Navigating credit in a higher yield world

While the sell-off in government bonds has unquestionably been the fixed income story of 2026, for active investors the sharp repricing of yields across the bond market brings a fresh set of opportunities and challenges in navigating credit.

Higher starting yields have unsurprisingly driven a resurgence in demand for multi-asset credit strategies, which may be well placed to take advantage of a structural backdrop that we think will be a tailwind for credit assets in the medium term.

Here we look at how investors can respond to this new environment, and where they might look to position themselves in credit in a higher yield world.

Crowding out a potential tailwind for credit

For the last two decades or more, public credit has been shrinking as a proportion of the overall financial markets, as government bond issuance has surged and equity markets have ballooned in size.

In 1990 the global public bond market totalled roughly $15tr, around 50% larger than the global equity market at the time.¹ While the bond market had swelled to $160tr by the end of 2025, that explosive growth has still not kept pace with the expansion in equities, such that the two markets are now broadly the same size (see Exhibit 1).² 

More importantly from a fixed income perspective, credit has been steadily shrinking as a proportion of the outstanding bond market. Back in 1990, public credit (corporate and financial bonds, mortgage-backed securities, covered bonds etc.) exceeded the value of government bonds outstanding. However, especially in the years since the global financial crisis, it is government bonds that have surged ahead, such that they now represent comfortably more than half of the asset class (see Exhibit 2).

This relative scarcity of credit is likely to persist. With interest rates higher for longer, we believe corporate borrowers will reduce their funding needs, while we see little appetite from governments to properly address their deficits, so the government bond issuance will likely keep coming.

According to IMF projections, we may see a net addition of $30-35tr in government debt by 2030 (not all of this will be public bond issuance). In the US alone, the Congressional Budget Office projects gross federal debt will rise by roughly $8tr by 2030.³ By comparison, the much-publicised AI buildout is expected to add a cumulative $2.1tr in IG corporate bond issuance by 2030, according to a top-end estimate from JP Morgan.

Beyond the net growth in the AI sector, it is difficult to envisage non-financial corporate issuance increasing significantly given higher yields naturally push project costs higher and should limit supply from sectors that tend to rely on leverage, such as real estate. The strong growth in the private credit and leveraged loan markets in recent years has provided some rebalancing away from public corporate bonds for many issuers (and investors), but we would expect higher rates to weigh on supply in these markets too.

All things considered, we expect credit to continue shrinking relative to government debt as a proportion of the public fixed income universe. In terms of valuations, our belief is that this “crowding out” effect will be a tailwind for corporate bond spreads and a headwind for government bonds.

General demand for fixed income likely to strengthen

While the journey to higher yields is a drag on total return for fixed income, as it has been year-to-date, the more attractive entry point does potentially increase its appeal to a broader range of investors, especially those seeking capital preservation.

Starting yields on the global 1-5yr investment grade (IG) corporate bond index, for example, are currently in the 90th percentile for the last 30 years, which means that since 1996 yields have only been higher 10% of the time. As Exhibit 3 shows, starting yield has been a strong predictor of subsequent three-year total return over that period, which encompasses multiple market cycles.

Fixed income “breakeven” rates have also increased significantly; with five-year USTs trading just around 4.8% at time of writing, for example, a sell-off would need to drive that yield to 5.95% for holders to make a negative 12-month return. Real yields in USTs (yields minus expected inflation) are also at levels not seen in years. In credit breakeven rates are even higher, with the US and European high yield (HY) bond indices now showing starting yields comfortably over 8% (see Exhibit 4).

For investors looking to safeguard the value of their portfolio or seeking greater resilience against inflation, we think these are attractive conditions that will generally increase demand for the asset class. For pension funds that often look to de-risk their equity holdings after long rallies, for example, fixed income yields are finally offering a compelling alternative, and we are already seeing some rotation towards bonds underway.

In addition to appealing outright yields, rapidly ageing societies may provide a further structural tailwind for fixed income demand. On average 11,400 Americans are turning 65 each day, according to the Alliance for Lifetime Income, with the estimated 4.2m people reaching that age in 2025 being the highest number ever recorded. Individuals often enter retirement with a traditional 60/40 or 50/50 equity/debt portfolio, which leaves ample room for a rotation out of equities towards fixed income, whether that is through mutual funds, outright government bonds or annuities. The rise in government bond yields in the late 1970s and early 1980s drove significant demand for annuity products, and we saw a similar trend in response to the spike in yields post-Covid. We would not expect the current environment to be any different.

