Building resilience with flexible fixed income opportunities

Factors supporting global bonds

In 2026, global bonds should benefit from continued central bank easing, with lower interest rates anticipated in both the US and Europe.

While sovereign debt yields could face upward pressure from fiscal concerns in advanced economies, yields are relatively high and the overall environment remains supportive.

Investment flows into corporate bonds have been buoyed by solid credit fundamentals and investors’ ever-present search for yield despite the relatively high valuations. With European investment-grade and high-yield bonds still at attractive absolute yields, we expect this trend to continue well into 2026, if only because their appeal over lower-yielding cash instruments and money markets remains compelling.

Similarly, sovereign fixed income markets have become much more attractive as long-term holdings in a diversified portfolio because their yields have risen from ultra-low levels of five years ago.

While it appears increasingly likely that 2026 could be a year of ‘carry’ (investors will earn their bonds’ coupons), what happens to a traditional bond portfolio if it is not? 

Fixed income: myriad opportunities

The global bond market is large, multifaceted, and expanding. There are numerous asset classes and strategies that could help reduce a traditional bond portfolio’s volatility, increase its yield, or both.

Today’s fixed-income market offers myriad opportunities to diversify by credit quality, structure, geography, maturity, currency, and more.

As examples:

• Exposure to fixed-income asset classes such as Treasury Inflation-Protected Securities (TIPS) can offer robust protection against rising inflation
• Structured products such as Asset Backed Securities (ABS) can offer diversification to corporate bond exposure
• Floating-rate securities such as collateralised loans (CLOs) can help diminish the impact of interest rate volatility.

However, the development of alternative strategies that explicitly target either an absolute return or a higher income may offer the most compelling combination of diversification and yield in these uncertain times.

Absolute return strategies generally involve a more unconstrained approach, allocating across global governments, corporates and structured products to deliver a total return above a standard benchmark.

In principle, this approach allows investors to find ever more efficient opportunities to generate returns than traditional bond benchmarks or actively managed funds relative to these benchmarks.

For example, greater exposure to Eurozone fixed income may help hedge against US-specific uncertainties, while including emerging market sovereign or corporate bonds can help diversify credit risk while adding yield.

Alternatively, credit exposure could be reduced, but placed into the higher-yielding sub-investment grade market, in the US or the Eurozone, to add yield, while pivoting the risk away from broader macroeconomic concerns and more towards industry or company-specific risk.

Absolute return funds are usually offered with either a short or long-duration target, making them suitable alternatives to cash or cash-plus allocations as well as to longer-duration exposures such as government or corporate bonds.

For more conservative exposure, income strategies aim to provide a predictable income, typically between 1-2% above money market funds². These strategies generally take only moderate (or very low) duration exposure and can thus be compelling alternatives to cash allocations or even investment-grade corporate bonds.

Meanwhile, the increasingly popular private asset markets, particularly alternative credit and real assets, continue to attract capital, supported by resilient fundamentals and policy tailwinds. However, uncertainty over regional economic outlooks makes selectivity and rigorous credit analysis more important. Flexibility, at the industry and security level, remains critical.

Similarly, sustainability remains a focus for many bond investors as regulatory frameworks evolve. European and Asian investors are currently leading the charge on green bonds, decarbonisation and climate solutions, even as political headwinds emerge in other regions.

Our broad outlook for global fixed income is positive. But macroeconomic uncertainties over growth, government deficits, inflation and monetary policy, geopolitics, and even valuations are bound to spur volatility. As such, traditional, less flexible, fixed-income strategies could see their performance lag that of more dynamic strategies. And yet, a large universe of fixed-income asset classes is available to bond investors looking to smooth returns, hedge against specific risks, or just boost yields, or returns, or both. 

Building more bespoke bond portfolios

Most years contain a surprise or two. While they usually have a temporary or relatively minor impact on a diversified portfolio of stocks and bonds, surprises such as the onset of the Covid pandemic can have massive effects on even a well-diversified portfolio.

While 2026 could spring a surprise of that magnitude, perhaps driven by increasingly complex geopolitics, there are several scenarios that are at least plausible in the coming year.

Below, we consider four scenarios and propose diversification strategies that could help improve an investor’s risk-adjusted returns should such an environment emerge. 

A broadly positive base case outlook

Significant drawdowns in fixed-income markets tend to occur only in response to an economic growth or credit-related shock. As neither is in our base case for 2026, we expect carry (the current yields) to deliver the bulk of the total return in the year ahead.

As such, higher-risk and higher-yielding bonds such as sub-investment-grade corporate and emerging-market bonds (both sovereign and corporate) should continue to find strength in sustained demand, the improving credit quality in developed markets, and an improving macroeconomic environment in emerging markets.

Nevertheless, mindful of the risks, we believe both diversification and flexibility will provide greater opportunities for improved risk-adjusted returns. The trend towards a weaker US dollar, for example, is particularly favourable to some issuers of local currency-denominated emerging market bonds.

Additionally, in developed markets, current-coupon US agency mortgage-backed securities (MBS) offer an attractive yield pick-up relative to US investment-grade corporate debt with lower credit risk in as far as MBS carry the same credit rating as US government debt. Having the opportunity to overweight exposure to asset classes or sectors such as these can boost returns while reducing the overall portfolio’s sensitivity to broader macro risks.

