Market Outlook
It’s been a busy start to the year with no shortage of impactful news and data for markets to digest. For bond investors, Kevin Warsh’s nomination for Fed chair was taken positively. He is seen as dovish on further cuts, but also an experienced candidate and stable choice from a Fed independence view. Economic data has been mixed but skewed toward the bullish side. Despite signs of a stalling labor market, the overall growth picture appears well supported, with the service sector moving back into expansion territory and core capital goods orders rising for a fifth consecutive month. The biggest market influence over the last several weeks has been the software selloff. Software equities have taken the worst hit, but the pain has moved into credit markets with spread widening in leveraged loans and BDCs, where technology exposure is high. This represents a decoupling from core markets as IG credit spreads have remained resilient, with spreads in the 70s, and core bond markets in general are delivering solid returns so far in 2026 (1.3% as of mid-February for the Aggregate Bond Index), outperforming equities.
As we have written previously, the typical script in a midterm year is pressure on rates early in the year, which then fades. This was the case in late January when 10yr yields pushed to 4.3% before fading to 4.1% by mid-February on soft inflation data. Market pricing has wavered between one to three Fed cuts and is currently pricing in two cuts starting in the back half. We would expect stable inflation, weak jobs data, and a dovishly inclined Fed to keep cuts baked into yields, along with a persistent curve steepening bias and a lower front-end trend. Intermediate and longer yields should remain rangebound as they have been since Fed hikes ended in 3Q of 2023. 10yr Treasury yields have been tethered around a 4.25% level, with a range that has been narrowing since then, and we don’t expect that to change in the near-term.
Stable yield levels and the prospect of cuts in a growing economy continue to provide a good backdrop for core fixed income returns overall. Spreads at historically tight levels suggest a more careful posture toward credit. To this end, we remain full duration and continue to drive excess yield while retaining a defensive posture toward our credit allocation. To do this we are leaning on security selection and curve allocation within credit and an overweight in MBS.
Fixed Income Allocations & Recent Changes
| Sector | Positioning & Recent Changes |
|---|---|
| Duration/Curve | US Treasury yields drifted marginally higher over the prior month but remained within the well‑defined trading range established throughout the fourth quarter. Recent economic data — covering inflation, employment, and consumption — did little to alter the market’s baseline outlook, reinforcing expectations for gradual disinflation alongside resilient growth. Policy expectations remain centered on roughly 50 basis points of rate cuts, now anchored in the second half of 2026 under the anticipated stewardship of Kevin Warsh, the Fed chair nominee. Warsh's nomination sparked debate around his historical views on balance‑sheet policy, fueling discussion over the timing and extent of future easing. Looking ahead, we expect Treasury yields to remain range‑bound until a shift in policy expectations or a change in economic data forces investors to recalibrate the forward outlook. |
| Investment Grade Credit | The year opened with record supply driven largely by hyperscalers, and the market has absorbed it well. Although spreads have moved off the tights, we remain within seven basis points of the 26‑year lows on the IG index. Fund flows into IG credit remain strong, and elevated yields continue to support the heavy issuance. AI remains a central theme — both as a catalyst for new supply and as a potential risk for certain business models. With spreads still in the 70s, we are maintaining a defensive posture, prioritizing strong carry in regulated sectors such as banks and utilities while avoiding companies more exposed to AI‑related disruption. We continue to approach the new‑issue market selectively, seeking concessions in sectors and issuers where we hold a constructive view. |
| Securitized | Despite solid outperformance to end 2025, the mortgage sector continued to grind tighter following President Trump’s directive for Fannie and Freddie to purchase $200 billion in mortgages. The intended consequence was to lower borrowing costs for homebuyers, and MBS tightened by nearly 20 basis points immediately following the news. Within the coupon stack, lower and belly coupons were the best performers, while higher coupons failed to keep up on concerns of rising prepayments as a result of the lower mortgage rate. Over the ensuing weeks, MBS retraced some gains as initial enthusiasm faded. Despite the recent underperformance, the current coupon spread still sits at 101 bps. While MBS isn’t the obvious buy it has been, we still believe there are pockets of value and maintain our overweight to the sector. |
| High Yield | High-yield markets are exhibiting a pronounced quality and sector divide, with lower-quality bonds materially underperforming higher-quality segments as the US HY B–BB OAS basis has widened to its widest level since April, despite index spreads remaining in the ~275 bps area. Sector dispersion is increasingly evident, led by Technology and Insurance, which are driving the bulk of B–BB decompression amid heightened concerns around earnings durability and secular disruption risks. In contrast, the Cyclical and Industrial sectors continue to see spread compression, reflecting sustained confidence in near-term fundamentals and cash-flow resilience, with Capital Goods and REITs among the few areas showing outright tightening. Overall, the market remains constructive but highly selective, favoring quality and sector-specific fundamentals over broad beta exposure. We continue to expect 2026 to be largely a carry-driven environment and maintain a disciplined, security-selection-focused approach as valuations remain somewhat rich. |
| Municipal | The municipal market delivered strong and orderly returns despite a historically heavy supply backdrop and continued UST volatility. Investor demand remained broad-based, supported by robust mutual fund inflows, declining money‑market balances, and strong SMA participation. Municipals largely decoupled from Treasuries, with spreads tightening and yields drifting lower even on days when USTs sold off. New issues were consistently met with oversubscription and price bumps, reinforcing the view that reinvestment cash and inflows continue to absorb supply efficiently. Credit fundamentals remained supportive, with ratings activity net positive and no systemic stress evident, although some early signs of strain appeared in rising secondary offerings and ETF flow volatility. |
Quality Bias Continues
Across both investment grade and high yield markets, performance has favored higher-quality credit. This trend has carried into 2026 and is likely to persist given current spread levels and growing concerns around less liquid private lending markets. Since mid‑2025, BB-rated high yield has led performance, while within investment grade, returns have skewed toward AA, driven in part by agency MBS, which currently offer historically attractive relative yields compared with BBB credit.
Signs of Trouble in Less Liquid Markets
While IG spreads appear well supported by strong fundamentals and have remained stubbornly resilient, there has been repricing in more opaque private lending markets.
Business development company (BDC) spreads have widened meaningfully as the selloff in software equities has spilled into credit markets. Public BDCs have significantly greater exposure to technology and software issuers than traditional high yield, and investors are increasingly reassessing how AI-related disruption could affect these more highly leveraged borrowers — and how that risk should be reflected in required premiums.
