This year is already shaping up to be another volatile year for geopolitics, economies and markets. Events in Venezuela and Iran have led the headlines, but later this year could see any number of different outcomes in Greenland and Cuba amongst others.
On the economic side, the US appears to be continuing to grow at around 2%. However, data also appears to be confirming that the bottom quintile of US consumers is struggling with payments on credit card debt and auto payments, and this ultimately could have an impact on GDP. Inflation, although falling, remains somewhat sticky and has fallen far more slowly than many would have expected.
Debt by contrast, does not appear to be meaningfully falling or being addressed by politicians across the G7, and with debt/GDP now likely heading towards 130% in the US by the end of this decade, persistent budget deficits have the capability to cause a return to power of the bond vigilantes – bringing risks of further yield curve steepening.
So how can fixed income investors navigate these risks and still aim to produce high quality returns?
The short answer is to focus on areas of fixed income that maximise “break even protection”. By this we mean a combination of attractive yield or carry to provide solid income, but with a low enough duration that capital risks from yield or spread volatility are minimised and do not detract from total returns, even if broader market volatility does move yields in the market.
But with yield curves now upwards sloping, shouldn’t investors be embracing more duration? To some extent yes, but with the aforementioned risks of curve steepening, we would caution investors to always maintain a healthy respect for the capital risks that higher duration positions have. However, one of the best things about upward sloping curves without taking too much duration is the return of “roll-down”, where time decay alone enhances returns as bond yields fall through time and this translates into modest capital gains on top of good starting yields.
In the last two years significant yield curve steepening has been seen (see Exhibit 1), with the US/UK and German yield curves pivoting around the two-year point. The UK curve (blue lines) has seen longer dated yields go from being lower than the US (red lines) to now higher, and with currency hedging costs essentially zero from GBP to USD, gilts are now looking more attractive from a valuation perspective.
It was partly because of this prior steepening that the ICE/BAML Index returned 5.49% in 2025 despite a yield at the beginning of 2025 of 4.33%. In short-dated, your total return in any one calendar year is not just the yield you buy on day one (although in fairness that is the most important variable in determining future returns). Roll-down, and the opportunity for capital gains from rates moves, or even spread moves, add additional opportunities for return on top of this.
Our back testing work has shown that using the BAML/ICE Global 1-5Yr IG index from its inception in the 1990’s, typically investors get 1.25x the starting yield as the total return in any one calendar year, see Exhibit 2.
In today’s markets, with spreads where they are, the opportunities for spread compression in 2026 are limited: however, with the Federal Reserve and the Bank of England likely to keep cutting interest rates, there are still modest opportunities for capital gains from the rates impact on short-dated funds. And as you can see in Exhibit 2 even with tight spreads, today’s starting yield remains attractive in absolute terms and in a historical context: the red dot is where the starting yield is right now, and it remains cheaper than the historic average for this data set which goes back to the end of 1996.
As firm believers in active management, we know that total returns do not come solely from starting yield + roll down: asset allocation and stock selection also have a part to play in enhancing total returns. So which sectors do we favour right now?
Financials remain our top pick, in particular, European banks and European Insurers. Fundamentals remain very solid: European banks retain the highest capital ratios they have ever had, they have solid asset quality and with tiny exposures to commercial real estate, the tech sector and the auto sector that means non-performing loans are very small and unlikely to rise materially. Valuations remain attractive, with senior spreads being wider than non-financials for the same maturity and rating – as such financials win on both fundamental and valuation grounds. We currently have about equal amounts in senior and subordinated bonds given how spreads have been tightening steadily for several years – senior financials give us more protection against any future spread widening we might see.
Non-financials that we favour are firmly within the utilities and telecommunications sub-sectors, where earnings are not only robust but also inflation protected. As such, we are happy to embrace the junior versions of these bonds, known as corporate hybrids. They do come with slightly higher risks than senior bonds, but the additional yield brings greater breakeven protection with short-dated maturities; as such we find they are often excellent sources of good risk-adjusted returns. We do not however currently invest in property linked hybrids as some of these bonds continue to exhibit higher volatility than we are comfortable with in our short-dated strategies.
ABS (asset-backed securities) are another of our favoured sectors, as they give very good diversification benefits and, as they are all floating rate securities, they are not as correlated to rates as the fixed rate part of the portfolio. On top of that, all in yields remain very attractive but it is worth saying that we only invest in residential mortgage-backed securities (RMBS) rather than Commercial Property, which is not allowed in our short-dated funds.
The world remains a volatile place, and uncertainty remains high. By contrast, we believe short-dated fixed income can give you a high level of confidence on total returns regardless of what happens in the investing world because break even yields are so high and protect you against losses in other areas. In our view the starting yield today is high enough to predict good returns in short-dated for the next few years, and our historical work demonstrates that you do not just get the yield every year from short dated, you typically get another 25% on top of that, making it even more attractive. Lastly, with active management we can squeeze out some additional return from our favoured sectors, and avoid some of the risks of other sectors such as autos where we have seen issues recently.
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