When economic uncertainty and volatility spike as has been the case this year, investors often rely on fixed income to be a ballast for their overall investment portfolio. Given the vacillating news on tariffs, the confusing economic data, and questions about monetary and fiscal policy, we continue to see fixed income playing an invaluable role for most investor portfolios.

As always, however, the devil is in the details. Allocating to a passive strategy that tracks one of the predominant fixed income indexes is one popular approach, though we think that might expose investors to unwanted risk. Passive funds are inherently less flexible than active strategies, given that they simply track their benchmark. They go where the index goes, without the ability to shift based on relative valuations or the dynamic nature of the economic data. In contrast, we believe that active fixed income management can strategically allocate across asset types to better manage risk and (potentially) improve income opportunities in changing market environments.

Cracks in Credit?

Does the ability to actively manage a portfolio really matter? In our opinion, perhaps now more than ever. Consider the state of the fixed income markets as we look toward the fourth quarter and beyond. There are meaningful differences among the various sub-asset classes, and having the ability to skew a portfolio toward and away from certain bond types can go a long way in determining performance. Take, for example, the notion that credit markets appear priced for perfection. Corporate credit spreads—which are typically defined as the difference in yield between corporate bonds and Treasuries with similar maturities—are very tight. In fact, our research suggests that these spreads were recently at some of the lowest levels seen over the last 25 years. Historically, when credits spreads have been in this range, corporate bonds have underperformed relative to similar duration Treasuries. This is the cornerstone of our current defensive view on corporate credit. Of course, outliers always exist, and that’s where fundamental analysis should be able to help with security selection. But on the whole, our investment team is defensively positioned regarding credit risk at present.

It's important to mention, however, that the views on credit (and all the asset classes) are dynamic. Credit spreads can widen quickly depending on a host of external factors. This occurred in the spring, and if/when it happens again our investment teams aim to position opportunistically. Again, this is one perceived advantage of an active approach to fixed income. 

Our cautious view with regard to credit spreads does not color our broader view on the entire fixed income asset class. To the contrary, we remain positive on the outlook for fixed income, thanks in part to elevated Treasury yields. New allocations to fixed income may be able to take advantage of today’s higher starting yields across fixed income, which we think is one of the most important factors in determining longer-term returns. Moreover, fixed income valuations appear attractive relative to equities, as the yield on a 10-year Treasury note as of mid-August was approximately 4.3%, exceeding the dividend yield of the S&P 500.

Areas of Interest

If we are cautious on credit but constructive on fixed income as a whole, what are some areas that look appealing? Here are three ideas:

1. We expect Asset-Backed Securities (ABS) to outperform in the second half of 2025. The gap between ABS and short corporate bond spreads has narrowed but remains wide relative to history, according to our research. The Auto ABS market has robust structures that have been able to withstand severe recessions like the Global Financial Crisis (GFC) and Covid, and we have confidence that these structures can also withstand any tariff-related pressures. ABS structures have the added benefit of de-leveraging over time, which makes ABS a potentially sound defensive play and could result in predictable upgrades as deals season.
2. As we head deeper into the second half of 2025, we also think Agency Mortgage-Backed Securities (MBS) have the potential to outperform. MBS spreads have been volatile but remain historically wide versus corporates. The supply/demand picture for the second half of 2025 points to flat to marginal MBS spread tightening, in our view. However, Federal Reserve rate cuts, interest rate volatility, and the finalization of new bank capital rules will all be factors to watch in the second half of 2025.
3. Municipal Bonds are another area of intrigue. Starting yields for municipal bonds, which we view as a good predictor of long-term returns, remain high. Although these elevated yields have declined slightly since their peak in recent years, they continue to offer an attractive entry point for investors, in our view, particularly on a taxable-equivalent basis. As of August 1, 2025, the yield on the Bloomberg Municipal Bond Index was approximately 4.0%, which is a taxable-equivalent yield of 6.7% (in the highest tax bracket). This compares quite favorably to the 4.6% yield of the Bloomberg U.S. Aggregate Bond Index (taxable). Despite some expected volatility, we expect municipal credit quality to remain relatively strong. Between elevated yields, strong credit quality and low defaults rates, we continue to view municipal bonds as a solid option for portfolio diversification.

Stay the Course

As we’ve outlined, uncertainty remains elevated on many levels, and the shifts in trade and fiscal policy are causing bouts of volatility, particularly for risk assets. Because this environment looks to endure in the near-to-medium term, we think that many investment portfolios might benefit from additional diversification into fixed income. Although we remain defensively positioned regarding credit risk, we maintain a positive outlook for fixed income and think it can be a helpful tonic to offset today’s strange days.