Don’t bet against bonds

Despite pervasive early‑year pessimism, US fixed income posted solid performance across most sectors, aided by attractive starting yields, contained inflation, a less-dire-than-feared fiscal outlook and the Federal Reserve’s first interest rate cut of the year.
We have mentioned many times previously that the starting point in yields significantly matters to prospective returns, and the year-to-date performance of the US fixed income market continues to prove this point. The Bloomberg US Aggregate Bond Index returned 6.13%, and the various sector-specific indices all posted similarly respectable returns (Figure 1), as of September 30, 2025.

Figure 1: Year-to-date returns strong across most sectors of the bond market

Source: Bloomberg as of 9/30/25. Past performance is no guarantee of future results and may not be repeated.

These strong and steady returns were mostly driven by the income earned from high coupons but were further supported by the price gains realized from lower Treasury rates and tighter credit and mortgage-backed securities (MBS) spreads. Even with the impressive returns experienced so far, US fixed income yields are still attractive relative to their history, generally ranking close to the top quartile across various sectors and past time periods (Figure 2). Bonds’ additional value also becomes clear when one considers the euphoric investor sentiment toward public equities and private assets because bonds can act as a liquid ballast against the potentially large swings in those markets.

Figure 2: Bond sector yields ranked by percentile over the past 10 and 20 years (100th percentile most attractive)

Source: LSEG DataStream, ICE BofA, as of 9/30/25. Indices used: Bloomberg US Aggregate Index, Bloomberg US Treasury Index, Bloomberg US Long Treasury Index, Bloomberg Securitized Index, Bloomberg Municipal Index, Bloomberg US Corporate Index, ICE BofA US Corporate 1-3 Year Index, Bloomberg US Long Corporate Index and Bloomberg US High Yield Index. Past performance is no guarantee of future results and may not be repeated.

Benign economic conditions should persist, supporting fixed income performance

The US economy continues to demonstrate a remarkable ability to absorb shocks. The dire projections that circulated in the weeks following “Liberation Day,” when new tariffs were announced by the Trump Administration, have simply not materialized. Many analysts had anticipated a sharp slowdown in consumer demand, a deterioration in corporate profit margins, and a re-acceleration of inflation. Instead, the economy has settled into a benign mid-cycle environment where growth is moderating from last year’s elevated pace, but the expansion remains intact, inflation is trending toward a range in the Federal Reserve’s (Fed’s) comfort zone, and the labor market is adjusting in a measured way. For fixed income investors, this combination of slower growth without a sharp contraction and contained inflation has historically provided fertile ground for strong total returns.

One of the key surprises of 2025 has been how limited the inflation pass-through from tariffs has been so far. While these tariffs initially raised concerns of an inflationary shock, companies have absorbed more of the price pressure than they did in the past. They have done so through productivity gains and their acceptance of lower profit margins, thereby passing on less of the increased cost to consumers (Figure 3).

Figure 3: Companies are helping to absorb the cost of the recent tariffs

Estimated share of tariff cost (%)

Source: J.P. Morgan Private Bank, Goldman Sachs, US Federal Reserve, as of 6/30/25

Additionally, housing inflation, which is one of the larger components of the core Consumer Price Index (CPI), continues to fall from its peak in mid-2023 (Figure 4). As a result, core inflation has continued to trend towards the 2.0%-3.0% range, giving the Fed room to initiate further rate cuts without reigniting inflation risks.

Figure 4: Housing inflation continues to fall

Owners’ equivalent rent year-over-year (%)

Sources: Schroders, LSEG DataStream. Economic indicators and related trends should not be solely relied upon to predict future outcomes.

At the same time, the fiscal impulse from the One Big Beautiful Bill Act (OBBBA) is helping cushion the economy from softer private sector demand. The immediate expensing of capital expenditures and increased federal investment commitments will likely offset much of the drag from higher prices and weaker manufacturing sentiment. This combination of pro-investment tax incentives and targeted public spending ensures that nominal gross domestic product (GDP) growth remains sufficient to stabilize debt dynamics and sustain labor demand. Importantly, the OBBBA stimulus has been more supply-side oriented than previous federal spending programs. It aims to deliver productivity growth through innovation and reshoring, which seek to increase capacity. The legislation is thereby less inflationary and more compatible with the Fed’s easing bias. The current US presidential administration’s broader deregulatory agenda adds another tailwind to the near-term growth outlook. By reducing regulatory scrutiny, compliance costs and accelerating project approvals, these policies could amplify the effectiveness of the OBBBA’s investment incentives, and that could have positive growth implications for the economy, even beyond the artificial intelligence boom.