Not all credit will thrive

While the technical picture for fixed income in the coming years looks supportive, the higher yield environment is also likely to increase performance dispersion within credit.

First, higher yields mean refinancing over-levered capital structures will be more difficult than in the 2009-2021 period, mechanically putting pressure on firms that have carried too much leverage into this stage of the cycle. In addition, as the spread pick-up offered by lower rated assets gets smaller as a percentage of overall yields, the risk-reward of capturing those few extra basis points of spread naturally becomes less appealing, which means funding sources for the weakest credits can be more limited. We are already seeing this trend play out in the declining percentage of CCC rated bonds in HY indices, for example.

Second, individual sovereigns that find themselves under pressure (e.g. France) will likely import higher funding costs to domestic businesses. To the extent that bank deposit rates compete with government bonds at the lower end of the risk spectrum, a rise in government bond yields will likely translate into higher funding costs for banks. If so, this will put them at a disadvantage to global peers and may also contribute to underperformance versus other pockets of fixed income.

Third, given we see general demand for credit assets outweighing supply, we could see a situation where certain investors begin chasing yield. Specialist credit hedge funds may reach out for more leverage to deliver their promised excess returns versus equity strategies, for example, or insurance firms may seek riskier assets to meet their objectives of growing annuity sales. This creates new potential pockets of vulnerability that may be a risk to valuations in individual credit sectors.

In our view, the above will make credit selection – picking the right geographies, sectors and single names – a more important contributor to returns in the coming years.

Active managers can look to adapt to these emerging trends. As an example, for a long time we have seen attractive relative value in subordinated financial bonds, where spreads in our view have often overcompensated for the underlying risks. While we still see bank Additional Tier 1 (AT1) bonds as an attractive source of yield, with the European banking sector’s recovery story increasingly played out, we see the upside from spread compression here as being more limited going forward, so we may find better relative value in supplementing this allocation with other sectors such as collateralised loan obligations (CLOs) and HY bonds.

Duration may be a source of volatility rather than excess returns

As the world recovered from the global financial crisis and interest rates were driven lower partly by quantitative easing (QE), fixed income experienced a massive boost from tightening credit spreads. The asset class has benefitted further from globalisation trends that helped bring inflation lower and led to significant capital gains from tightening in longer dated government bonds. This led to lower yields at the front end of the curve and investors increasingly seeking yield by moving further out.

In a world of higher government bond yields, some of these dynamics are shifting. Attractive yields at the front end may reduce the need to extend credit into longer exposures in search of returns, which could lead to steeper credit curves.This is particularly true if the recent volatility in longer dated government bonds remains a feature of the market. After all, the increase in government bond term premium and volatility in the long end might also impact demand for longer dated credit.

In this context, our preference for the medium term would be to stick to relatively modest duration and focus on asset classes that we think provide attractive risk-adjusted yields without the drag of rates-driven volatility at the longer end. This would potentially include selective shorter duration exposures in IG and HY, as well as more specialist sectors that have consistently offered a yield premium over similarly rated mainstream bond markets, such as CLOs and bank AT1s.

To be clear, for broader fixed income mandates, we continue to see government bonds as a useful hedging tool in the right circumstances. If there was a large exogenous shock that tipped the global economy into recession, we do think government bonds would rally strongly. However, there is more doubt about the reaction of government bonds today than in the past, given recessions usually mean lower tax revenue and more government stimulus – the opposite of what is needed to balance the books governments currently run. We would expect market participants to increasingly use other available instruments in combination with government bonds as a potential hedge against the risk of credit spread widening.

Focus on steady returns rather than capital gains

In our view, the structural backdrop for fixed income today means we are far less likely to return to the ultra-low yield environment of 2009-2021.

Deglobalisation, an increasingly fractured geopolitical landscape and persistent fiscal deficits requiring heavy government bond issuance should all reduce the likelihood of yields falling to the anaemic levels of the pre-Covid era, and as such we think the focus should be on steady returns from income rather than significant capital gains from chasing spread compression in riskier parts of fixed income.

Higher starting yields have historically been a strong predictor of healthy medium-term returns, and as a consequence they may increase demand for credit, whose structural undersupply relative to government bonds seems likely to continue. However, rates-driven volatility in longer dated exposures and greater performance dispersion are risks that in our view are best addressed through active management.

We are firm believers that demand for credit is here to stay, and that flexible multi-asset credit strategies are well placed to take advantage of the market’s generally favourable dynamics.