Fixed Income

“Normal” Rates…the Sequel

So, where can Treasury (UST) yields go in this environment? Treasuries had rallied going into the September FOMC meeting and in the immediate aftermath of the rate cut. As a result, the UST 10-Year yield fell to 3.99%, but as we saw following last year’s first rate cut, also in September, that didn’t last long and quickly moved back above the 4% threshold.

It is important to note that the resumption of Fed rate cuts is not occurring against a backdrop of widespread economic weakness, but rather, as Powell himself put it, it’s more of a “risk management” move. However, looking at Treasury yields, the broader market is discounting two more rate cuts for this year, especially at the front end of the curve.

To provide some perspective, the UST 2-Year yield is fully priced for two rate cuts and actually fell below the low watermark of 3.54% that was registered following the Fed’s 50-bp rate cut at the September 2024 FOMC meeting. However, the 10-Year yield has not experienced the same type of déjà vu. Indeed, at this time last year, the UST 10-Year yield fell to almost 3.60% based on the increasing recession odds at that time. We’re not there at this point in terms of recession expectations.

Against this backdrop, the more likely scenario is for the UST 2-Year/10-Year yield curve to continue to steepen in the months ahead. In fact, without further weakening in the labor markets, one could argue that the UST 10-Year yield could resume an upward trajectory to close out 2025.

Opportunities in Asset Allocation

Fixed income markets regained some balance in the third quarter. Interest rate swings moderated, corporate spreads fully retraced their first-quarter widening, and the U.S. dollar steadied. Emerging market debt maintained its leadership, with both hard currency and local debt delivering strong results. The most notable surprise was the resurgence of municipal bonds, which, after two muted quarters, delivered their third-best quarterly return in the past decade. Investors, reassured over the security of municipal tax exemptions, took advantage of attractive valuations and favorable seasonal supply dynamics.

Despite a year marked by pre- and post-Liberation Day anxieties, a mid-year reassessment of labor market strength and recurring challenges to Fed independence, our base-case scenario from January remains largely intact: gradual Fed easing, a resilient economy and reasonably anchored inflation expectations. This supports maintaining a steady fixed income allocation. We remain duration neutral, with selective over-weights in securitized debt and in corporate credit positions screened for quality.

Income Remains Central

Securing diversified income sources continues to be a priority for the remainder of 2025; carry remains king. Within U.S. taxable markets, securitized debt is our favored source of income—supported by both relative value and attractive risk-adjusted return potential. We see opportunity in agency RMBS and, increasingly, in non-agency markets for Value-oriented investors.

Corporate bonds remain a core component of income portfolios. However, spreads relative to Treasuries are at historically tight levels, leaving less margin for error. Fundamentals still support current yields, but discipline is critical. In both investment-grade and high-yield, we prioritize issuers with stronger fundamentals than the market as a whole.

Within investment-grade, we favor the shorter end of the corporate curve. In high-yield, we prefer low-duration bonds over senior loans, given broader sector diversification and the anticipated impact of future Fed rate cuts.

Select Opportunities Abroad

For investors with higher risk tolerance, select opportunities remain in emerging market local debt. While currency support versus the dollar may moderate compared to earlier in the year, 10-year real yields remain compelling in certain countries, and fundamentals across many EM economies are sound.

Municipals: Room to Run

For tax-aware portfolios, municipals should continue to benefit from their third-quarter rebound. Yields remain attractive both on an absolute basis and relative to taxable alternatives, while credit quality is solid, and technical conditions are improving as we move deeper into the fall. Within municipals, we prefer stable revenue sectors—such as public utilities and water and sewer systems—over general obligation credits.