Seek Stability in Rate and Credit Markets

As we wait for the Federal Reserve to cut rates, being more active with bond allocations potentially can help insulate portfolios from macro-led volatility.

Uncertain fiscal policies and ambiguous “wait-and-see” US central bank guidance have whipsawed rates markets. And credit spreads widened significantly in April before recovering slightly.

These trends have made the notion of bond market stability seem anachronistic.

And there’s little relief on the road ahead. If the Federal Reserve (Fed) eases, inflation could rise. If the Fed doesn’t ease, growth could fall. Either way, the constraints on US monetary policy may lead to rates staying higher than previously expected, enhancing the appeal of the carry (yield) that bonds can offer over cash.

Because managing the volatility of earning that carry will be key to navigating shifting policy, investors seeking stability should consider:

• Active core strategies with wide remits to help insulate the largest part of your bond portfolio from macro-led rate volatility.
• Short duration investment-grade (IG) corporate bonds for balance and income while the Fed “waits and sees.”
• Actively managed multi-sector credit exposure for the potential to enhance income and position opportunistically as markets rapidly reprice risk.

Policy High on Uncertainty, Low on Clarity

The chaotic implementation of trade policy has created outsized volatility as markets react to every headline. It also has created an ambiguous monetary policy environment, where rate cut forecasts are being rapidly repriced — stoking rate volatility across the curve.

Policymakers’ divergent views on the economy haven’t helped soothe investors’ nerves. Text analysis from Federal Reserve policymakers’ speeches and interviews shows broad disagreement on both economic outlooks and policy. State Street Global Markets’ central bank voter disagreement barometer for the Fed has nearly doubled since the start of the year.¹

Interestingly, the same text analysis finds European Central Bank and Bank of England policymakers have been in greater agreement this year. This reflects how US trade policy is creating a strong, consistent impulse for other central bankers to proactively ease to offset any potential growth drag from the redrawing of international trade principles. But unlike other central banks, the Fed cannot ease proactively to offset growth pains.

The Fed’s constraints and lack of tariff clarity have led to a widening of risk premiums across the curve — driving US Treasurys to decline in April, failing to provide the perceived natural buffer to equity declines. In fact, the term premium on the US 10-year Treasury is now at its highest level since 2014, after trading at a negative level for most of the past decade.²

This elevated term premium means the old bond market paradigm is history. That is, today:

• Long-term yields (risk premiums) will widen if this macro-led volatility continues to erratically impact growth and inflation, meaning the bid for US Treasurys may soften as their diversification appeal declines.
• Intermediate- to long-term bonds now provide a more positive carry to entice buyers at the longer end of the curve.

Even if bond yields rise, there’s a ceiling where it will start to entice demand. The problem is that nothing is stable. The environment has been brought about by sizable disagreement and a lack of clarity on the endgame of fiscal and monetary policies. So, even if the carry at the long end of the curve is attractive to entice demand, the risk to earn that carry is high.

Bonds’ Elevated Risk Amid Macro Uncertainty

While the curve has steepened, resulting in the positive carry and term premium, the risk to earn that carry has also increased. For example, the yield differential between long- and short-term US Treasurys is 1%. When adjusting for the different volatility of those maturity bands, the differential flips to -1.68%.³

Driven by the spike in volatility, this reflects the lack of compensation longer bonds have at a time of elevated uncertainty. The rolling 30-day volatility spread between long-term and short-term US Treasurys spiked following the paradigm shift in policies. The current volatility spread of 14% is 24% above the one-year median and in the 92^nd percentile.⁴

The same is true for the corporate curve; the 12% volatility spread between long- and short-term US corporates is 45% above the one-year median and in the 95^th percentile.⁵  The greater spread for corporates reflects corporate growth uncertainty and the risk premium attached to lending out longer term.

This environment has made bonds riskier on the long end and the carry less attractive given the volatility needed to earn that yield.

