The Fixed Income Paradox: When Pressure Turns into Opportunity

Mora Capital Group’s Senior Investment Advisor in Miami analyses why bonds are having a difficult year and why, at current yield levels, US dollar fixed income is once again offering attractive income with contained risks.

Sebastian Salamanca, CFA, CAIA, Senior Investment Advisor at Mora Capital Group in Miami, reviews the key drivers behind a challenging year for bonds. The yield on the 10-year US Treasury has reached its highest level since 2007, driven by economic growth, inflation, deficits and a surge in new debt issuance. However, with the market pricing in three further rate hikes over the next year and inflation easing, albeit slowly, much of the bad news already appears to be priced in. Where the market sees risk, he argues, opportunity emerges.

The yield on the 10-year US Treasury has reached its highest level since 2007, while equivalent German and Japanese government bonds have not seen these levels since 2011 and 1996, respectively. While global equity markets are up 12% year to date, global fixed income, measured in US dollars, has delivered a total return of -1%.

According to the author, there are five key factors:

• Stronger growth and higher inflation. The US economy continues to grow above its potential, while manufacturing and services activity remain in expansionary territory. Geopolitical conflicts have added to the pressure on inflation, which is largely being driven by energy prices. Brent crude has exceeded $118 a barrel, while diesel averages $6.20 per gallon. This combination is unfavourable for bonds: stronger demand for capital increases borrowing costs, while inflation erodes the real value of future fixed coupon payments.

• Central banks return to a restrictive stance. With a resilient labour market and low unemployment, the Federal Reserve raised interest rates in September and has left the door open to further increases unless inflation declines convincingly. Europe and Japan have also raised rates.

• Record fiscal deficits and public debt. US government debt has surpassed $40 trillion for the first time, and OECD countries are expected to issue around $18 trillion in bonds this year, alongside record defence spending. The greater the volume of debt that needs to be absorbed by the market, the higher the yields investors demand to finance it.

• The artificial intelligence boom. The race to build AI infrastructure has driven companies to issue more than $400 billion in bonds this year, much of it from high-quality, large-cap businesses such as Meta and Alphabet. Governments and companies are competing for the same pool of capital, pushing up financing costs for everyone.

• A changing investor base. The Federal Reserve and foreign central banks are playing a progressively smaller role in the Treasury market, replaced by private investors who are more sensitive to price. In addition, the global savings glut that kept interest rates low for decades has run its course.

Understanding the reasons behind the trend, Salamanca points out, does not mean it will continue indefinitely. The market is already pricing in three further Fed rate hikes by the end of 2027. Moreover, rising yields are being driven primarily by higher real interest rates—that is, rates adjusted for inflation—rather than by fears that inflation will remain elevated for many years.

The Fed itself expects inflation to moderate over the next two years. Technology could also act as a disinflationary force by boosting productivity, as it did in the 1990s, and potentially easing pressure on the labour market. If inflation comes in lower than expected or economic growth loses momentum, there may be limited room for yields to rise further.

The most important point for investors, the author notes, is that at current levels fixed income is once again offering something that was scarce for years: yield. It is now possible to build US dollar portfolios yielding around 6%, focused on the short and intermediate parts of the yield curve, without buying very low-quality bonds or taking on very long maturities.

Salamanca acknowledges that bonds are not fulfilling their traditional role as a cushion against equity market declines, having fallen this year even as stocks have risen. He therefore proposes a change in perspective: rather than viewing fixed income primarily as a strict diversifier, investors should see it as a source of consistent income.

With starting yields at elevated levels, coupon income acts as a buffer against further rate increases. By way of illustration, a three-year bond yielding around 6% could withstand a further increase of approximately two percentage points in its yield over the next year before generating a negative total return.

Bonds may remain volatile in the short term, Salamanca concludes, but for investors with a medium-term horizon, current levels offer something unusual: attractive income with contained risks, without the need to take on volatility at the longer end of the curve. After years of minimal yields, fixed income is once again paying investors to wait.

Data source: Bloomberg.

Sebastian Salamanca, CFA, CAIA, is Senior Investment Advisor at Mora Capital Group in Miami.

We invite you to read the full interview in Citywire 👇

The Fixed Income Paradox: When Pressure Turns into Opportunity