Fixed Income Forward: January 2026

Global markets began 2026 by extending the previous year’s gains, with riskier assets and emerging markets in the spotlight. Second only to convertible bonds in terms of performance, emerging market sovereign debt and Asia high-yield beat other fixed income assets by delivering equity-like, double-digit yearly returns in US dollar terms. Local currency bonds, especially in Latin America, performed especially well thanks to currency appreciation against the dollar. So far this year, the capture of Venezuela’s president Nicolás Maduro by US forces has not disrupted but rather sustained and extended the emerging market rally.

The US dollar did benefit from some flight-to-safety support in the immediate aftermath of events in Venezuela. Nonetheless, we maintain a relatively weaker US dollar bias in 2026, believing that US interest rates have more room to compress relative to the rest of the world. Several high-carry emerging market currencies, such as the Brazilian real, still look attractive due to high real interest rates. Our constructive view on currencies extends to Asia, and in particular to trade-surplus and tech-heavy economies such as South Korea, which benefits from the artificial intelligence (AI) investment theme and a relative easing of international trade tariff concerns.

Credit spreads ended 2025 at near cyclical lows, thanks to investors’ strong appetite for yield products. We expect “search for yield” behaviour to continue in 2026, as a relatively neutral to dovish outlook for core rates could help reallocate trillions currently sitting in money market funds. While spreads are indeed tight and starting yields for most credit markets are lower than at the start of 2025, we believe these yields remain decent compared to cash and are a better indicator for forward returns than spreads alone. That said, we see earnings diverging as changing policies and regulations affect industries and companies differently across sectors and regions. For example, energy and financials are poised to benefit from deregulation, while low-end consumers and sectors that rely on rising input prices could struggle.

Global high-yield bond returns were mainly driven by carry and duration return in 2025 – and boosted by exposure to emerging markets and Asia. Our calls to underweight CCC-rated bonds and overweight BBs paid off, particularly towards the end of the year. Throughout last year’s turbulence, high-yield credit has shown more resilience than equities thanks to low defaults and high carry – a trend we expect to continue. Spreads are indeed tight, but we believe such rich valuations are partially justifiable by stronger credit fundamentals compared with previous cycles and an overall higher-quality investment universe. We monitor developments in private credit but so far see limited systemic risk and consider that greater vigilance in underwriting can offer an opportunity for credit differentiation and outperformance. We think strategic allocation to emerging market and Asia high-yield corporates can continue to offer diversification and compelling return potential.

In technology, we think the AI investment theme will require bond markets to play a bigger role, with fixed income serving as both an enabler and diversifier. The investment-grade credit market will be essential in funding AI capital expenditure needs, even as this same expansion fuels a greater concentration of risk – as in previous cycles, we expect the high-yield market to follow suit. We believe bond investors should look past the extremes of greed and fear, and approach the sector as they would any other – by diligently watching balance sheets, credit metrics and funding conditions.

Overall, we think the range of possible macro outcomes has narrowed. The probability of a sharp slowdown in growth, or a sharp rise in inflation, is in our view lower than a year ago. With most central banks closer to their neutral rates, a shift from incremental monetary easing towards policies focused on fiscal spending should keep financial conditions accommodative. That said, geopolitical risk seems to be on the rise, which we think highlights the importance of core rates to strengthen portfolio foundations. If the broadly neutral outlook were to be disrupted, we would expect core rates, particularly US duration, to behave as a hedge for risk assets and to provide liquidity during times of stress. While we prefer the front end and belly of the yield curve for now, we would not write off the long end just yet, despite concerns for fiscal sustainability. To summarise, we think the current environment calls for: globalising core rates exposure to capture divergent regional cycles; a broad toolkit for taking duration risks with curve positioning and relative value positioning; and an active and nimble approach as the rate environment evolves.

1. Latin America - Following its intervention in Venezuela, the US has issued warnings to other non-aligned South American states including Cuba, Nicaragua and Colombia. Brazil and even Mexico could be targeted too. In a positive scenario, a smooth transition of power in Venezuela could restore the country’s access to bond markets and fuel further credit spread compression in the region.
2. Credit defaults - Global high yield defaults at end-September stood at 1.4%, largely from CCC-rated credits. For 2026, we estimate a default rate of around 2%, again driven by CCCs. This compares with a long-term average of 4.5%. The default landscape has improved due to higher average credit quality, weaker issuers being served by private credit, and active creditors staving off imminent defaults with pre-emptive restructuring.
3. Inflation diverges- December’s inflation data from Germany and France suggest a downside inflation surprise in the euro area. In contrast, November’s weaker US inflation reading may have been biased to the downside due to missing data from the government shutdown. Final readings for December will provide further clues on how inflation is diverging from central banks’ targets.