In the year ahead, the trajectory of U.S. policy rates and fiscal deficit concerns will continue to be the principal drivers of the shape of the Treasury yield curve, and quality credit spreads could remain well supported on strong corporate balance sheets. However, unlike this year, the case for a wider dispersion of returns in the fixed income asset class is emerging, and performance returns could grow uneven across 2026.

A fiscal-monetary “tug of war” 

Under our base case scenario, U.S. economic activity should remain robust in the first half of 2026, followed by a moderation as labor market demand softens against the fading effect of front-loaded fiscal stimulus. As such, we expect the Federal Reserve (Fed) to continue monetary easing, lowering policy rates toward the “neutral” range of 3–3.25% by mid-2026 and slightly ahead of current market pricing.

Falling interest rates should generally guide Treasury yields lower, absent other influencing factors. However, with concerns regarding debt sustainability amid sizable fiscal deficits likely to persist over the year, long-end rates may remain elevated, with the yield curve on U.S. Treasuries steepening. Also, with risks of a more dovish Fed adding pressure to short-end rates and the growing potential for additional fiscal stimulus ahead of the mid-term elections, which could prompt markets to demand a higher term premium, the outlook on U.S. Treasuries appears biased toward further steepening of the yield curve.

Notably, curve steepening is not unique to the U.S., and fiscal expansion has been a recurring theme across developed economies, including Germany’s increased defense and infrastructure spending, and anticipated tax cuts and fiscal stimulus under Japan’s new prime minister. However, the expected divergence of central bank directions in 2026—as the European Central Bank (ECB) has limited room for further rate cuts and the Bank of Japan (BoJ) continues a tightening bias—marks U.S. Treasuries as unique, where fiscal and monetary actions are counteracting forces on long-end rates, with the yield curve in a bull steepening. This makes U.S. Treasuries more attractive on a relative basis, in addition to 10-year yields offering additional income compared to other developed markets’ government bonds. 

Started from the bottom, now we’re still at the bottom

Corporate credits have also been a reliable source of additional yield this year, despite low levels of initial spreads. Yet, both investment-grade and high-yield credit spreads narrowed even further to the tight end of their historical ranges, as corporate fundamentals remain in good shape with strong profitability and subdued default rates. Net upgrades, albeit at a slower pace than last year, also suggest further improvements in credit quality (Exhibit 1). 

While further spread tightening in the year ahead appears limited, total yields appear reasonable to add healthy carry to portfolios against the tailwind of resilient economic growth for corporates. Any resurgence of credit stress headline noise in the near term may present attractive entry points for spread compression.

However, as the case of slower growth in the second half of 2026 becomes gradually priced in by markets, weaker corporate profits could expose broader balance sheet vulnerabilities, adding pressure to the deceleration in rating upgrade momentum observed this year. Portfolios could accordingly reallocate toward higher-grade and higher-quality bonds as a prudent approach to mitigate rising default risk.

The outlook on securitized assets also appears constructive. A persistent housing undersupply is likely to continue supporting the mortgage-backed securities (MBS) market against the backdrop of a stable housing market with low vacancy rates. Resilience in consumer balance sheets also suggests a positive view on asset-backed securities (ABS), as default rates remain low, albeit with recent pickups in student loan and auto loan delinquencies. Furthermore, ABS’s positive convexity also provides a natural hedge against prepayment risk should the Fed cut rates faster than expected. 

The U.S. dollar in Asia

Extending the fixed income spectrum into Asian bonds, our view that central banks appear to be slowing down on monetary easing should see limited room for Asian duration to rally further in 2026. And while a narrowing interest rate differential, as the Fed continues easing, could see some Asian high-yielding currencies gain on the USD, the pace of appreciation is expected to be modest as central banks prioritize currency and financial stability.

Instead, Asian hard currency sovereign and corporate debt appear relatively more attractive on both fundamental and technical fronts. Default rates have continued to trend down alongside improving credit ratings, including the S&P upgrade on India’s sovereign and corporate ratings in September, and trends of slow new issuances at negative net financing are expected to continue, keeping market supply tighter than demand and justifying the spreads to stay at tight levels.

Summary

We continue to see merits in different corners of the fixed income opportunity set to add diversified yields to portfolios, anchored on our macro base case. Active allocations remain crucial. However, stretched valuations across markets suggest that robust medium-term growth is mostly priced in, leaving little margin for error. Should risk sentiment shift toward the downside, fixed income, particularly U.S. Treasuries and high-grade bonds, will remain a resilient asset class to hedge market risks.

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