Market Views on Fixed Income | Insight Investment

Harvey Bradley: Good morning everyone. Now turning our focus to the key fixed income market views that we have as a house as we move into 2026. In the face of deteriorating longer term fiscal dynamics that Adrian spoke to and the ongoing erosion of the US dollars structural support that Francesca's talked about. There are two key questions for the US treasury market. Firstly, do they still play the same role in global financial markets? And secondly, if current market dynamics continue, who will buy the ever-growing stock of them?

US treasuries at times of broader market stress will likely still play their role as the global risk-free asset, but investors are increasingly looking for alternatives and there is of course a key exception. What if the cause of market stress is the US administration or treasury market itself? A key tail risk for financial markets this year is that long dated US treasuries might break out of the preexisting range and move towards yield levels not seen since the 1990s.

On the chart, we show the foreign holders of US treasuries since 2008. Now China has been gradually running down their exposures since around 2014. A trend that seems unlikely to reverse. Japan has been holding exposures steady since 2020, but with the yields now at multi-decade or record highs in the domestic market, you might expect further repatriation and for that number to start to fall. So who's been offsetting this? It's been the Eurozone and the UK over the last decade, but with current geopolitical risks, who's to say that's going to continue? Now we are privileged to have a deep and global client base with official institutions.

Reserve managers whose patterns change in years and cycles, not days and weeks. And they're all asking themselves these questions and the direction of travel is clear.

It's not a speedy exit from all US assets, but at the very least it's diversifying away from what is typically the most significant currency and market exposures that these investors have given the growing risks.

So what can a debt office do about this If the supply needs keep rising but the demand side of the equation is not as healthy as one might like? Now you can reduce the net duration you supply to the market. And as you can clearly see on from the left hand chart, this is what the US Treasury have been doing in recent years. T bill issuance has risen significantly since 2015, whilst broader bond issuance has been stable. Another key reason why perhaps President Trump would like lower rates that direct feed through to financing costs. And on the right hand chart you can see the impact of this. Slowly the average debt maturity is coming down, but this follows a decade of terming out your debt risk in the low or zero interest rate world, which is firmly behind us. And your cost of financing longer dated debt has of course risen as well. Another reason to bring issuance shorter and it's worth noting this theme is not just a US one. We see the same patterns in the UK, Australia, the Eurozone, and across most developed markets, but there's no free lunch of course. Debt offers is simply increasing refinancing risk and there's no guarantee that short rate levels will stay at these levels or lower as we go through the next cycle.

So what do we expect for central banks in 2026? We are at an interesting inflection point as Francesca highlighted, whereby we have markets pricing rate cuts in a number of developed market economies, those in light green but rate hikes in those in dark green with one or two hikes priced in the likes of New Zealand, Japan, and Australia. For us, we do expect one or two rate cuts in the US and UK. Why? inflation close enough to targets and things like the labor market continuing to gradually soften with a tail risk for more in the US if the politicization of the Fed becomes a reality. However, we do think it's a little too soon to be pricing the turn in the cycle in places like Sweden and Australia. Given the underlying economic dynamics, Japan, the outlier that Adrian highlighted, they are behind the curve, they should be raising rates faster and they'll continue to do so this year.

So when it comes to duration, as Adrian highlighted, no high conviction directional call for us with central banks largely out to play for 2026 and structural forces continuing to build term premium in longer dated maturities, we expect this range trading environment we've been in really since the end of 2023 to persist. So for us in active strategies, that means opportunistically entering overweight and underweight duration positions on a tactical basis.

The key will likely be reacting quickly as and when some of the lower probability risk events play out and take us out of this trading dynamic.

And whilst we don't see significant direction opportunities in rates markets at this juncture, we do see a ripe environment for relative value risk taking and starting with yield curve shapes. We do believe the path of lease resistance is to further steepening central bank dynamics keep the front end of the curve while anchored, but it's a very different story at the long end and where those risks are greatest and the imbalances are most prominent as highlighted in the US. So we favor continuing to run with yield curve steepness in this market.

However, we do favor relative flattening to the US in places like Japan and the UK.

For the UK there remains more term premium than the US but arguably the fiscal risks are now in the price and on a relative value basis to the US the fiscal dynamics don't look quite as bad. And as for Japan, the curve is already exceptionally steep. Bank of Japan rate hikes and repatriation flows of capital back into the domestic bond market should both help the yield curve to flatten in due course at the very least on a relative basis, moving to different markets by currency. There's a couple of things we can look to do here. So we might look to identify outliers who we think on a fundamental basis don't justify that outlier stasis. On the left hand chart you can see the implied terminal rate embedded within interest rate markets. We use the five year five year rate as a proxy. That is the five year yield priced into markets in five year time.

