Q1 bond market outlook for ETF investors Bond positioning for 2026: Income, resilience, and flexibility in a late-cycle market
- Policy easing and fiscal support point to continued US growth in 2026, but their impact on inflation may limit additional easing
- With tight credit spreads, still-elevated yields, and a steeper yield curve, bond returns are likely to be driven more by carry than by spread compression
- Any economic weakness at today’s tight valuations reinforces the need for flexible active strategies and bottom-up security selection as issuer outcomes diverge
After more than a year of rate cuts totaling 175 basis points (bps), the two-year Treasury yield has only recently begun to converge toward the fed-funds rate—meaning financial conditions are just starting to reflect the cumulative impact of monetary policy shifting toward a more neutral policy stance (Figure 1). This alignment is unfolding against an unusually complex macro backdrop. Fiscal stimulus is expected to boost growth in 2026, even as labor markets soften—creating a fragile balance between resilience and risk.
That combination of growth potential and heightened sensitivity to downside risks underscores the need for careful positioning as policy and market conditions coalesce. And with tight credit spreads, elevated yields, and policy normalization, fixed income returns are likely to rely more on income and carry than on beta. In this environment, investors should focus on:
- High-quality exposure in the short-to-intermediate part of the curve to help capture carry and roll-down while managing reinvestment risk and limiting reliance on further spread compression.
- Active, bottom-up strategies to seek opportunities when volatility emerges and issuer outcomes diverge.
Alignment of policy and markets: Brings stability, but masks risks
Federal Reserve Chair Jerome Powell’s comment that the Fed is “in a good position” signals confidence in policy transmission, but it also highlights how closely aligned policy and market pricing have become. In such environments, markets often price a relatively narrow range of outcomes, creating periods of apparent stability.
But that calm may mask important risks. Rate volatility, as measured by the MOVE index, drifted lower throughout 2025 and now rests at its lowest level since May 2021 (Figure 2), suggesting a market that’s increasingly comfortable with the current rate environment.
But this also makes markets vulnerable to sharp repricing, as expectations hinge on incremental economic data. In November 2025, for example, the odds of a December rate cut jumped from as low as 29% around mid-November to above 80% by the end of the month after new data revealed softer labor markets—highlighting how quickly sentiment can swing.1
Curve positioning: Capture carry without overreliance on duration
In this environment, positioning along the front end and the short-to-intermediate portion of the curve becomes increasingly important. As cash rates gradually drift lower, reinvestment risk becomes more relevant for investors relying on very short-term instruments. Managing exposure at the front end can help lock in income while retaining flexibility should front end volatility re-emerge.
Just beyond the front end, the belly of the curve remains relatively steep, offering attractive carry and roll-down potential. This segment benefits from elevated starting yields and a structural return component as bonds age and roll toward lower-yielding maturities. Importantly, this positioning also may offer more balanced downside protection.
While not our base case, in the event of an economic slowdown, the short-to-intermediate part of the curve may perform more defensively than longer-term bonds, which today remain more exposed to fiscal dynamics, elevated issuance, and term premium pressures that could limit their traditional hedging properties.
As rates move toward neutral and volatility remains prone to episodic spikes, focusing on the front end and the middle of the curve can help balance income generation, roll down, and downside protection—without overrelying on long-duration exposures.
High-quality carry: The primary driver of returns
Looking ahead to 2026, the fixed income opportunity set is increasingly shaped by historically tight credit spreads with limited scope for further compression. And as we approach the neutral rate with two to three cuts priced in for 2026,2 rates are expected to remain largely range bound. This suggests that future returns are likely to be driven less by duration-induced price appreciation and dependent on income and carry.
Historical relationships underscore this point. Since 2008, in years when the S&P 500 was up at least 10%, high yield bonds have outperformed the Agg by an average of 10.3%, reflecting the strong beta typically associated with risk-on environments. But that historical relationship has weakened meaningfully. Despite the S&P 500 being up nearly 18% in 2025, high yield outperformed the Agg by only about 1.3% (Figure 3).
This divergence suggests that the traditional upside associated with lower-quality credit may be more limited in the current cycle, particularly with historically tight spreads and elevated valuations. In this environment, return outcomes appear increasingly driven by income generation rather than spread compression, reinforcing the relative appeal of higher quality fixed income exposures.
At the same time, despite progress toward policy normalization, today’s yields remain elevated relative to those of the past 18 years.3 When combined with the steepness of the short-to-intermediate portion of the curve, elevated carry and roll-down can provide a meaningful source of return that does not require taking on more risk.
While the yield curve has already steepened meaningfully over the past year, historical context suggests there may be room for it to normalize. The current spread between 10-year and 2-year Treasury yields is around 0.67%, compared with a 20-year average of roughly 1.1%. This gap suggests potential for further steepening, reinforcing the potential for continued roll-down benefits in the short-to-intermediate portion of the curve (Figure 4).
Importantly, carry and roll-down from high quality exposures like investment-grade corporate and securitized securities can help offset the impact of modest spread widening, a relevant consideration in a late-cycle environment where downside risks may materialize more quickly than upside surprises.
In this regime, high quality carry is not simply a return enhancer—it becomes a form of structural risk management. With directional rate moves constrained by fiscal dynamics and long-duration hedging properties less reliable, high- quality carry in the short-to-intermediate of the curve most likely will be the primary driver of fixed income returns in 2026.
Flexibility and selectivity: Why active strategies matter now
With monetary easing, fiscal stimulus, and softening labor data pulling in different directions, markets may oscillate more frequently between growth optimism and downside concerns. These rapid and short-lived shifts can increase the cost of static positioning.
In this environment, flexibility becomes a critical differentiator. Actively managed strategies with flexible guidelines and wider opportunity sets can help adjust exposures, recalibrate risk, and respond more dynamically if volatility increases. The ability to rotate across sectors, adjust credit quality, modify duration, or reposition within the capital structure allows portfolios to pursue opportunities while managing downside risks, particularly as correlations rise and dispersion increases.
Bottom-up security selection is likely to play a more critical role. With spreads tight at the aggregate level, headline valuations may obscure meaningful differences across issuers. That means outcomes could diverge more sharply based on fundamentals, balanced sheet strength, and relative value.
Historically, during periods of elevated volatility, high yield spreads have tended to widen the most when starting valuations are tight, underscoring the importance of flexibility and selective risk-taking (Figure 5).
An active strategy focused on security selection with the flexibility to respond as market conditions evolve will be increasingly important in navigating a late-cycle environment that’s defined less by long-term trends and more by the uncertainty of a period of transition.
Looking ahead: Navigating a late-cycle transition
As markets move from familiar trends—such as prolonged rate hikes and steady growth—toward uncertainty driven by policy normalization, shifting growth dynamics, and episodic volatility, investors must adapt to evolving conditions.
With tight spreads, elevated yields, and policy normalization, 2026 fixed income returns are likely to rely more on income and resilience than beta. Positioning in high-quality exposures along the short-to-intermediate curve and choosing active strategies can help capture carry, manage reinvestment risk, and navigate volatility during this transition.
Short-term and intermediate strategies:
Actively managed core-plus strategies:
Actively managed credit strategy: