Introduction

In April 2025, we published Why Own Fixed Income? Our Purpose-Driven Approach, arguing that fixed income is not a portfolio ballast or filler, but rather “a suite of precise and targeted tools”.  At the time, that suggested favoring short duration, senior CLO tranches, closed-end municipal funds trading at wide NAV discounts, and niche private credit with outsized return potential, while avoiding public corporate bonds at tight spreads and mainstream private credit.

The fixed income landscape has since shifted

The Fed raised rates for the first time in over 3 years in September with the dot plot indicating another increase by the December FOMC meeting. Treasury markets responded sharply, with 2-year yields reaching their highest levels since 2024. Hyperscaler issuance combined with persistent and growing deficits as we transition to a multipolar world, has pushed longer maturity Treasury yields to levels not seen in nearly 2 decades, with the 30-year reaching its highest level since 2007. The Treasury responded by announcing at least a doubling of its liquidity-support buyback operations in the 10- to 30-year maturities. While yields fell initially, a further buyback announcement was met with outright selling, with the 30-year pushing back over 5.3%. With breakeven inflation rates well behaved, the increase largely reflects rising real rates and a widening term premium.

Conversely, spreads have compressed across the major fixed income sub-categories while default rates have largely been stable.

Sources: Various, TwinFocus

While yield levels are attractive in absolute terms, we noted that “when spreads are tight, returns are generally low”. The question we asked in April 2025 remains: where are investors being adequately compensated for assuming additional duration and default risk?

CLO spreads have generally tightened with the balance of upside-to-downside risk less attractive. In April of 2025, we concluded that AAA CLOs were interesting. Since then, AAA CLO spreads have tightened materially, compressing the floating-rate coupons on new issues and increasing spread risk. While AAA CLOs are not expected to be impaired within historical default scenarios, the balance of upside-to-downside risk became less attractive, which suggested rotating AAA CLO exposure to short-term money market securities.

Sources: CFIC, Nuveen

Spreads across CLO tranches are not linear, nearly doubling from A to BBB and more than doubling from BBB to BB, as the BB spread is little changed. The caveat is that the share of downgraded BB CLOs has risen, though slowing YTD, while BBB CLO downgrades have reemerged.

Source: CIFC, Intex, Bloomberg, Nomura

In parallel, Bloomberg reports that rating agencies are poised to upgrade CLO bonds as they revise their methodologies. Moody’s is reviewing 24% of outstanding US CLOs and 52% of European CLOs rated. Fitch expects positive changes, typically 1-2 notches, on an estimated 5-15% of CLO ratings.

The agencies argue the revisions reflect realized CLO performance. The scale and timing though have revived fears of ratings inflation similar to that preceding the Global Financial Crisis when competition among rating agencies gave managers room to ratings shop. Those concerns are heightened by building stress in software and services, which accounts for ~15% of US CLO collateral.

Time will tell if the rating revisions appropriately reflect future CLO performance or whether the agencies are anchoring on the past just as underlying credit risk is turning.

Municipal bond tax equivalent yields remain attractive. The municipal yield curve is steep, providing attractive tax equivalent yields (TEY) at longer durations, while municipal balance sheets are healthy, providing opportunities in the high yield and taxable markets. The curve is steepest through 20 years where, assuming a 37% Federal rate and 3.8% Medicare Surtax, the AAA general obligation TEY is ~6.4% while the BAA GO TEY is ~8%.

Source: Bloomberg

We favor active management given the dispersion of credit risks across issues, sectors and structures.

The case for Emerging Market debt is more balanced as spreads have compressed and heightened geopolitical risks call for greater selectivity. Fiscal credibility has migrated given that emerging market credit ratings have broadly improved and developed market ratings have been lowered, as EM countries have improved their fiscal positions and benefit from stronger current account balances. Yields remain higher while EM central banks, which raised rates early and aggressively in 2021–22, are positioned to cut into positive real rates while developed markets face persistent inflation and widening deficits. EM local currency bonds also provide US dollar diversification.

While we have typically favored dollar-denominated exposure, we seek active strategies, given the broad dispersion of risk and return, with the flexibility to allocate to local currency to capture more attractive risk-adjusted yields as structural shifts raise the potential for longer-term US dollar weakness.

Treasury Inflation-Protected Securities (TIPS) have become interesting again. The real yield curve has shifted higher and flattened, lying largely above 2% with the 10-year ~2.6% and the long-end above 3%. TIPS principal is adjusted to track CPI-U while receiving the greater of the adjusted principal or face value at maturity, providing solid returns during periods of rising inflation, an otherwise challenging environment for fixed income. Broad TIPS market exposure encompasses interest rate risk, notably real rates rise faster than inflation, with a duration over 7.5 years, with short duration TIPS mitigating this risk by generally holding bonds with maturities of 5 years or less.

Source: Bloomberg

We remain wary of Private Credit beta… and continue to be selective within private credit as the bar to tie up capital in less liquid funds has risen with publicly traded BDCs marked at or near par, non-listed BDCs continuing to gate redemptions and with growing signs of strain.

Source: JF Lehman

PIMCO argues traditional default measures understate the true level of distress in direct lending. Their “shadow default” measure suggests 19% of issuers of first- and second-lien loans held by BDCs were in some form of distress as of March 2026, up from roughly 14% in 2022. Most of these events were “soft” defaults, e.g., maturity extensions, rather than outright payment failures while the level has stabilized over the last few quarters.

Over the last 3 years, first-lien syndicated loan recoveries have declined, with recoveries below 30% rising while recoveries of 90% or higher have declined, likely reflecting underlying structural changes such as declining junior debt, which traditionally absorbed losses before senior lenders, the increase in software and service business loans, reducing tangible collateral, and liability management exercises, which have weakened creditor protections.

Source: JF Lehman, Bloomberg

The point here is not that we do not like private credit. Rather we believe that structure, incentives and starting point matter. High-single to low-double-digit returns do not appear sufficient compensation for potential risk exposures. Instead, we believe opportunities where expected returns justify the risks currently exist in more focused, capital-constrained credit markets.

 With regard to public corporate bonds, as we noted in April 2025:

Even today spreads haven’t moved anywhere near historical levels. You may hear “the quality is better now” but we view this as equivalent to saying “this time it is different.”

Since then, investment grade and high yield corporate bond spreads have tightened further and are in the range where 12- and 24-month returns have historically been lower than the return to Treasuries.

Source: Federal Reserve Bank of St. Louis, Bloomberg, TwinFocus

Source: Federal Reserve Bank of St. Louis, Bloomberg, TwinFocus

Conclusion

Bonds continue to have a place in client portfolios, but the right allocation remains dynamic with credit and duration treated as risks to be managed rather than static allocations. With Treasury yields elevated, spreads tight and signs of private credit stress, we remain selective, focused on markets that provide for more attractive risk-adjusted expected returns.

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