Pursue bond upside with active short duration and credit
Rising deficits, persistent inflation, and steepening yield curves pose headwinds. In this environment, we favor short-duration positioning and active credit strategies across securitized assets, investment-grade corporates, and high yield, where income—not price appreciation—will likely drive returns given historically tight spreads.
After trailing cash in three of the past four years, global bonds finally pulled ahead in 2025. Holding that lead in 2026 will mean navigating a maze of shifting market dynamics with greater focus and flexibility. Rising deficits, stubborn inflation, and steepening yield curves will challenge investors. While rate cuts may help, they could also fuel term premiums and further curve steepening—making duration management critical.
Credit remains a source of upside, supported by fiscal and monetary catalysts and its growth-linked profile. But with spreads already tight, further compression is unlikely to drive returns.
Positioning bond portfolios to beat cash in 2026 calls for active strategies that diversify across bond markets and credit segments, including:
- Short-duration strategies favoring securitized assets, to extract more yield-per-unit-of risk while managing uneven risks across the curve
- Core-plus allocations with an investment-grade multi-sector credit framework, for balanced upside potential
- High-income exposures that actively manage below investment-grade opportunities across sectors, issuers, and credit types
Bond momentum—and yield curves—rising
Global bonds have finally rebounded from their worst stretch of underperformance versus cash on record. Before Q3/Q4 2025, bonds trailed cash in 42 consecutive rolling-36-month periods, at one point underperforming by a record 9%.1 Returns are now positive, but the recovery is modest: the latest 36-month excess return is just 0.8%.2
This rebound was driven by higher starting yields and rate cuts from the Federal Reserve (Fed) and other central banks. Global central banks delivered more than 120 rate cuts in 2025,3 signaling a clear pivot to growth-friendly policy. And, of the major developed economies—the US, Canada, UK, Eurozone, Australia, and Japan—only Japan is forecast to hike rates in 2026. Even then, hikes will keep its rates below 1%.4
Looking ahead, lower cash rates may help bonds outperform again in 2026—but too much stimulus could steepen yield curves, eroding gains for long-duration bonds.
This policy shift, combined with rising deficits that heighten concerns about solvency and inflation, is pushing yield curves higher worldwide (Figure 1). Consensus points to even steeper yield curves in 2026.5
As major developed economies push central bank rates toward the lower bound, some emerging markets’ rates remain in the double digits. This global stimulus wave has flipped the script—today, inflation is a bigger risk for developed-market bonds.
This shift is evident in recent trends: year-over-year inflation now hovers above 3% in developed economies, compared to just above 2% in emerging economies6—a sharp reversal from the past 15 years, when inflation in developed markets averaged 2.7% versus 4.8% in emerging economies.7 Rising inflation can weigh on nominal bond returns, dampening momentum in 2026—prompting investors to reassess duration risk.
How can investors navigate inflationary pressures while capturing evolving yield opportunities in this environment?
Better balance in shorter-duration markets
Long maturities may offer higher yields, but they don’t fully compensate investors for inflation and deficit risks—hence the rise in term premiums. After years in negative territory, the US term premium has been positive for more than 240 days, the longest stretch since 2011,8 as investors demand more protection.
Even with higher yields, long-term bonds remain vulnerable.
If curves steepen further—especially in a bear steepening scenario where short-term rates fall (driven by central bank cuts) and long-term rates rise (on inflation, growth, and deficit dynamics)—price declines could offset income gains. This risk extends beyond US Treasurys to global bond markets (Figure 2).
Against this backdrop, investors should turn to shorter-duration strategies to mitigate rate risk without sacrificing return potential. Success, though, requires more than simply shortening maturities—it demands disciplined sector selection, liquidity awareness, and a focus on credit quality.
While the yield curve has steepened this year, short-term rates are still above historical averages (3.1% versus 2.2% average).9 As a result, the 1-7-year segment is particularly attractive (Figure 2).
