Fixed Income

“Normal” Rates, but with Volatility

There certainly have been a lot of headlines/news thrown at the U.S. Treasury (UST) market this year. At times, it has functioned as expected in terms of “risk-on/risk-off” situations, but at other times, yield movements have been a bit more unexpected. It is not because the global investment community has altered its broader premise of Treasuries being a store of value, but rather market participants trying to navigate their way through the heightened levels of uncertainty on many fronts. In fact, through April (Liberation Day), Treasury Department data revealed that foreign holdings of Treasuries had increased year-to-date, led by Japan and the UK. With respect to China, its UST holdings were down only slightly, -$1.8 billion or -0.2%.

As the calendar flips to the second half of the year, and perhaps tariff-related uncertainty goes into the rearview mirror, the UST focus will turn more and more to the macro fundamental backdrop, i.e., the economy, inflation and Fed policy. We expect the UST 10-Year yield to remain in its more historically “normal” territory (elevated, as compared to its pre-COVID-19/COVID-19 levels) but with heightened volatility remaining a visible part of the trading landscape.

Just like the Fed, the UST market is highly data-dependent for yield direction. If fiscal policy comes back into focus, there could be dueling forces to contend with, like the potential for both rate cuts and higher budget deficits.

“We expect the UST 10-year yield to remain in its more historically ‘normal’ territory... but with heightened volatility remaining a visible part of the trading landscape.”

Opportunities in Asset Allocation

Fixed income investors reversed course in the second quarter. Treasury yields rose, and credit spreads tightened, supported by resilient economic data and reduced concern over aggressive tariff implementation. Municipals received greater support as fears around the repeal of tax exemptions subsided, and seasonal issuance pressures ebbed. Despite the broader reversal, three themes remained intact from the first quarter:

+ the coupon portion of the Treasury curve continued to steepen, + the dollar weakened against both developed and emerging market currencies, and + EM local debt outperformed.

So, where does this leave us? We are feeling:

+ A bit more confident in the trajectory of growth, + Somewhat more relaxed—though not fully resolved—on the impact of tariffs, + Increasingly concerned about geopolitical risks and + Assured that the municipal bond tax exemption remains intact.

Still, changes in perspective are only a tweet away, and investors must remain alert. Conviction remains challenging in this environment.

The base-case scenario we adopted in the beginning of the year—incremental Fed easing, a resilient economy and reasonably anchored inflation expectations—persists largely intact and argues for little change in our fixed income asset allocation. Securing diversified sources of income remains a key consideration for investors for the rest of 2025.

Corporate bonds remain a core income source but have now returned to valuation levels that are historically tight. Fundamentals continue to be strong, and many corporations have taken proactive measures to defend against tariffs. We maintain our current positioning with a focus on quality screened credits but could look to add incremental allocations if spreads widen from current levels.

Our principal overweight within taxable fixed income remains securitized debt, where we see attractive valuations and the potential for volatility to ease somewhat in the months ahead. It remains the largest overweight allocation within our income-focused strategy, reflecting both relative value and our view on risk-adjusted returns. We see value in agency RMBS as well as broadening opportunities for value investors in non-agency supported debt.

Positions in emerging local debt have long featured as diversifiers in our less-conservative fixed income models. While currency returns may be less of a tailwind for these positions in the coming months, the carry advantage of emerging market local positions relative to the developed market ex-U.S. sovereign debt is sizable and presents an interesting option for investors looking to diversify their bond exposure outside the U.S.

Within tax-aware portfolios, we think municipals offer a great deal of value. Yields are attractive, credit fundamentals remain solid, and the threat to the municipal tax exemption has passed. Technicals also turned positive, with the seasonal rush of issuance behind us. We prefer stable revenue sectors such as public utilities and water and sewer credits to opportunities offered by general obligation credits.