Fixed Income Asset Allocation Insights: Positioning for Volatility After the Post-April Rally

Credit markets have rallied strongly since late April, following the rapid market selloff after the Trump Administration’s 2 April tariff announcements. Total returns have now turned positive across most credit assets, and spreads have broadly snapped back to where they started the year.

Despite fear surrounding the ultimate impact of tariffs and policy uncertainty from the US, the economy has largely remained in good shape, and the labor market has been resilient. In May, the change in non-farm payrolls was better than expected at 139,000, and the unemployment rate was steady at 4.2%. Inflation in May was also better than anticipated, with the Consumer Price Index (CPI) increasing just 0.1% for the month. Consumer confidence, as measured by the University of Michigan survey, was much more positive than expected in June, with a reading of 60.5, compared to market expectations of 53.6. While the Federal Reserve remained on hold at its June meeting and continued to preach patience before cutting rates further, the window looks to be opening for the Fed to act in the back half of the year.

While the economy has remained resilient, we have seen some weakening trends. Initial claims remained near six-month highs, although this is partly driven by seasonality. Continuing claims have reached the highest levels since late 2021, suggesting it’s harder to find jobs for unemployed individuals. We also see a number of downside risks, including heightened geopolitical tensions, uncertainty around tariffs and trade policy, and a potential uptick in inflation resulting from the trade policies already enacted. Higher-for-longer interest rates could also hit corporate fundamentals, and a rise in the fiscal deficit if the new tax bill is passed could divert more federal funds away from productive fiscal programs and toward the rising interest burden.

For now, these risks are still primarily on the horizon, and we remain constructive on credit metrics overall as we wait for the scenarios to play out. Based on current economic data, our base case is for a slowdown but no recession. Issuer fundamentals remain strong. Earnings are moderating but aren’t falling off a cliff, so corporate balance sheets are positioned to withstand a moderate downturn. However, as markets have rallied since the turbulence in April, valuations for many credit assets appear rich. Ultimately, we are taking a more neutral stance in portfolios given a sanguine economic backdrop paired with tight credit spreads. We expect additional bouts of volatility during the second half of the year and favor maintaining the ability to shift further into lower-rated assets during periods of market weakness.

Our Asset Class Outlooks

Investment Grade Credit The first quarter’s earnings suggested that fundamentals remain stable for US corporates, with some areas of weakness within cyclicals. Amid the renewed optimism, valuations have retraced much of their widening. We expect spreads to remain in a range for much of this year, likely supported by attractive all-in yields. We will continue to view any widening of spreads as a buying opportunity. However, a measured approach is warranted.

Securitized Products April volatility has settled down, and we believe mortgage-backed securities (MBS) investors can feel more confident buying. MBS spreads are set up to tighten as volatility falls. The most recent data on money manager weightings shows a continued overweight to MBS. Overall, we remain bullish for the long term.

Leveraged Finance Fundamentals for leveraged finance issuers remain robust. More companies are beating than missing estimates thus far in the earnings season, with help from a supportive pre-tariff stocking trend. However, more companies are now guiding down than guiding up, which is consistent with heightened trade uncertainty. As recession concerns abate, the credit market has erased nearly all its year-to-date weakness. We expect further spread compression and believe all leveraged finance asset classes have upside potential under these conditions. Following recent spread tightening, we maintain a neutral stance in portfolios on overall risk positioning but maintain our key convictions from an issuer and security selection standpoint.

Emerging Markets Domestic macro environments are favorable for most emerging markets, and we expect sovereign credit metrics to improve throughout 2025. EM economic data remain robust. Domestic conditions in most countries still support policy easing. Overall, high carry and robust fundamentals should support EM assets. EM corporate fundamentals also remain robust and are expected to be resilient in the face of Trump’s policies. Valuations look fair, and we expect the technical picture to remain supportive.

Non-US-Dollar Currency We are gradually turning neutral on the US dollar. The dollar has been correcting in recent months amid a change in market perceptions of US exceptionalism. Portfolio flows and technical factors appear to have gained more power in determining the US dollar’s direction in the short term. While the US dollar trades cheap to its rate differential with Germany, other factors, such as the USD’s long-term valuations, increasing FX hedging ratios, and the dollar’s temporary loss of safe-haven appeal, suggest the USD could remain misaligned with rate differentials for a while.