Here you can see Australia is something of an outlier with the terminal rate implied a hundred basis points or more relative to most developed market peers. And whilst we think a slightly higher terminal rate due to higher potential growth and a higher inflation target may be justified, you're talking about 25 to 50 basis points, not north of a hundred. So to us this is a market you want to be overweight relative to other developed markets on a relative value basis. And on the right hand side, we show 30 year government bond yields hedged back into sterling, the two allies here, Japan and New Zealand at a premium of a hundred basis points over peers. We do think this is the clear catalyst for Japanese repatriation to pick up as we've mentioned a couple of times after 30 years of net overseas buying. So this is likely to have ramifications for other global bond markets as well.

A notable thing to watch perhaps would be a domestic bellwether changing their asset allocation policy, someone like the GPIF that other domestic investors typically follow. And whilst an accelerated rate of Bank of Japan policy rate hikes might start to erode this head shield pickup, that should then help to start flatten the curve, which would help our view within that market.

Moving now to the Eurozone and looking at France, Italy is now trading through France something that would've seemed fanciful 10 years ago.

And whilst French spreads have started the year on the front foot with political and budget risk receding, in our view this is very much temporary in nature.

The structural direction for poor debt dynamics in France will ultimately lead to more ratings. Downgrades and political risk will rise as we approach the presidential election in 2027. The key message here from us stay underweight and look for opportunities to increase. This is the year goes on. The asymmetric payoff profile in spreads is pretty clear from the chart. We're at relatively expensive levels and looking at where Italy has traded relative to Germany over the past 15 years gives you some idea where French spreads could get to if these risk events come back to the market's focus.

And finally, in terms of our high conviction, relative value views US inflation linked assets 30 year US real yields are at 2.6%. They've rarely been higher. And in an environment where we have elevated macroeconomic and geopolitical risk and environment where inflation is running a little above central bank targets, fiscal policy remains loose and global trade friction and commodity prices are surging. We think investors should, if anything be demanding a premium for real return certainty and they simply aren't. We think 30 year tips are an attractive asset either on an outright basis or relative to other markets.

So the question becomes which expression or combination of those views is best.

US breakevens are implying an inflation rate over the long term, a roundabout or just below the implied federal reserve target. So they look attractive there. But perhaps more compelling is on a relative value basis to UK inflation. We have 30 year inflation swaps shown on the right hand chart in the UK you're still pricing an above central bank target inflation period in perpetuity and is a market where perhaps structural demand for inflation protection faces some headwinds through time.

With that, I'll pass over to Adam, who will talk us through some of the key credit market views and themes in 2026.

Adam Whiteley: Great, thanks Harvey. Our central case of trend growth falling inflation and like the easier policy should create a supportive environment for risk assets and by extension credit spreads. But we also need to look at what's in the price. And on the chart here we can see that spreads are close to 20 year lows. And whilst we can justify that in our central case, there's no margin for error and at least to our directional view on credit to be very close to home.

But if we change our frame of reference and look on the right hand chart here and look at yields whilst they've fallen, they're still very close to 20 year highs. And that leads to a question we're getting a lot from clients. Spreads low yields are high, what to do? And in our view, there are two key answers to that.

The first is keep it simple, stay invested, capture the income, shorten duration, build resilience. On the left hand chart, we're showing investment grade yields and where the dark green area is, the sub five year component, you can capture 90% of the income but with less than half the volatility.

And whilst it's fair to say that a lot of the heavy lifting there on yield is being done by the government yield curve on the right hand chart, if we look at credit spread curves, they're very flat. You're barely getting any extra compensation for lending for three years compared to 30 years. In fact, it's about 30 basis points. And that makes no sense because the visibility over the next three years and our ability to forecast is much greater than it is over 30 years. And that's even more relevant in the markets like high yield where the default rates are very real.

What's the second answer? To improve resiliency? It's to add flexibility. Why is that relevant? Not all risk Premier are priced equally within credits. There are six different types of risk. Premier, we've got systemic risk premium, that's investment grade subordination risk premier, that's the capital instruments issued by investment grade companies. Default risk premier, that's high yield country risk premiers, emerging markets and complexity risk premiers asset backed that Shahir will expand on later. And what we can see from the chart here is that it's the investment grade risk premiers that are most expensive.

Here we're looking at on the horizontal axis, a percentile using 10 years of history. The vertical axis is our measure of the current level. So whether it's systemic or subordination, IG risk factors most expensive, there's much better value in country risk, premium and complexity risk premium. And for em it's about tailwinds. Em we think can outperform because of the good growth environment. A weaker dollar as Francesca touched on, but also the drive to diversify against US assets for complexity. Risk premium for asset-backed is about not having headwinds, not having to worry about being exposed to political risks, not having to worry about lingering concerns on the health of the corporate sector.