While broad-based global short-term markets are more balanced than long-term markets, specific sectors offer the most compelling opportunities. Focusing on duration—not just maturity—can unlock value, especially in securitized assets like residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed securities, and other amortizing structured credit markets. For example:
- US investment-grade corporates (1-3-year duration): 2.2 yield-per-unit-of-duration,10 higher than the 1-3-year global maturity band (Figure 2)
- US securitized assets (1-3-year duration): 2.5 yield-per-unit-of-duration, exceeding the global 1-3-year band (1.6), global bonds (0.7), and the broader US securitized market (0.8)11
In short, shorter-duration strategies—especially those targeting high-quality corporates and securitized assets—offer a compelling balance of yield and resilience to help weather volatility while capturing opportunities in a shifting rate environment.
Credit: Priced for perfection
Credit offers opportunity beyond duration risk, but it brings its own complexities. Credit-sensitive corporate bonds and securitized assets have a growth bias, adding another layer of risk. Yet both sectors deliver a higher yield-per-unit-of-volatility than global 1-3-year maturity bonds and the broader global market12—a metric that reflects total volatility, not just rate risk.
Positive global economic and fundamental growth trends should help keep the environment supportive for credit in 2026,13 much like it was in 2025 when credit outperformed broad aggregate bonds.14
However, despite positive growth forecasts, strong recent returns, and a 2.4 yield-per-unit-of-duration ratio that outpaces investment-grade corporate bond markets, the upside in below investment-grade credit is limited.15 The man constraint: tight credit spreads, now in the bottom-ninth percentile historically.16
Compression across rating bands adds to the challenge. The gap between triple-B (lowest tier of investment-grade) and double-B (highest tier of high yield) is just 90 basis points (bps), well below the historical average of 120 bps.17
Tight spreads—whether across rating bands or the broad market—don’t signal weak returns. Rather, they reflect pricing for near-perfect conditions with little room for disruption. That view is supported by forecasts for near-double-digit earnings growth in US large and small caps in 2026.18
The risk is that with spreads this compressed, the cushion against shocks is thin. If growth disappoints, spreads have little room to absorb volatility, leaving credit markets vulnerable. Returns will likely come from carry mostly, not price gains. And with a current yield-to-worst of 7%, credit’s income potential remains strong and could help it outperform core bonds again in 2026.19
Convexity—a measure of upside versus downside potential—is deeply negative for credit, signaling limited benefit from further spread compression at current low levels. High yield convexity ranks in the bottom-third percentile over the past 20 years,20 reinforcing the lack of price-driven upside. And, history shows a clear link between spreads, convexity, subsequent returns, and contributors of those returns (Figure 3).
When both convexity and spreads fall into the bottom decile, returns tend to stay positive—but almost entirely driven by coupons, not price appreciation. In these conditions, price returns are essentially flat, reinforcing today’s “priced for perfection” profile.
This dynamic should set expectations for 2026. With starting yields near 7%, carry will be the primary source of returns, while selective positioning with active credit can help navigate tight spreads and uncover issuer-level opportunities. Beyond fixed-rate high yield, other below investment-grade credit markets offer additional income potential.
Despite widespread rate cuts, floating rate bank loans and collateralized loan obligations (CLOs) have delivered positive returns over the past year thanks to strong carry.21 In fact, credit-sensitive BB-rated and B-rated CLOs outperformed core US Aggregate bonds.22
Both CLOs and loans also offer defensive benefits, given their lower correlation to equities.23 A multi-credit approach—spanning high yield, loans, and CLOs—may be able to enhance income and diversify returns amid tight spreads, outperforming a simple broad high yield allocation.
Active management of risks and opportunities
2026 is likely to bring both promise and pressure: positive growth, inflation risks, steeper yield curves, and tight credit spreads. At some point, investors may demand higher premiums over Treasurys to compensate for multiple macro risks, triggering curve steepening until equilibrium is restored. Growth could also falter if the Fed cuts rates fewer times than expected.
To outperform cash again in 2026, investors must agilely manage these dynamics—adjusting duration and making informed, issuer-level decisions across credit markets. As conditions shift, active strategies provide the flexibility to rotate across sectors, manage liquidity, and capture income where risk-adjusted opportunities exist.
In a market priced for perfection, that means looking to credit-focused strategies that emphasize quality and resilience, paired with shorter-duration profiles that avoid the long end of the curve, where investors’ compensation for risk remains inadequate.
Implementation ideas
Short-duration strategy
Core-plus allocation
High income exposure