Tariff revenues have quietly become a meaningful fiscal offset. Monthly customs duties have climbed to roughly $30 billion, with the indication that they will reach $300 billion or more in annualized revenue (Figure 5). This impact has been discounted by markets, but it is becoming a major contributor to deficit improvement. These inflows help counterbalance the rise in discretionary spending from the OBBBA and could help stabilize projected budget deficits. Even if parts of the tariff regime face legal challenges, alternative tools under existing trade acts would likely provide sufficient flexibility to maintain much of the current tariff structure. In effect, the tariff channel acts as a stabilizer, providing a source of fiscal capacity without the political friction of explicit tax increases.

Figure 5: Tariffs are making a major contribution to federal revenues

US tariff and excise tax revenue ($bn)

Source: Daily Treasury Statements, Bipartisan Policy Center, as of 10/2/25

The recent weakness in employment data should not be mistaken as a sign of an economy falling off a cliff. The labor market is evolving toward a new equilibrium in which the number of new jobs needed to maintain stable unemployment (the “break-even rate”) may now be lower than it was in the pre-pandemic era. A recent paper from the Federal Reserve Bank of Dallas suggests the monthly break-even requirement declined from approximately 250,000 new jobs in 2023 to about 30,000 in mid-2025. In other words, softer payroll reports are consistent with labor-market normalization, not deterioration. Government hiring has slowed, and public-sector job growth remains a modest drag, but the private sector continues to add positions, led by steady gains in the various service industries.

The US consumer remains broadly healthy, supported by robust household balance sheets (Figure 6). However, spending patterns have become increasingly concentrated among the top 10% of earners (Figure 7), who account for a disproportionate share of discretionary consumption. This concentration cushions aggregate spending figures but suggests that growth momentum is more fragile beneath the surface. It also helps explain why consumer confidence surveys and spending data occasionally diverge. For policymakers, this skew reinforces the argument for measured interest rate cuts to sustain aggregate demand without stoking inflation.

Figure 6: Household debt-to-assets ratio at its lowest point in 30-plus years

US household total liabilities as a % of total assets

Source: Federal Reserve Economic Data (FRED), as of 4/1/25. Current economic trends are not a guide to future results and may not continue.

Figure 7: Top 10% of earners account for half of all spending

Share of total spending (%)

Source: Bloomberg, Moody’s as of 6/30/25

In combination, these forces portray an economy that is slowing but not stalling, one in which inflation pressures continue to fade, fiscal policy provides balance and household balance sheets remain healthy. Such conditions have historically been highly supportive of fixed income returns, offering both income and potential capital appreciation as yields adjust to a more moderate policy and growth backdrop.

Risks to the benign outlook

For much of the past few years, non-bank lenders (including private credit markets) have absorbed refinancing needs and lending to middle-market companies that traditional banks were reluctant to provide. With assets under management in the private credit universe now projected to increase to $3 trillion by 2028, according to Moody’s, the sector’s rapid expansion has made it systemically relevant.¹ Recent failures in private issuers have started to reveal cracks beneath the surface. In September 2025, Tricolor Holdings, a subprime auto lender, and First Brands Group, an auto-parts manufacturer, collapsed into bankruptcy. While neither company utilized private credit direct lending as their primary means of financing, these implosions expose the potential risks presented by less regulated and less transparent lending with regard to due diligence standards, asset valuation and the potential for a wider credit contagion. The recent evidence of those risks could enhance the value investors attach to the transparency, liquidity and quality that publicly regulated debt markets can offer.