The sixth are premiums illiquidity, and that's where private credit plays a role. And we can see on the left hand chart here that's been getting compressed to over the last 10 years. And whilst that's still very much worth owning as an investor at these levels, you need to be very specific around which assets and which managers you select.

But what we saw last year is that the equity market is beginning to sniff out if there's a problem within private credit and we're showing on the uh, the right hand chart here, share prices of the BDCs or the business development companies versus the broader US market. And something changed. The equity market is concerned about these BDCs who are companies that extend private credits to small and medium enterprises. And the equity market's concerned for two reasons. If you've got lower rates, lower spreads, that means lower dividend income. But there's also a concern over the quality of the underlying borrowers because of some of the headlines that you will have seen last year.

And if the market's right then where should we be looking if these risks becoming more systemic? The obvious place to start is the insurance sector where the chart here is showing for the US insurers at a system level, their allocation to private bonds, which is now nearly half of their overall bond allocation. I should caveat that's not just high yield private credit, that's private IG private asset two, but over the periods of the last 12 months, the equity market's also become concerned and is pricing in risks around that concentration?

Is the equity market right to be concerned? Probably not. If we look at the chart on the right here, we can look at defaults for direct lending as well as the loan markets and you can see that they've been stabilizing. And in that central case, whilst there are risks around it, the central case of stable growth, lower rates, default rates are probably not gonna see any upward pressure. And this is creating security selection and sector strategy opportunities for us in the bonds that are being issued by the BDCs as well as the insurers.

The story for tomorrow may well be is AI a bubble. The story for today is the enormous CapEx that's being spent to enable the AI revolution. Something that Adrian touched on earlier and on forward looking projections. This is expected to be nearly 2% per annum of US GDP. That's providing an enormous tailwind for growth, but it's not obvious. It's boosting the labor market and that's coming back to that unstable equilibrium which markets for the time being are happy to ignore.

Last year AI came to the credit market. We had an explosion of issuance from the big companies undertaking this CapEx to help their funding needs. And what that's done is remove the rarity value from these companies that used to be very sporadic issuers creating security selection opportunities.

The numbers we're talking about here are enormous. We can all make assumptions around what the CapEx will be over the next five years. We are penciling in something like a $5 trillion figure. But these companies have got different levers to pull to finance that they can use private credit, they can use secured finance, they can use public bond markets as well as their own cash flow generation. And if we think that maybe 10% comes from public new issuance, public bond markets, the matters are complicated, that's $500 billion over the next five years. And that would nearly double the weight that this tech segment has within global bond indices becoming something close to 10%.

In contrast to the.com bubble, the companies that are undertaking this investment today have got very established, very profitable existing businesses. And if we were to project forward over the next five years, expectations for their cashflow generation in the dark green cashflow from operations. But then if we knock off shareholder returns, we knock off capital expenditure for the most, but not all, you still have a like green bar that's positive or they end up with free cashflow. That spare after undertaking all of that CapEx again reinforcing. There'll be winners, there'll be losers, there's opportunities, there's risks, creating the security selection opportunities for the analyst team.

Bring it all together. What's the view? Harvey talked about An overall duration environment that we expect to be tactical one year ahead. For 10 year treasuries. We're expecting 4.1% for gilts. That's 4.5% cross market. As much as these are global themes, as we've seen already, they're not all priced the same. Favoring overweights in governments like Australia relative to the US as well as Germany versus Sweden within yield curve shape, the core view is a steeper US yield curve. Front end's gonna be much more sensitive to the expected rate cuts. It's the long end that will feel the lingering concerns on fiscal policy and any requirements for term premium to increase. But those risks aren't priced the same across regions. Relatively speaking, much more value at the long end in the UK as well as Japan. And within inflation, there's some good trades to be looking at here too. Overweight US inflation expectations both outright and relative to Europe and the UK and our other macro decisions. Agency mortgage backed securities have become exceptionally expensive after recent intervention by US politicians. And on the currency side, we favor longs in the Euro Norwegian kroner, but an underweight in the US dollar and the Swedish kroner. Turning to credit in terms of the beta management or directional view, it's a positive cycle backdrop, expensive valuations leading to a more neutral posture for overall debt directionality. And then on the macro credit, rv, EM'S attractive asset backs appealing to try and capture that cheaper risk premier on the country and the complexity side. And as we move more bottom up in sector strategy, it's finding the opportunities from the CR private credit spillovers either in the BDCs or to some extent in the insurance sector. And within security selection, the focus is all on the CapEx funding, the winners and the losers.