With benchmark government yield curves relentlessly trending upwards and core markets credit spreads at 19-year lows, the need for specialist fixed income solutions offering contained interest rate risk, substantial excess spreads, intact valuation profiles and true diversification benefits remains, in my view, pressing.
29 September 2026
The long way back to reality
For much of the past two decades, the market backdrop for fixed income investors was set. Central banks across the western world were not just controlling the short end of the yield curve but also took control of the entire yield curve via an unprecedented series of blockbuster quantitative easing (QE) programmes to depress real interest rates, while effectively acting as the buyer of last resort to absorb any excess supply. As a result, correctly reading central bank actions and guidance most of the time mattered more to ultimate investment outcomes than understanding and acting on underlying economic fundamentals.
But clearly, this market backdrop is gone. Since 2022, central banks around the world have been forced to abandon their ultra-low-rate policies to battle inflation. QE programmes were brought to an end and are in the process of being at least partially unwound, while guidance, too, has now been curtailed in the case of the US Fed.
The consequence of this has been a volatile, and sometimes violent realignment process of yields with underlying economic fundamentals and true supply/demand dynamics, a process that, in my view, has not yet been completed in rates markets, and in the case of core corporate credit markets, has not even started. Another important and increasingly visible effect of this realignment process has been the collapse of decorrelation factors between asset classes that continue to undermine traditional concepts of diversification.
With all this in mind, I believe that fixed income investing continues to require sober judgement, clear selectivity and tailored, specialist solutions with sound underlyings, attractive and fundamentally warranted spreads, contained interest rate risk and intact decorrelation and diversification characteristics.
The case for shorter-end duration with contained interest rate risk
Real central bank rates across both the Western world and emerging markets are back in positive territory, at least measured against less volatile core inflation numbers. And given sharply higher energy prices on the back of the Middle East conflict and the danger of headline inflation becoming more widespread and more deeply embedded the longer the situation remains unresolved, markets are now pricing in 50 to 75 basis points (bps) of hikes over the next 9 to 12 months for most western central banks.
Nominal and real central bank interest rates (%)
Source: Bloomberg, GAM. Note: Daily data to 17 September 2026. Real central bank rates based on nominal rate minus core CPI%. Developed Markets central banks include US, EU, UK, Switzerland, Sweden, Norway, Canada, Japan, South Korea, Australia, New Zealand. Emerging Markets central banks include Brazil, Mexico, Chile, Colombia, Poland, Hungary, Czech Republic, South Africa, Indonesia, Malaysia, Thailand, China.
If markets are correct in their assessment and such hikes materialise, the price effective on lower duration fixed income strategies would be limited, but the lift-up in interest rate carry would flow through swiftly, thereby lifting the overall yield profile of such strategies. As these yield hikes are implied to be similar in size and timing across virtually all Western central banks, the effect on cross-currency hedging costs, where applicable today, should also be very limited for those investors using currency hedges. And from a portfolio diversification angle, it should also be worth noting that shorter-end duration strategies are typically substantially less correlated to asset classes such as equities or commodities than longer-end duration strategies.
The case against over-extending interest rate duration risk
Longer-dated government bond yields, which are now trading at or near multi-decade highs, may be a tempting proposition to many investors. But in my view, both fundamental and market technical considerations do not yet support the case for a material extension of interest rate duration well beyond five-year maturities, both in terms of scenario-based absolute returns, but even more so, in risk-adjusted return terms. Using a fundamental approach that implies historically and fundamentally normalised average expected inflation rates, real short-term rates and real term premia for 10- and 30-year maturity buckets, the realignment of yields with fundamentals still has some way to go, in my view.
But even if fair valuations underpinned by fundamentals were to be in place today, longer duration positions are likely to underperform, both from a return and volatility angle. Firstly, taking the example of the US, implied future inflation, as expressed in breakeven rates, is lower than for the vast majority of past periods, be it in the long or short run.
Also, real short-term rates and real term premiums may need to move higher to continue attracting sufficient buyers when government fiscal and credit trends remain unfavourable, other issuers are competing for longer-dated debt financing in size, foreign holders continue to reduce their market participation, a de-globalising world provides for more volatile [geo]politics, or political influence over central banks could grow. Without a buyer-of-last-resort backstop as during QE, a re-assessment on these or other factors might trigger further re-pricing.
From a portfolio diversification and risk management perspective, I believe longer-duration government bonds have largely lost their traditional role as a decorrelated strategy, namely to equities.
3-Year rolling correlation of US Treasuries to S&P 500
Source: Bloomberg, Bank of America (BofA), GAM. Note: Monthly data to 31 August 2026. Indices used are BofA US Treasury Index and S&P 500.
The case for specialist credit – not “mainstream” corporate credit
While benchmark bond yields have taken the long and painful journey towards normalisation, as outlined above, mainstream corporate credit spreads have moved in the opposite direction, with valuations starting to detach ever further from fundamentals post-QE, not least driven by strong and steady demand for income. Indeed, spreads in many segments of the corporate credit market now trade at their tightest levels since mid-2007.
Taking the example of global corporate high yield bonds, which at an index level incorporate approximately 2/3 US issuers, the BofA index series today trades at a spread of just +270 bps over governments. But when considering 12-month rolling underlying credit default rates, the overriding economic cycle or technical risk indicators, such as S&P 500 implied volatility (VIX), the asset class spreads should be priced closer to a +450 bps mark based on relative historical patterns.
Global high yield bonds relative to 12-month rolling underlying credit default rates and economic growth
Source: Bloomberg, BofA, Moody's, GAM. Note: Monthly data to 31 August 2026. Index used is the ICE BofA Global High Yield Index.
But this goes beyond over-stretched valuations and extends into the breakdown of portfolio diversification benefits. More specifically, as underlying yield curves have risen substantially over recent years while spreads contracted, the total yield composition of corporate bonds has changed rather dramatically.
Today, taking US investment grade corporate bonds as an example, a mere 15% of their yield is attributable to their credit spread, but 85% is attributable to the benchmark Treasury curve, the most extreme tilt since 2007. Even for US high yield corporates, this mix stands at 35% to 65%, respectively. As a result, and unsurprisingly, the correlation of US investment grade corporate bonds to Treasuries has shot up to an extreme 0.96, while US high-yield corporate bonds have reached an all-time high correlation of 0.78.
Treasury yield component of US Investment Grade and US High Yield Corporate Bonds and 3-year rolling correlation to US Treasuries
Source: Bloomberg, BofA, GAM. Note: Monthly data to 31 August 2026. Indices used are ICE BofA US Corporate, ICE BofA US High Yield and ICE BofA US Treasury Index.
So yes, corporate bonds can seem to be an easy fix to generate some additional return over government bonds, and a good number of investors may even feel more comfortable lending to companies rather than governments. But looking at it soberly, mainstream corporate bonds offer no risk compensation that would be considered nearly adequate and, in addition, no longer offer meaningful diversification benefits. Investors seeking alternatives may therefore wish to consider specialist fixed income solutions, where spread levels, valuation profiles, interest rate sensitivity and diversification characteristics can differ materially from those of mainstream corporate credit markets.