Fixed income outlook

Fixed income investments are versatile, addressing a range of investor goals. Defined benefit pension plans use fixed income as an interest rate hedging tool, typically through longer duration securities, to match liability risk. For investors like endowments, foundations and First Nation trusts, who focus on generating absolute returns across different market environments, stable returns is generally the primary objective.

This article summarizes some of the discussion at a recent Strategic Exchange webinar on the outlook for fixed income and the range of strategies available to investors to manage the challenges in the current economic environment.

Broad range of strategies

Traditional fixed income assets, like government and corporate bonds, have long been core holdings for investors. Today, non-traditional fixed income investments are added to enhance core bond holdings (Figure 1).

Figure 1 – Range of fixed income strategies

Bond yields generally indicate expected longer-term return. Yields have declined from the higher levels in 2024, suggesting there will be continued interest in non-traditional fixed income strategies to complement traditional strategies to enhance returns.

Tariffs, the economy and fixed income

President Trump’s “America First” agenda introduced tariffs to protect US industries and reduce trade deficits, causing global market volatility and sparking concerns about inflation and sustained high interest rates.

There is a wide range of possible outcomes from the tariffs. Weakening growth combined with sticky inflation are ingredients for stagflation. Central banks have little or no flexibility in this scenario. In the pre-COVID world, in anticipation of weakening growth or a weakening labour market, central banks could cut interest rates. However, they do not have the same luxury today, particularly considering sticky inflation.

TJ Sutter, Head of Fixed Income at Connor Clark & Lunn Investment Management, noted the tariff situation is fluid, and the Trump administration has sometimes backpedaled on their resolve. However, the concern is a lot of the potential damage to growth and inflation outlook is already done both in the United States and Canada with business confidence being low, uncertainty high, business investment and capital expenditure intentions stalling and, in some cases, falling off a cliff.

The uncertainty lies in whether the hard economic data will match the soft data of intentions and confidence. These indicators suggest a high probability of a further slowdown. Sutter noted that for his team, the current sentiment is the introduction of the tariffs indicate a recession probability range of 40% to 60% for both Canada and the United States.

Darren Ducharme, CEO of the fixed income specialist manager Baker Gilmore & Associates, noted the sharp rise in geopolitical risk and the associated uncertainty has made navigating markets, including fixed income, much more challenging. Volatility is likely to remain high, and the rise in headline risk will continue to make forecasting expected movements in fixed income markets challenging.

Ducharme emphasized that effective risk management is essential in this volatile environment. While market volatility offers opportunities for active managers, it is vital to appropriately size risk to withstand market turbulence.

Non-traditional fixed income strategies

Incorporating non-traditional fixed income strategies alongside core fixed income holdings can cater to different investor needs and market conditions.

Non-traditional fixed income strategies offer several advantages for portfolio diversification and returns, including:

• Higher yield potential: These strategies often provide higher yields than traditional fixed income investments, making them attractive in low interest-rate environments.
• Diversification: Investing in assets like mortgages, emerging market credit and absolute return strategies can reduce overall portfolio risk by adding exposure to various economic cycles and credit markets.
• Flexibility: Absolute return strategies allow managers to adapt to changing market conditions and seek returns across various asset classes.
• Inflation protection: Some non-traditional fixed income investments, like mortgages, offer better protection against inflation compared to traditional bonds.
• Enhanced risk-adjusted returns: A multi-strategy solution balances interest rate risk with credit risk, improving long-term risk-adjusted returns.

Stay alert to risk

Fixed income investments are vital for diversified portfolios, offering an alternative stream of returns. Tariffs and rising geopolitical risks have heightened market volatility, making effective risk management more crucial. Traditional fixed income assets, like government and corporate bonds, remain core holdings for investors. Non-traditional fixed income strategies, including mortgages, emerging markets credit, private loans and absolute return strategies, offer valuable opportunities to enhance returns and diversify risk.

In these challenging times, investors should carefully size risk and consider incorporating a broad range of fixed income strategies to weather market turbulence. Leveraging non-traditional fixed income investments can help portfolios achieve better risk-adjusted returns and cater to diverse investor needs. Investors should remain vigilant and adaptable, ensuring their portfolios are well-positioned to thrive in the evolving economic landscape.