Market Outlook
Fixed income returns were modest (+0.65%, Aggregate Index) for Q2, with yields under upward pressure from a more hawkish Fed, but high levels of income carry providing an offset to total returns. The curve flattened throughout the quarter as the Fed repricing was felt more directly in the front end, with 2-year yields finishing 38 basis points higher. Since the moves were driven almost solely by Fed expectations rather than term premium risks (longer-term inflation and supply concerns), back-end yield moves were relatively mild, with 10-year yields only 15 basis points higher and 30-year yields virtually unchanged for the quarter. As a result, longer-duration Treasury and credit segments outperformed, as did higher-yielding, more spread-sensitive markets such as IG Credit (+1.4%) and HY (+2.5%).
Our base case for the back half of the year calls for range-bound rates at slightly higher levels, reflecting an environment of still-muted core inflation dynamics, easing energy-related pressures, and firm growth but with pockets of weakness. This view reinforces our income-driven return theme for core fixed income — strong carry at this higher base level provides meaningful cushion and attractive return potential through the back half. We see particular value in intermediate-duration core fixed income. Most core and intermediate duration strategies hold most of their exposure in the middle of the yield curve, where investors can capture attractive yields relative to cash, benefit from rolldown, and avoid exposure to the long end of the curve, where fiscal, supply, and long-term inflation risks are most concentrated. While we expect rate volatility to stay above historical norms given wider potential policy outcomes and event risk around FOMC meetings under the new policy regime, we would not shy away from duration in asset allocations. We see diversification benefits as more favorable for core fixed income in a backdrop where income is higher, the Fed now has room to ease if necessary, and equity valuations are much more demanding. Credit valuations are also at unforgiving levels, but the difference is that investors can still win going sideways, which is the zone we are in. Strong fundamentals and overwhelming demand for yield are likely to keep spreads stable.
From a positioning standpoint, we enter the third quarter near full duration, as elevated rate volatility and a less transparent Fed make duration tilts more difficult to implement with conviction. More importantly, our outlook remains centered on a range-bound rate environment where income is likely to be the primary driver of fixed income returns. Within portfolios, we are focused on harvesting yield through security selection and sector tilts, while maintaining relatively low tracking error and a defensive credit profile. We continue to view credit primarily as a carry opportunity, with the greatest value residing at the security-selection level rather than through broad market beta. We also continue to overweight MBS, which we view as offering the best risk‑reward profile within core fixed income, combining attractive yields relative to credit with a higher‑quality profile. Within core plus strategies, we maintain moderate and well‑diversified exposure to non‑core sectors, including loans, bank preferreds, and emerging market debt.
Fixed Income Allocations & Recent Changes
| Sector | Positioning & Recent Changes |
|---|---|
| Duration/Curve | Treasury yields were mixed during June, with shorter-maturity rates moving higher while longer-dated yields remained relatively stable, resulting in a flatter yield curve. Markets continued to adjust to a shifting policy landscape as investors reassessed the likelihood of near-term Federal Reserve easing. Economic data remained broadly resilient, while inflation pressures showed limited signs of returning to the Fed's target, reinforcing expectations that monetary policy may remain restrictive for longer than previously anticipated. Federal Reserve communication adopted a more hawkish tone during the month, emphasizing inflation risks and the importance of preserving price stability. At the same time, easing concerns surrounding energy markets and geopolitical developments helped temper longer-term inflation expectations and limited upward pressure on long-end yields. Looking ahead, we expect Treasury yields to remain sensitive to inflation and labor market data, with policy expectations continuing to be the primary driver of rate volatility. |
| Investment Grade Credit | Investment grade spreads remain near historically tight levels despite a more volatile macroeconomic backdrop. Corporate fundamentals are solid, with strong earnings and healthy balance sheets. At the same time, AI-related infrastructure spending is resulting in increased issuance, which at times is adding pressure to the investment grade market. Strong income levels and persistent demand for yield have kept technicals favorable, with fund inflows and institutional demand generally providing support during periods of market weakness. Although valuations remain rich and leave little room for fundamental disappointment, elevated all-in yields continue to offer an attractive source of income for investors. Given the limited compensation for taking incremental credit risk, we remain defensively positioned, favoring issuers with strong free cash flow generation, durable asset coverage, and essential business models. We continue to prefer hard-asset sectors that are less vulnerable to technological disruption, as well as highly regulated industries, such as banks and utilities, where spreads continue to offer relative value. |
| Securitized | Mortgages largely brushed aside the sharp swings in the Treasury market, with the current coupon spread remaining fairly sticky near 110 basis points despite the 25-basis-point move in the 10-year Treasury. While sentiment seems rather muted, the higher rates brought out yield buyers in higher coupons where yields approached 5.50%. Pay-ups on specified pools did underperform as higher rates alleviated prepayment concerns and drove interest into more generic paper. As we look at the second half of 2026, we maintain our conviction on the sector. While the spread is at the tighter end of the range of the last several years, we still believe that the relative value is attractive, given tight spreads in the corporate sector and the heavy issuance seen in that space. Within the coupon stack, we favor higher coupons for income but continue to pair them with some lower coupons that will likely outperform in a rate rally. |
| High Yield | In June, high yield markets remained resilient, supported by historically attractive all-in yields. We continue to expect returns to be driven primarily by carry and income, while maintaining an emphasis on higher-quality segments of the market. At the same time, we are closely monitoring signs of stress among lower-rated issuers, particularly where AI-driven disruption is creating pressure on business models and earnings durability. Over the medium term, our focus remains on disciplined security selection, favoring companies with strong balance sheets, solid free cash flow generation, and the financial flexibility to navigate geopolitical uncertainty and potential inflationary pressures. |
| Municipal | The municipal bond market staged a strong recovery in the second quarter, as attractive yields following the first-quarter selloff, robust reinvestment demand, and persistent fund inflows more than offset concerns surrounding record new issuance, geopolitical uncertainty, and moderating economic growth. Yields declined across the curve, particularly in longer maturities, producing solid positive returns and reversing much of the earlier year's weakness. Remarkably, the market absorbed historically high issuance volumes without a meaningful deterioration in valuations, supported by strong demand from mutual funds, ETFs, SMAs, and seasonal reinvestment cash flows. Credit fundamentals remained broadly healthy across most sectors, although increased differentiation emerged in healthcare and higher education as investors focused more closely on issuer-specific risks. By quarter-end, municipal valuations had become considerably richer, suggesting future returns may rely less on broad market appreciation and more on coupon income, active security selection, and relative-value opportunities across sectors and credit tiers. |
The Risk-Reward for Core Bonds Is the Best in Years
The rise in yields since 2021 has also come with falling duration or rate risk at the index level. So, investors are being paid more income per unit of interest-rate risk, improving the risk-reward profile of core fixed income while preserving its role as a portfolio diversifier. Yields at the index level are almost 3% higher since 2021 while duration is a year less.
Intermediate and Core Duration Exposure in Sweet Spot
Investors have continued to lean on money markets for yield and diversification, but they are sacrificing yield and not utilizing the benefits of duration as a diversifier. Intermediate and core duration exposure has become particularly attractive, with significant yield pickup to money markets, a better duration-to-yield profile, and a composition that has limited exposure to the long end of the curve, where fiscal and inflation risks are more of a factor.
