Fixed income investors today face a dilemma: soaring government bond issuance and sticky debt ratios are colliding with fading demand, while credit spreads remain tight. But the current environment also offers opportunities. 

Bond investors allocate based on predictions – the important thing is not how much a bond yields now, but how much it could yield next year, factoring in market expectations around developments in interest rates and the economy. So what are investors saying today? 

Concerns about the economy abound – a combination of high public levels of debt, low growth and sticky inflation in developed countries does not inspire confidence. Lok Ma, a professional trustee at Law Debenture, believes stagflation is an “increasingly likely” scenario. 

Growth is low, and so governments are facing the challenge of trying to boost growth, while central banks are trying to manage inflation. 

“Sometimes that stress is exhibited through bond yields,” says Mark Parry, who heads up the manager research team at consultancy Barnett Waddingham. However, “what we don't have is a traditional wage price inflation spiral, which has been a cause of concern in the past”, he argues. As a result, he believes the priority for investors is to fine-tune fixed income exposure rather than respond to an acute inflation threat. 

Recent GDP figures show a patchy global picture. The UK expanded by just 0.1% from July to September, compared with 0.3% in the EU. In the US, growth has rebounded to 3.8% for April to June after three quarters of decline.

Growth is slowing, including in the US, concedes François Collet, chief investment officer and portfolio manager at asset managers DNCA Investments, but he does not expect there to be a recession. While the impact of import tariffs is now affecting consumers, there is large-scale investment in the artificial intelligence sector, he points out. For Europe, Collet expects “a few more quarters of zero growth”, but he notes that the European consumer is “in good shape” thanks to high levels of savings. 

Most major central banks are now in a rate-cutting phase or edging toward one. The US Federal Reserve cut its lending rate by 25 basis points in October to a target range of 3.75%–4%, with further reductions possible before year-end. The Bank of England may follow suit. Meanwhile, the European Central Bank kept its deposit rate at 2% in October despite a slight uptick in inflation and is expected to hold steady until 2027.   

Lower rates change the investment calculus. “You could start to think differently about the fixed income market,” says Collet, noting that such an environment is more conducive to long-only positions. DNCA, an independently managed boutique within Natixis Investment Managers, invests largely in global developed market government bonds. 

“We are seeing stock markets and credit market pricing very high. So I think that having long duration on government bonds is starting to be interesting,” he says. 

For pension investors, given the generally strong funding level of UK DB schemes, the current focus tends to be on minimising the risks of defaults and downgrades. With fixed income now forming the bulk of most DB portfolios, diversification may be less about complementing equity-like investments and more about ensuring a good spread across bond-like investments, says Ma. 

Pressure from tight credit spreads is felt across the market. “More recently we have seen some schemes shift towards shorter-dated instruments for a more attractive spread,” Ma notes, while some schemes are holding ‘dry powder' for increasing credit allocations in future should spreads widen. 

As for government bonds, there has been a subtle change in how investors perceive the US amid a risk that the current administration could undermine the independence of the Federal Reserve, he says. 

“For now, our advisers are typically not recommending material changes to either the allocation to the US or the extent of currency hedging. The one area where I may have seen a change is around the view of US treasuries being a ‘flight-to-safety' asset to mitigate downside risk, given the greater political and economic uncertainty,” he remarks. 

UK pension funds are mainly reliant on gilts given their liabilities are in sterling, but there is an emerging problem; not only are DB schemes leaving the market via insurance settlement, Ma says even the ones still around have largely bought all the gilts they need to match their liabilities.  

“So we are potentially seeing a reduction in demand at the same time as an increase in government borrowing,” he points out. 

The gilts panic of 2022 also still casts a shadow over this market, even though liability-driven investments are now generally better positioned to deal with a sudden spike in yields thanks to larger buffers. But the episode has left its mark – ever since that fateful ‘mini’ Budget, gilt markets have been easily spooked by fiscal policy leaks. Even the chancellor’s tears can spark a sell-off. 

“The topic of an unlikely but possible sovereign debt crisis is being raised by several of our advisers. Once again, we are keeping a closer eye on the collateral positions for our LDI programmes,” Ma says. 

Things may, however, seem less dramatic when put into a wider perspective. Collet acknowledges there are fiscal fears in Europe, which he thinks are justified in some cases, but adds: “I think that in some other countries like the UK, like Japan, these fears are overdone and that it's a pretty interesting opportunity to buy duration and to buy govvies in these countries.” 

He says it’s about being selective: “We don’t want too much French debt, but other countries are doing pretty well – Spain, Italy, Portugal.”  

Germany too is interesting despite big fiscal stimulus, he says, because of the country’s low baseline debt.  

DNCA’s absolute return strategy for fixed income takes a top-down approach, but the team believes that nobody can always be right – so macro views are combined with a quantitative tool for calculating a Risk-Adjusted Time Premium, to identify opportunities that are well rewarded for taking duration risk, says Collet. “It's very important to find value on top of money market rates,” he remarks.  

With fixed income offering a range of instruments, others suggest wider diversification is key.  Consultancy XPS Group favours securitised markets for their yield pick-up and diverse borrower exposure, for example. XPS investment consultant Emma Coleman says hard currency emerging market debt also has some attraction due to a weaker dollar and strong fundamentals, but stresses that this is often issuer specific. 

The total return yield on fixed income has been heavily driven by high government bond yields, bolstering demand and helping credit markets withstand recent shocks like US president Donald Trump’s 'Liberation Day’, she believes. 

“However, the risk of a global recession could threaten borrower fundamentals. Defaults remain low, but lower-quality market stress is rising, with decreasing interest coverage and increasing debt levels,” says Coleman. “This, alongside limited investor upside due to tight spreads, contributes to our ‘unfavourable’ view on public credit.” 

Credit spreads across investment grade and high yield are historically tight, agrees Parry.  

“That has certainly put investors off,” he says. “But it depends what you're trying to achieve. If you want a long-term good return, then perhaps you shouldn't be too alarmed about the relative expensiveness of the asset class.” 

Fixed income investors face a landscape shaped by fading structural demand, highly sensitive fiscal dynamics and uneven opportunities across global markets. Diversification—whether through securitised assets, selective emerging market exposure or countries with stronger fundamentals—appears increasingly important for building resilient portfolios. Tight credit spreads and an uncertain economic outlook demand a disciplined, selective approach – one that recognises both the opportunities that come with higher yields and the vulnerabilities that drive them.