Segment Snapshots

Using our independent analysis and research, organized by our fundamentals, valuations, and technicals framework, we take the pulse of each segment of the global fixed income market.

Investment Grade Credit

US Dollar Investment Grade Credit

Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income

FundamentalsFundamentals remain firm, with good balance sheet strength and leverage metrics. While tariffs remain uncertain, there is optimism surrounding a resolution at lower levels. An extension of the 2017 tax cuts is also expected.

ValuationsCredit spreads have rallied back through April’s widening. All-in yields remain attractive to investors, notably at the long end as the curve has steepened. Select credits continue to offer good value, and new-issue concessions have recently increased.

TechnicalsNevertheless, negative broker/dealer inventories of greater than five years and the search for quality credit continues to support tighter credit spreads. Lower net issuance in 2025 when adjusting for the reinvestment of coupons is supportive of favorable technical conditions. Greater adoption of ETFs has improved liquidity in stressed periods.

Non-US-Dollar Investment Grade Credit

Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit

FundamentalsNeutral. Companies in general continue to post decent results while balance sheets remain healthy and M&A activity remains low. Management teams, however, are providing cautious outlooks, citing limited visibility into future sales and margins as the economic outlook remains uncertain.

ValuationsNeutral. We view credit spreads as close to fair value and expect the index to trade within a range in the coming weeks and months. We see a low probability of a large index move in either direction. For that reason, sector and security selection will be the key to potential outperformance.

TechnicalsPositive. Flows into euro corporates have been strong for the past 12 months, while supply has been well absorbed despite trending higher than in previous years. Investors continue to be better buyers of credit, and new issues perform well.

Securitized Products

Andrew Budres, Portfolio Manager, Securitized Products

FundamentalsWhile new-production MBS is evidencing very high negative convexity, the backdrop for prepayments is low. Rates seem sticky at higher levels, and home price appreciation has slowed.

ValuationsThe spread difference between MBS and investment grade (IG) corporate bonds stands at 1.8 standard deviations – cheap relative to a historical 10-year look-back.

TechnicalsTrump’s social media posts about the future of the government-sponsored enterprises (GSEs) help remove a nagging long-term issue from the market, although MBS never really priced in a massive disruption by the GSEs.

Leveraged Finance

John Yovanovic, CFA, Head of High Yield Portfolio Management

FundamentalsLast-12-month (LTM) par-weighted default rates increased slightly month over month to 1.33%/0.43% (with and without distressed exchanges). The par-weighted upgrade/downgrade ratio stabilized in May at 1.05 (1.13 by issuer) versus 1.34 (1.00 by issuer) year to date. First-quarter earnings season has concluded: revenue is +1.4% year-over-year, and EBITDA is +0.7%; the beat-to-miss ratio is 2.1x; and average leverage is up slightly, to 4.08x.

ValuationsUS high yield (HY) option-adjusted spread (OAS) stands at 308 (BB, 183; B, 295; CCC, 716), which is 9 basis points wider month over month, while yield to worst (YTW) is flat at 7.42%. Spreads have settled into the 300-325 range over the past month as tariff-induced volatility from April has abated. At current spreads, the market is once again pricing in something between a continuation of growth and a modest slowdown, with little room for error. The spread-to-maturity for the Morningstar US Leveraged Loan Index continued to tighten, hitting S+406 on 13 June versus S+413 on 23 May, due in part to a recovering economic outlook and supportive technicals.

TechnicalsUS HY new issuance bounced back strongly in May following a weak April. Issuance was balanced between the BB and B tiers, and we are still seeing very little CCC issuance. Fund flows were decidedly positive in May. Net loan supply should continue to improve with a low but steady supply of M&A and LBO transactions. However, primary market volumes will be increasingly dominated by refinancings and repricings if current conditions hold and the percentage of the market trading above par trends higher. In terms of demand, narrower CLO liability spreads will continue to improve.

