Investment Outlook
Central banks are raising rates again. We look at three areas where fixed income investors may find value while limiting interest-rate risk: short-dated US Treasuries, AAA-rated CLOs, and convertible bonds.
Higher policy rates may increase the appeal of short-dated bonds
- Central banks are once again tightening monetary policy. The market is pricing further rate rises but the exact number may hinge on oil prices, and the degree to which inflation pass-through can be limited. Higher front-end rates may increase the relative appeal of short-duration exposures.
Central banks are back in a policy-tightening mode with the Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ) all raising rates in September. US 10-year (10y) yields have risen around 75 basis points (bps) since the end of Q2, as markets have priced in further rate rises.1 Curves initially flattened around the Fed rate rise, but fears over inflation and budgetary issues then precipitated a re-steepening late in Q3.2 Long-dated forwards have risen, with the 10-year forward of the 10y rate above 6.20% — the highest level in around two decades (see Figure 1).
With US markets pricing at least three 25 bps rate rises by mid-2027 and with forwards looking elevated,3 it may be tempting for bond managers to add some duration. We urge some caution.
Interest rates are high only when compared to the low-rate regime that prevailed for much of the period after the Great Financial Crisis. Relative to the pre-Great Financial Crisis environment of 2%–4% US CPI inflation and strong growth, with limited central bank interventions, current yields are broadly consistent with longer-term historical norms.
For bond markets to sustain a durable rally either the oil price needs to fall, or it needs to become clear that pass-through to inflation from higher oil prices is limited. Given the strength of the US domestic economy, supported by the AI capital expenditure build-out, and high levels of government spending, it may be some time before it is clear how long elevated inflation will last. The US economy remains a key driver of global bond markets, meaning shifts in US growth, inflation and monetary policy may have significant implications for fixed income investors in EMEA.
Stay at the front end
While these uncertainties persist, it is unclear whether adding duration risk is worthwhile.
- Upfront returns: The Fed funds rate is at a level which may make short-dated yields appealing. The US 3-month Treasury bill yield is just over 4%. Yields rise to over 4.90% for the two-year equivalent. We question whether extending to 10-year securities for an additional 40 bps is worthwhile, given that duration would rise to more than four times that of the two-year.4
- Duration can be an unreliable ally: longer duration bonds have historically tended to outperform once rates peak.5 In the current cycle, however, periodic steepening of the curve driven by higher inflation expectations, and deteriorating fiscal positions, has called this longer-duration allocation decision into question. Breaking returns down by maturity buckets over the 2024-2025 rate-cut cycle (Figure 2) shows that an investment made at the start of 2024 into 1-3 year maturity Treasurys would have delivered higher total returns than longer duration buckets over large parts of the Fed easing cycle.
- Role as a portfolio stabiliser: Bonds often form part of a balanced portfolio because bond prices have tended to rise when equities fell. For this to work some duration would be necessary in order for price gains to be sufficient to compensate for equity moves. But the effectiveness of bonds as a hedge has been poor over the last few years.6 For example, the 2022 equity sell-off coincided with a bond sell-off.7 With the effectiveness of bonds as a portfolio hedge in question, having bonds with duration may be less of a priority.
- Volatility has risen: The ICE BofA MOVE Index of bond volatility has risen in September, revisiting the highs seen in March at the time of the US-Iran conflict. Volatility rose during the 2022–2023 Fed tightening cycle.8 The lower duration of short-dated bonds may help limit the effect of rising volatility.
Until it becomes clear that inflation risks are on the wane, or growth slows, it seems unlikely that markets will be able to sustain materially lower yields. It therefore may be appropriate to limit duration exposure. This approach may result in lower levels of volatility for a relatively modest yield sacrifice.
Implementation Ideas:
Collateralised loan obligations may benefit from rising rates amid regulatory reforms
- The ECB has raised rates twice this year, and markets are pricing further tightening. Collateralised loan obligations (CLOs) may be well placed in this environment, given their short interest-rate duration and coupons that reset with rates. The reform of Solvency II will also ease the capital burden of CLO adoption for insurer portfolios.
The ECB increased its key interest rates in June and September. With inflation above target and oil prices still high, overnight index swaps point to further rate rises.9 This has created a challenging backdrop for European fixed income. CLOs, however, have benefitted from rising rates—CLO coupons reset higher when rates rise. Figure 3 shows the breakdown of returns from price moves and coupons for the J.P. Morgan Euro CLOIE AAA Index. Higher ECB rates since 2023 have allowed CLOs to generate a higher proportion of their returns through coupons.