Another potential pothole exists with the rapid cross-pollination of capital within the artificial intelligence (AI) ecosystem. The enthusiasm surrounding generative AI has fueled an extraordinary wave of investment across chipmakers, cloud infrastructure, data-center real estate and software platforms. While much of this investment is grounded in genuine technological progress, there are growing signs of interconnected exposures that are reminiscent of prior asset bubbles. Large technology firms are increasingly taking equity stakes in each other’s supply chains and/or extending credit to ecosystem partners. Some have both ownership and lending relationships with the same counterparties, effectively blurring the lines between customer, supplier, creditor and owner. This creates circular balance-sheet dependencies, similar to the cross-shareholdings that characterized Japan’s corporate sector during the late-1980s bubble. While the parallels are not perfect, the structural similarity warrants caution. A valuation correction in one node of the AI supply chain could potentially trigger cascading effects across the entire ecosystem because of tightly woven financial relationships.

Positioning for quality in a higher yielding world

While we continue to believe that the broader fixed income market offers an attractive prospective return profile, the current environment calls for greater selectivity across the various sectors. Looking across the opportunity set within fixed income (shown in Figure 8), we see value in increasing exposures to high-quality duration assets such as tax-exempt municipals and securitized instruments where investors are better compensated for risk, while avoiding generic credit beta that no longer offers sufficient spread premium. In our view, with yields already attractive, investors do not need to stretch for incremental carry. We believe investors should focus on securities and sectors where income is sustainable and downside risks are limited.

Figure 8: Current percentile of option-adjusted spreads (OAS) for various spread sectors over the past 10 years

Source: Schroders, LSEG DataStream, Bloomberg, as of 9/30/25. Indices used are the Bloomberg US Corporate Index, Bloomberg Corporate High Yield Index, Bloomberg Emerging Markets USD Aggregate Index, Bloomberg US Mortgage-Backed Securities Index, Bloomberg US Aggregate ABS Total Return Index, Bloomberg US Aggregate CMBS Index, ICE BofA US Municipal Index, and the ICE BofA Broad US Taxable Municipal Securities Index. Municipal data uses the AAA municipal yield as a percentage of the 30-Year Treasury yield. Current performance is not a guide to future results and may not continue.

Not looking for beta and being selective with corporate credit

Corporate bond spreads have continued their slow march tighter in the third quarter of 2025, supported by resilient fundamentals, strong technical demand and a benign macroeconomic environment. Yet the underlying message is still the same as it has been for much of the past six months — valuations are tight and getting tighter. The investment-grade corporate index spread has compressed to 74 basis points (bps), well inside its long-term average of 143 bps, while the high-yield corporate index spread of 267 bps sits near the lower end of its historical range (both as of September 30, 2025, as depicted in Figure 9). In other words, investors are paying up for marginal incremental yield at a time when the macro backdrop, though stable, offers little margin for error.

Figure 9: Investment-grade corporate and US high yield spreads (in bps)

Source: Schroders, LSEG DataStream. Investment grade represented by the Bloomberg US Corporate Bond Index and high yield by the Bloomberg US Corporate High Yield Index, both shown as of 9/30/25. Current performance is not a guide to future results and may not continue.

We are also starting to see signs of late-cycle behavior creeping into the market. Mergers and acquisition (M&A) activity is rising and is expected to continue growing by 15% in 2026 (Figure 10), as management teams take advantage of strong equity valuations and moderate funding costs to pursue acquisitions increasingly funded with cash and debt. This re-leveraging impulse, coupled with tight valuations, argues for a more discerning approach to credit exposure.

Figure 10: US M&A expected to grow 15% in 2026

Last-12-months announced M&A volume ($tn)

Source: FactSet, Bloomberg, Barclays Research, as of 6/30/25

Against this backdrop, we think investors stand to benefit from an approach that is selective rather than beta-oriented with regard to exposure to corporate credit. Within investment grade, we favor industries where valuations remain reasonable and balance sheets are well-supported, such as banks, energy and autos. We continue to have a negative view of those industries where spreads no longer justify the risk, such as re-leveraging industrials. In our view, the best risk-adjusted opportunities do not exist from gaining broad market exposure but rather from selectively investing in idiosyncratic stories. Having an in-depth team of credit analysts, as Schroders does, helps to identify those.