Emerging Markets

Sovereigns

Sam McDonald, Sovereign Analyst, Emerging Markets Fixed Income

FundamentalsEM growth trends are structurally strong, supported by increasing fiscal discipline and reform momentum. The external picture is allowing for robust current account surpluses, combined with increasing remittance and foreign direct investment and portfolio investment (FDI/FPI) flows – enhancing levels of FX reserves. Risks to oil/commodity names were increasing, but EMs are going into this period with stronger fundamentals. Political and geopolitical risks remain high.

ValuationsSpreads have tightened past “Liberation Day” levels following the tariff de-escalation. At 321, the EMBI is 8 bps tighter month over month and 3 bps tighter year-to-date. EMBI HY spreads tightened by 10 bps month over month, while IG spreads are 5 bps tighter.

Technicals2025 issuance expectations have been revised down moderately to $195 billion but are still close to 2024 levels, when EM sovereigns issued around $184 billion. The net supply is projected at $96 billion, which aligns with 2024 levels. Issuance continues to undershoot the expected monthly averages, following front-loading seen earlier in the year. June and July are particularly strong for returning cash flows. Year-to-date fund flows remain negative.

Corporates

Kim Keong, Trader, Emerging Markets Fixed Income

FundamentalsEarnings in the first-quarter results season have broadly met expectations thus far, with a tilt toward positive surprises. Expectations for 2025 remain robust, with revenue and EBITDA growth projected at +5% and 11%, respectively. In terms of sectors, consumer, utilities, and technology/media/telecommunications (TMT) are expected to deliver growth, while the industrial and metals and mining sectors may see some divergence within their respective segments. Key takeaways from the BofA and J.P. Morgan conference on EM corporates suggest that the fundamental picture remains resilient and that leverage levels should remain stable.

ValuationsOver the past month, the CEMBI BD spread to worst tightened by 3 bps, with HY (+2 bps) underperforming IG (-2 bps). In IG, CEEMEA (+9 bps) lagged Asia (-7 bps) and LatAm (-6 bps), while in HY, Asia (+34 bps) lagged CEEMEA (+2 bps) and LatAm (-9 bps). In terms of countries in the IG space, the outperformers were Kazakhstan, Macau, Thailand, Brazil, and Mexico. The laggards were Israel, Nigeria, Kuwait, Qatar, and UAE. In HY, the outperformers have been Nigeria, Ghana, Brazil, South Africa, and Panama, and the laggards were Hong Kong, Ukraine, China, the Philippines, and Israel. The spillover from the Israel/Iran escalation has been limited. Compared to developed markets, EM IG corporates lagged by +5 bps and EM HY corporates outperformed by -7 bps.

TechnicalsPrimary activity saw the busiest May since 2013, with $44 billion of deals priced. The scheduled and unscheduled cash flows totalled $37 billion, resulting in net financing of +$7 billion. Most of the issuance came from MENA, Asia, and Argentina, with continued strong interest among EM and crossover investors. June is typically both a high issuance and high cash flow month, so we expect net financing to be more balanced. However, given the escalation in the Middle East, we issuance could fall short of expectations.

Non-US-Dollar Currency

Anders Faergemann, Senior Portfolio Manager, Emerging Markets Fixed Income

FundamentalsWhile we acknowledge that the US brand has faded slightly, underlying support remains intact, considering the AI and productivity outlook. Markets have absorbed the tariff and trade shocks and seem to be adjusting to the US fiscal situation, signaling a desire to add carry once volatility surrounding geopolitical tensions subsides.

ValuationsWe kept our 12-month EUR/USD forecast at 1.1500. The US dollar remains overvalued on a real effective exchange basis, and the US’ twin deficit is weighing on the currency. We maintained our 12-month USD/JPY forecast at 140.00 to reflect the weaker US dollar and the temporary loss of its safe-haven appeal.

TechnicalsAccording to J.P. Morgan as of 15 June, the USD remained clearly short going into the Fed meeting. Increased geopolitical risks stemming from conflicts in the Middle East led to more de-risking than outright USD buying.