The portfolio in Exhibit 1 has a defensive allocation to help reduce volatility, while significantly increasing the range of fixed-income asset classes the portfolio can invest in. Such a portfolio is likely to perform well in our base case scenario given its relatively high absolute yield, while simultaneously generating less volatility than a traditional global bond benchmark. 

Weaker growth or rising geopolitical risk   

2026 may prove a more challenging period than markets expect for global growth, especially given the still-uncertain level and impact of US trade tariffs. Should the macroeconomic environment deteriorate more than expected, and/or inflation fall faster than expected, longer-dated government bonds yields could fall across the yield curve.

This scenario could significantly lower the yield available on cash instruments, potentially impacting a wide range of investors. In an uncertain environment, the stability and security of cash investments have been attractive. But if inflation is falling on the back of weaker growth, falling policy rates (particularly in the Eurozone) will steadily erode the usefulness of cash as a yield-generating instrument.

Turning to geopolitical risk, tensions have persisted and could rise further. The US administration has challenged many long-held assumptions about America's role on the global stage, raising uncertainty over a range of active and potential conflicts. Should concerns over geopolitical stability continue to rise, economic instability will likely follow.

Whether due to weaker economic data, equity market volatility, or evidence of growing credit stress in either private or public markets, credit markets could underperform our base-case assumptions.

In such an environment, government bonds should be favoured over corporate bonds, and investment-grade corporate bonds should be favoured over riskier securities such as high-yield corporate or emerging market debt. 

• Global government and inflation-linked bond funds for exposure to falling yields while increasing diversity to reduce volatility
• Corporate bond funds to boost income
• Short duration government bond funds to generate income and return should interest rates fall.

The portfolio in Exhibit 2 could suit investors seeking a more conservative exposure – those holding traditional long-duration government bonds and large cash allocations. It diversifies some domestic government bond exposure into inflation-linked bonds and global bonds to help reduce interest rate volatility, while maintaining duration exposure. It diversifies money market exposure into higher-rated short-duration corporate and government bonds to boost both yield and return. 

Higher inflation, greater fiscal concerns

Whether due to faster-than-expected economic growth, expanding trade tariffs, external shocks, concern over the fiscal outlook, or any sense of increased politicisation of monetary policy in the US, it would not be unreasonable to suppose that the largest risk to a bond portfolio is rising yields, driven by higher inflation or fiscal concerns.

However, shifting some nominal government bond exposure to inflation-linked securities and shorter-duration assets could help.

Additionally, increasing exposure to absolute return strategies could help protect returns, while exposure to more alternative fixed-income asset classes such as emerging market local-currency bonds or private credit, could help reduce volatility given their generally lower sensitivity to Treasury yields.

Finally, structured products, especially instruments with floating-rate coupons, could provide attractive yields and help lower a portfolio’s overall volatility.

The portfolio in Exhibit 3 assumes investors will require additional compensation for holding longer-maturity government debt in 2026, whether due to inflation or concerns over government bond supply. To help mitigate these risks, the portfolio favours shorter-duration instruments and shorter-duration credit exposures, while allocating more to high-quality ABS to help support the overall portfolio’s yield. 

Weathering weather major surprises or just higher volatility

In this scenario, none of the above risks fully emerge. Instead, the year unfolds with ongoing concerns over higher inflation, geopolitical risk and a slowdown in growth. That is, global bonds will have periods of high volatility – much sound and fury, signifying nothing. In such an environment – or should a more significant and unpredictable external shock arise – a traditional bond portfolio will likely deliver underwhelming risk-adjusted returns.

Adding strategies that could improve portfolio diversity such as absolute return, private credit and structured products could help lower volatility, while adding sources of additional income such as income funds or private credit could help raise the portfolio’s returns. Either approach – and likely both – should help improve risk-adjusted returns in a more volatile environment.

We have not illustrated such a recommended portfolio because it is the same as the one we recommend for our base case scenario: A balance of global government and corporate bonds, and allocations to structured products and absolute return vehicles.

So, yes, we believe the portfolio best suited to our base-case outlook would also outperform in the event of higher-than-expected bond-market volatility – and even a significant external shock. 

Portfolio construction matters

That the same portfolio can be optimal in both our base case outlook and in the event of a severe external shock illustrates the power of more refined portfolio construction. As mentioned above, the universe of fixed-income asset classes, sectors and securities is vast and differentiated. Investors should take advantage of the diversification these options offer to boost returns and reduce risk.

In each of the scenarios explored here, we propose specific portfolios that investors could adopt to improve their risk-adjusted returns for that specific scenario. But all our sample portfolios share a common theme: Reducing risk through diversification does not have to come at the expense of significantly lower expected returns.

In all our scenarios, the sample portfolios aim to increase diversity and boost yield, income, or absolute return. In our view, diversification and return need not mean a trade-off.

For decades, bonds have been a staple of diversified portfolios because they offer yield, liquidity, capital preservation and diversification. However certain or uncertain the current environment may be, it does not alter the strategic – or even the tactical – value of holding bonds: 2025 saw the welcome return of US Treasury diversification from US stocks as government bonds rallied in both the April and November stock sell-offs.

Traditional bond exposures have value and belong in a diversified portfolio. But investors can increasingly benefit from a more flexible approach to portfolio construction.

Fixed income has learned to bend. Now it is up to investors to make full use of the variety of fixed-income instruments available to further preserve capital, reduce risk and boost income.