Global bond trends also have been flipped on their head. Over the past 15 years, US bond markets — across many segments and sectors — have outperformed non-US markets. The strength in the US dollar was an important driver. And now, with the dollar’s role in international trade coming into question (e.g., if the US imports less, then the US exports less dollars that will then be reinvested back into US assets), bond market returns have inverted.

Across five dimensions, non-US markets are now noticeably outperforming US markets (Figure 2), mirroring the trend we see in equities.

These divergent paths underscore two central truths heading into the rest of the year:

• Ambiguous growth and inflation trends, mainly impacting US markets, mean US assets (bonds included) may face greater headwinds versus the rest of the world.
• A broader universe to build portfolios may allow for enhanced alpha opportunities.

Credit Upside Out of Balance With Downside Risks

These imbalances extend to credit. Credit spreads round-tripped and fell back down to the 300 levels shortly after the turmoil in April.⁶ This doesn’t leave much room for further gains from spread compression and creates an imbalance between potential upside versus downside risks, as illustrated by high yield trading at a significantly negative convex state (Figure 3).

At a level like this, there is little room to withstand volatility shocks, as the risks are out of balance.

These spread levels also imply a more docile macro environment with rising growth expectations as the consensus. That outcome is unlikely given the current policy climate where the range of outcomes for growth is wide but indicates downward bias.

But this doesn’t mean credit should be disregarded. While growth is projected to fall, it’s still expected to be positive. Not one of over 70 economists’ forecasts have 2025 US Real GDP growth negative or contractionary.⁷  Fundamentally, corporate earnings growth is projected to be positive around the world — although it’s been revised lower by over 200 basis points globally and 500 basis points in the US.⁸

Positive, but falling growth combined with tight spreads and limited upside due to negative convexity, mean:

• Credit returns will come mainly from the coupon — at an attractive 7.5% versus the 15-year average of 6.9%.⁹
• Dispersion across sectors and credit types will widen as the market reprices risk premiums based on the latest policy and growth trends.

Be Balanced, Not Bold in Bonds

Core-plus active strategies have the flexibility to manage rate risks while pursuing opportunities in a broader universe — like going overseas. And that may be the most beneficial approach in the core, especially given both the volatility of bonds across different points on the curve and the inverted return trends.

Compared to indexed core exposures, active strategies have the potential to lower or extend duration relative to the benchmark and implement curve steepener or flattener trades to seek alpha. That flexibility’s attractive if rate forecasts turn out to be different than expected.

More so, combining traditional (e.g., investment-grade corporates and US Treasurys) and non-traditional bond sectors (e.g., CLOs and securitized credits) can add income and diversification benefits, supporting the tactical positioning along the yield and credit curve that seeks relative value mispricings and alpha opportunities.

Outside the core, there are two potential tactics to restore balance in bonds.

First, don’t fight the Fed’s “wait and see.” This means using high-quality, short-duration corporate bonds to earn a yield above that of inflation, without enduring significant volatility. The 1-3 year investment-grade corporate (IG Corp) bond market represents one potential solution.

Compared to other high-quality bond markets, the 1-3 year IG Corp space carries one of the more attractive risk-adjusted yields (yield minus cash divided by volatility, Figure 4).

With a well-diversified core and a potential Fed ballast in 1-3 year corporates, the balance of risk in that mix leans defensive.

A second option, and more biased to positive upside surprises, is to prepare for the wide range of outcomes by seeking enhanced income with below investment-grade active multi-sector credit strategies that contain more than one high income sector. As with a wide remit, active management may be able to manage risks as well as identify relative value opportunities at the single issue, rating, sector, and credit universe level to enhance returns beyond earning just the coupon.

Multi-sector credit strategies can also mix in differing lower beta exposure than equities (high yield bonds have a 0.46 beta, senior loans a 0.27 beta)¹⁰  to position toward potential growth upside — but in a more resilient manner as the equity bias not as direct.