Where we see value: Agency MBS and long tax-exempt municipals

Agency mortgage-backed securities (MBS) have been one of the standout performers in 2025. The agency MBS index delivered very strong performance in the third quarter of 2025, posting its best year-to-date (YTD) excess returns over Treasuries (+0.97%) in more than a decade. The third-quarter gains also boosted YTD total returns to +6.76% — the highest level for the first nine months of the year that has been seen in more than 20 years. This strength stems from a combination of stabilizing interest rate volatility, consistent income and revived bank demand as the Fed eased. While valuations have tightened following this performance, MBS remain attractive relative to corporates, as they offer minimal spread differential without the same credit risk (Figure 11).

Figure 11: MBS index Z-spread versus corporate investment grade Z-spread

Source: Schroders, Bloomberg, J.P. Morgan, as of 9/30/25. Z spread is the constant spread added to the risk-free yield curve so that the present value of a bond’s cash flows equals its current price, factoring in options. Past performance is no guarantee of future results and may not be repeated.

Within the sector, agency collateralized mortgage obligation (CMO) floaters compare favorably with AAA-rated collateralized loan obligations (CLOs), as they provide similar carry without exposure to the credit risk of the underlying loans. At the pool level, we prefer high-coupon specified pools that offer prepayment protection while delivering higher yields than generic collateral. These structures remain among the most efficient ways to earn high-quality income because they minimize negative convexity risk while maintaining excellent liquidity. In short, even after an impressive rally, we believe agency MBS continue to represent a core high-quality income opportunity for fixed income portfolios.

In our view, the long end of the tax-exempt municipal market also offers compelling value, following its recent underperformance relative to taxable US Treasuries. The US Long Tax-Exempt Municipal Bond Index underperformed the Long Treasury Index by 5.33%, on a YTD basis as of September 30, 2025. (During the quarter — on July 31 — the YTD return relative to Treasuries had even dipped as low as -6.57%). The Long Tax-Exempt Municipal Bond Index at quarter end also had a taxable-equivalent yield (assuming a 40.8% tax rate) of 7.82%. Tax-sensitive investors would need to buy single-B-rated high-yield corporate bonds, with materially more credit risk, to achieve similar yields on an after-tax basis. This period of municipal bond market underperformance has been driven mostly by the fear amongst retail investors of higher inflation leading to higher interest rates causing them to move away from long-dated municipal bonds. In other words, this technical dislocation in the municipal market — and not any warranted concern from investors about credit fundamentals —has been the main factor driving the underperformance. Historically, such periods of relative weakness have been followed by rebounds, as market technicals normalize and demand returns (Figure 12).

Figure 12: Tax-exempt municipals offer compelling opportunity

Relative performance of long tax-exempt municipals versus long US Treasuries

Source: Schroders, LSEG DataStream, as of 8/31/25. (Meredith Whitney is the market analyst, who, in December 2010, predicted widespread default in the municipal market. That caused considerable panic among muni investors, but her forecast was ultimately proven to be inaccurate.) Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell any financial instrument.

The case for long-dated tax-exempt municipals is not limited to tax-sensitive investors. Even ignoring the tax benefits, long AAA-rated municipals to long Treasury yield ratios were approaching 100% early in the third quarter but ended it hovering around 90%. This means that investors without tax considerations could stand to benefit from the technical rebound in municipals when the ratios normalize, without sacrificing income. With high-grade credit quality and attractive valuations versus its taxable peers, this sector, in our view, provides an appealing balance of income and total-return potential for investors.

Conclusion: A focus on quality and value likely to be rewarded

Despite volatility and pockets of uncertainty, the core message of 2025 remains clear: don’t bet against bonds. A combination of moderating inflation, less dire fiscal dynamics, and a slowing but resilient economy continues to create a constructive environment for fixed income. While corporate credit spreads leave little room for error, the high level of all-in yields allows investors to earn attractive income without taking undue risk. In this environment, we believe in favoring transparent, high-quality sectors such as agency MBS and long-dated tax-exempt municipals where valuations remain compelling. The strong performance in 2025 reinforces the thesis that starting yields still matter, and disciplined investors who focus on quality and value are likely to continue to be rewarded.

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Originally Posted on October 26, 2025 – Don’t bet against bonds

Footnotes:

1. “Private credit—primed for growth as LBOs revive, ABF opportunities accelerate,” Moody’s, 1/21/25