CLOs also have a short interest-rate-duration of around three months, which reduces price sensitivity to rising rates. They do have spread duration, which for the J.P. Morgan Euro CLOIE AAA Index is around 3.66 years. On a simplified, all-else-equal basis, a 100 bps spread widening applied to a spread duration of 3.66 years would imply an approximate price decline of 3.66%, broadly comparable with the index’s stated annual coupon of 3.67%.10 Moves of this magnitude are relatively rare. In the past seven years there have only been two episodes where spreads have widened that far: at the onset of the Covid-19 pandemic, in March 2020, and in 2022 ahead of the ECB rate rises.11
A broader appeal for insurers
For European insurers operating under the Solvency II standard formula framework— for calculating an insurer's capital requirement—capital charges have been one factor limiting investment in securitisations. European policymakers have recalibrated the capital framework for securitisations with the intention of better aligning the risk of the underlying asset with the capital charge and to encourage a broader take-up of securitisations. The changes are expected to take effect in January 2027.
Securitised assets have typically accounted for less than 1% of total invested assets for European insurers.12 This is low relative to the US, where capital treatment differs. Around 3% of cash and invested assets were invested in CLOs alone as at year-end 2024.13
CLOs have several applications for insurers:
- As a partial substitute for investment-grade credit. CLOs can both shorten duration and improve the credit quality of an investment portfolio if highly rated tranches are used. Figure 4 shows the annualised returns versus volatility profile for AAA-rated Euro CLOs and how, over the past seven years, investors could have received higher returns and experienced lower volatility than had they invested in a conventional all-maturity investment-grade portfolio.
- The ease with which ETFs can be sold means that CLO ETFs may be used as a part of a portfolio liquidity sleeve to enhance fund liquidity.
- As a component of cash allocations. This is not a direct cash substitute, but the AAA-rated tranche of CLOs can raise returns and reduce cash drag, while maintaining a strong ratings profile.
Figure 4: Seven-year annualised returns versus volatility
To explore the theme of Solvency II reform and how insurers can use CLOs within their portfolios see: CLOs unlocked: White Paper How European insurers’ fixed income rules are being rewritten
Implementation Ideas:
Falling deltas may make convertible bonds a more balanced option
- Equity markets’ enduring resilience suggests fixed income investors may consider convertible bonds as a way of capturing some of this upside. Deltas have fallen from earlier highs, which may offer a more balanced mix of equity participation and bond-like characteristics.
Following five successive quarters of positive returns for convertible bonds, the third quarter of 2026 proved more challenging, with a return of -2.6%.14 Equity markets posted gains but the negative pull from rates, as the market embraced central bank rate rises, dragged on performance.
Despite this, convertible bonds are still up over 13% year to date15 having benefitted from the strong investor risk appetite that has seen equity market setbacks reverse relatively quickly this year. Convertibles may continue to appeal to investors seeking to add equity-like exposure to their fixed income portfolio, and to market participants seeking exposure to the AI theme:
- Equity-type risk may support returns: fixed income has struggled due to rising central bank interest rate expectations. In contrast, equity markets have performed positively, supported by robust economic growth and strong earnings. Convertibles have provided upside participation in equity gains but with lower levels of volatility than equity. The annualised 5-year volatility on the FTSE Qualified Global Convertible Index is 11% versus over 15% for both the S&P 500 and the MSCI ACWI indices. The US-Iran conflict also resulted in a smaller drawdown relative to equities when the conflict began.16
- Delta dropping: The index delta—a measure of how sensitive a convertible bond's price is to movements in the underlying share price —has lowered to 55.1 from highs of over 62 in early June. This is the result of new issuance, which typically has a lower delta because it is often close to par when issued, while some of the older, high-delta bonds will convert and be removed from the index. Deltas of around 50 are seen as desirable because they may represent a more even rate of participation in equity rallies, while retaining the protection of the bond floor if stocks fall.
- Low duration: With an average duration of around 3.3 years in the FTSE Qualified Global Convertible Index,17 convertibles may be less sensitive to moves in the belly of the Treasury market curve than many more traditional fixed income exposures.
AI support
Convertible bonds may also offer an alternative route to accessing tech. The AI capital expenditure build-out has been a driver of convertible issuance: there was over US$17 billion in tech issuance in September.18 Higher market rates mean that companies are increasingly opting for convertible issuance as a way of funding —the optionality of the bond allows them to offer a lower coupon.19 Strong gains in tech companies’ share prices mean that investors have been keen to take up supply.
Heavy issuance is not always supportive of performance but, in this instance, it has resulted in new, more liquid, bonds replacing older bonds, which have rolled out of the index. Strong underlying share-price appreciation may drive convertible bond prices higher. These gains may often be crystallised by either the investor converting the bonds to equity or by the issuer buying back the bonds. The removal of the typically high-priced, high-delta bonds has helped to lock in gains and means the Technology sector, which is also the largest in the index,20 has been the key contributor to returns (Figure 6).
Implementation Ideas: