Mid-year fixed income outlook

Fixed income markets enter the second half of 2026 with a broadly supportive backdrop, but also clear risks. Growth remains resilient, credit fundamentals are solid, and demand for income is still strong.

At the same time, inflation expectations have moved higher, central banks remain focused on inflation, and the Middle East conflict adds uncertainty. In emerging markets, the long-term convergence theme remains intact, although recent geopolitical risks call for a more defensive near-term stance. In credit, fundamentals remain healthy and technicals are supportive, but tight valuations limit the scope for further spread compression.

Rates outlook

Inflation expectations have started to move higher, but the message from markets is still nuanced. The recent repricing of short and medium-term inflation expectations is not a sign that long-term inflation credibility has been lost. It is better understood as an early indication that investors are becoming somewhat less comfortable with the inflation outlook over the next few years.

Inflation swaps are one of the tools investors and central banks use to assess whether inflation expectations remain anchored. They are not a perfect measure, as they include risk premia, liquidity effects and market technicals. However, they do provide a useful read on how markets are pricing inflation risks across different horizons.

The latest move has been most visible in the intermediate part of the curve. The 2y2y forward inflation rate has risen markedly in both the US and the eurozone. In the US, the 5y5y forward has also started to show some modest upward pressure. By contrast, the 10y10 forward has remained broadly stable.

This suggests that markets are not pricing a structural break in long-term inflation expectations. Rather, they are assigning more weight to the possibility that inflation remains somewhat firmer over the policy-relevant horizon. That is a more subtle message, but still an important one for fixed income investors.

For central banks, this type of move is likely to matter. Both the Federal Reserve and the ECB have made clear that inflation expectations are part of the framework through which they judge the appropriate policy stance. In the US, the labour market appears balanced enough for the Fed to focus more directly on the inflation side of its mandate. In the eurozone, the ECB’s focus is even more explicitly centred on price stability.

The market repricing of policy rates is understandable. If forward inflation expectations are moving higher, even modestly, central banks have less room to validate easier financial conditions. The removal of expected cuts, or the pricing of additional hikes, is consistent with a policy environment in which central banks remain cautious and focused on inflation.

The more difficult question is whether investors should agree with what is now priced. Much depends on the outcome of the war in the Middle East.

A relatively benign outcome is still possible. Energy and commodity supply conditions could gradually stabilise, even if prices remain elevated and risk premia persist for some time. In that scenario, inflation expectations would probably stop moving higher, risk assets could remain reasonably well supported, and central banks would likely deliver a policy path broadly in line with what markets have already priced.

The less benign scenario is one in which disruptions last longer and commodity prices rise further. That would create renewed upward pressure on headline inflation and could keep inflation expectations firmer for longer. The key issue would not be a single move in energy prices, but whether these moves start to influence broader pricing behaviour, wage demands and medium-term inflation expectations.

For duration investors, that leaves a less attractive risk-reward profile. In the benign scenario, there may be limited scope for a rates rally if central banks remain cautious. In the adverse scenario, nominal duration would be more exposed to further pressure as markets price a longer period of restrictive policy. The range of outcomes does not support aggressively adding rates exposure.

This is also why inflation-linked bonds remain useful in portfolios. The post-COVID environment has reminded investors that inflation can be more volatile than it was in the decade before the pandemic. Supply shocks, energy markets, fiscal policy and geopolitical risk can all create periods in which inflation uncertainty rises. That was already our view two years ago. With inflation currently more cyclical and less dormant, linkers can play an important hedging role, particularly when they can be added at reasonable levels.

The conclusion is therefore a prudent one. The recent move in forward inflation expectations is not alarming, and the curve is still behaving in a broadly anchored way. However, it is an early signal that deserves attention. Central banks are likely to remain focused on inflation, and fixed income investors should be careful about assuming that duration will be quickly rewarded, notwithstanding the attractive carry.

For now, we would remain cautious on nominal duration and continue to see a role for inflation-linked bonds as a hedge against a more volatile inflation cycle.

Emerging markets outlook

The convergence narrative, as outlined in our outlook for 2026 back in December, remains the primary long-term theme and driver for emerging market sovereign bonds.

This convergence is multifaceted, encompassing several dimensions:

Interest rates: A trend towards lower and narrower rate differentials.

Inflation: Inflation rates in emerging markets are, on average, converging towards those of the US.

Credit quality: The balance of credit rating actions continues to favour upgrades over downgrades.

Currencies: Emerging market currencies are supported by elevated real rates.

Growth and policy: Higher growth rates and an improved policy mix across emerging markets are providing additional support.

The convergence theme has been further reinforced by unpredictable US policy actions, which have prompted a reallocation of capital as investors seek to diversify away from USD exposure. Emerging markets have been notable beneficiaries of these flows.

On spreads: comparing current spreads with historical averages can be misleading. The convergence story has established a new paradigm of lower spreads. What was previously considered an average spread now represents a relatively high spread in the current environment.

A return to spread levels seen in 2022–2023 is highly unlikely.

Against this, we maintain a fundamentally constructive long-term view on the asset class.

Recent developments in the Middle East have, however, prompted a temporary shift to a more defensive positioning across several dimensions:

Geographic exposure: No direct exposure to the Middle East.

Duration: Maintaining a low-duration stance.

Regional allocation: Low exposure to Asia, given the region’s sensitivity to higher oil prices.

Credit quality: Reduced exposure to lower-rated issuers, particularly in hard currency.

Looking ahead, we consider two main scenarios:

01

Escalation of the crisis: Potential implications include higher inflation, lower growth and possible central bank intervention. As a result, maintaining the current defensive stance seems appropriate.

02

Swift resolution: This could trigger a relief rally, leading to opportunities to add duration, benefit from steeper yield curves, and seek exposure to undervalued FX and rates (e.g. KRW, PHP).

Credit outlook

The macro backdrop remains broadly supportive, but is becoming increasingly divergent across regions. The US continues to benefit from strong capex-driven growth, while Europe lags, with modest expansion amid persistent energy-related headwinds and weaker confidence.

This divergence is sustainable in the near term but remains dependent on the resilience of US investment and a stabilisation of the Middle East conflict, with an agreement allowing oil exports to resume. Any deterioration or prolongation of the conflict would increase market volatility.

Current resilient economic data and a positive earnings season remain supportive across most sectors. This helps anchor credit fundamentals at solid levels.

Credit markets have absorbed volatility well and remain technically strong. Spreads briefly widened earlier in the year but have largely retraced. Investment Grade spreads are back close to pre-stress levels, reflecting limited concern about defaults.

High Yield has followed a similar pattern, with spreads slightly above their tightest levels but still contained.

Markets continue to differentiate, with weaker credits underperforming.

The dominant feature remains the strength of demand for the asset class.

Primary markets have been exceptionally active, with record issuance being absorbed smoothly.

Secondary market performance confirms that investors continue to seek income and carry.

Year-to-date flows into Investment Grade remain positive, while High Yield flows are slightly negative but have improved recently. Overall, technicals remain supportive, with no sign of fatigue in demand.

Valuations are tight, limiting the scope for further spread compression. However, the carry profile remains attractive in a low-volatility environment.

We do not expect spreads to tighten materially from current levels. At the same time, a significant widening appears unlikely in the absence of a deterioration in the geopolitical situation.

Leverage is low and margins remain supportive, providing a cushion against shocks. As a result, default cycles are likely to remain contained.

The outlook remains constructive, with dispersion rather than systemic stress as the dominant theme.