The Fixed Income Edge: Why Fixed Income Could Surprise Everyone in 2026

Fixed income markets enter the final weeks of 2025 in a state of delicate balance. The Federal Reserve has now delivered a 25 basis point (bps) cut at its December meeting, yet long-term yields have risen rather than fallen in response. Credit spreads remain remarkably tight, carry remains attractive, and the Treasury yield curve is steepening for the first time in years.

In the absence of major shocks, the asset class is positioned for positive but moderated returns driven primarily by income rather than capital appreciation. Structural challenges, notably surging Treasury supply and divergent global monetary policies, will continue to create dispersion and opportunity. Investors who maintain flexibility across duration, credit quality, and geography are best placed to navigate the year ahead.

The Current Landscape

Following the December 2025 FOMC meeting, the US Treasury yield curve has steepened to its widest level since 2022, with the 2-year/10-year spread approaching 60bps. The 10-year note trades around 4.2%, while the 30-year sits close to 4.8%. These levels reflect a market that has largely priced in a soft landing: inflation trending toward target, labour markets cooling without collapsing, and growth remaining above trend.

Credit markets tell a similar story of resilience. Investment-grade corporate spreads are near historic tights, and high-yield indices have delivered positive total returns despite the backup in risk-free rates. Emerging market debt has been one of the standout performers year-to-date, supported by a weaker dollar and improving fundamentals in select sovereigns.

Municipal bonds have proved remarkably stable, benefiting from strong state and local finances and limited new issuance relative to demand. Global divergence is evident: the Bank of Japan has begun normalising policy, pushing Japanese government bond yields higher, while the European Central Bank and Bank of England maintain a more dovish stance than the Federal Reserve.

Key Drivers for 2026

Several structural and cyclical forces will shape fixed income performance in the coming year.

Monetary Policy Paths

The base case assumes the Federal Reserve delivers two to three additional cuts in 2026, bringing the federal funds rate to a terminal range of 3.5 to 3.75%. Markets, however, assign meaningful probability to a higher-for-longer outcome if inflation reaccelerates or productivity gains prove slower than hoped. Central bank divergence will remain a theme: the European Central Bank and Bank of England are likely to ease more aggressively, while the Bank of Japan continues its cautious exit from negative rates.

Treasury Supply and Fiscal Dynamics

The United States faces another year of elevated issuance, with net Treasury supply projected to exceed $2 trillion. This structural pressure has already contributed to the rise in term premiums and is likely to cap how far long-term yields can fall even in a cutting cycle. Investors will need to monitor refunding announcements and any shifts in the Treasury’s issuance mix toward shorter maturities.

Credit and Spread Outlook

Absent a recession, credit fundamentals remain supportive. Corporate balance sheets are generally healthy, default rates are low, and interest coverage ratios have held up better than feared. Emerging market sovereigns benefit from improved current account positions in many cases. Spreads are tight, leaving limited room for further compression, but carry remains the primary source of return in a range-bound rates environment.

Emerging Themes: AI and Productivity

A less discussed but potentially significant wildcard is the impact of artificial intelligence on productivity and inflation dynamics. Stronger-than-expected productivity growth could allow central banks to maintain easier policy for longer without reigniting inflation. Conversely, if AI-driven investment surges fiscal deficits or labour market disruptions, it could exert upward pressure on real yields.

Implications for Fixed Income Allocation

In this environment, several strategic considerations stand out:

• Income over duration: With yields at multi-year highs relative to recent history, locking in carry across quality sectors offers an attractive risk-adjusted return profile.
• Selective credit exposure: Investment-grade corporates and high-quality emerging market debt continue to offer value, while high-yield requires careful issuer selection.
• Municipal bonds (munis) as a defensive anchor: Strong credit quality and tax advantages make munis compelling for taxable investors seeking stability.
• Geographic diversification: European and select Asian rates markets may offer better entry points as policy divergence widens.
• Flexibility as the core principle: Barbell strategies combining short-dated high-quality paper with intermediate credit can provide both income and the ability to adjust duration quickly.

Looking Ahead

Fixed income enters 2026 in a stronger position than many expected a year ago. The asset class benefits from elevated starting yields, resilient credit fundamentals, and a central bank backdrop that remains accommodative in most major economies. Returns are unlikely to match the windfalls of 2023 to 2024, but positive total returns appear achievable across a range of scenarios.

The primary risks (renewed inflation, fiscal dominance, or geopolitical shocks) are real but not base case. Investors who focus on income, maintain diversification, and preserve flexibility will be well positioned to capture opportunities as they arise.

The era of zero rates is firmly behind us. What lies ahead is a more normal, if still uncertain, fixed income world, where discipline and selectivity matter more than ever.

The views expressed in this article are those of the author and do not constitute investment advice, a recommendation, or an offer to buy or sell any security or financial instrument. Readers should seek independent professional advice tailored to their own circumstances before making any investment decisions. Market conditions can change rapidly, and past performance is not indicative of future results.

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