Fed easing—but a resolution to the conflict could see bond yields decline. TIPS’ longer duration profile should help returns even if front-end breakevens narrow.The Bloomberg US Govt Inflation-Linked All Maturities Index has a duration of 6.8 years, compared with 5.75 years for the Bloomberg US Treasury Index.2
If the conflict persists, inflation will remain elevated and push longer-dated breakevens wider. TIPS can provide protection because real yields would rise by less and the curve steepen less than nominal Treasurys. There may be a tipping point where inflation fears give way to growth concerns—a period during which investors might consider extending duration as the Fed’s policy bias shifts from hawkish to dovish.
Implementation Ideas:
Positioned for rebound
- Fixed income had a difficult first quarter —but convertible bonds proved more resilient. Diversified issuers and limited new issuance supported performance. Convertibles also offer potential upside participation if equity markets rebound.
Rising yields and growth concerns weighed on most fixed income strategies in Q1. Equities also came under pressure. Even so, global convertible bonds closed the first quarter with positive returns—the FTSE Qualified Global index returned 2.8% over Q1.3
Figure 2: Convertibles still up year-to-date
Risk controlled equity exposure
A key question for fixed income managers is how to position. A timely resolution to the conflict should benefit fixed income exposures—but this is not certain. Pass-through of higher energy costs could keep inflation high and central banks cautious for an extended period. Energy prices are unlikely to retreat to pre-conflict levels for a long time.
The limited degree to which rate markets can reprice suggests even higher beta bond exposures such as high yield may be slower to rebound. The limited degree of spread widening, even relative to April 2025, means it will be hard to generate strong returns.
Equities, by contrast, have shown sensitivity to any progress toward conflict resolution. Convertible bonds’ hybrid structure may provide a way to capture upside while retaining fixed income characteristics:
- Delta levels close to 60 imply sensitivity of convertible bonds to their underlying stock is higher than the long-term average. This could be an important driver of return. It suggests that a rapid equity market rebound would see convertible bonds enjoying considerable upside.
- Diversity: The fund has around a 55% weight to US issuers, which should be less impacted by the energy shock.There is a 68% weighting toward investment-grade issuers, where spread widening has been more contained and should be more defensive in a growth slowdown. Sector allocations have also helped performance, with an allocation to technology of 29.7% against just 3.6% for a typical global high yield index, for example when comparing the FTSE Qualified Global index with the ICE BofA Global High Yield Constrained Index. This results in limited correlations to other classes of fixed income, including a 33% correlation to Global Aggregate over 10 years. Ten-year correlations to high yield and small caps are 67% and 78%, respectively. Small caps tend to lead early in risk-on moves.
- The convertibles market continues to exhibit low levels of issuance. While not a positive for liquidity over the longer term, limited supply can enhance stability when market sentiment deteriorates and be a favourable tailwind to prices when demand picks up. Flows into convertible ETFs remained strongly positive in Q1 2026, although there was some paring back of positions in March. Flows into State Street® SPDR® FTSE Global Convertible Bond UCITS ETF were $196 M for Q1 2026 but -$19.9 M in March 2026.4
Convertible bonds therefore offer diversification and a controlled channel for equity participation within fixed income portfolios.
Implementation Ideas:
Read our Q2 inflation outlook