How will policy uncertainty and macro headwinds shape opportunities in fixed income?
As we approach the mid-point of 2025, volatility is defining the investment landscape. The first half of the year has underscored multiple key learnings for investors that look set to play out as we move through 2025 and beyond, chief among them is to expect instability, not only in markets but also in the geopolitical and policy environments that shape them.
Policy uncertainty drives markets
Policy decisions – particularly those related to trade and tariffs – have been the primary market driver so far this year and this is expected to continue through the second half of 2025. The current administration issued an unprecedented number of executive orders in its first 100 days, creating an environment of uncertainty for companies. As a result, there is a reluctance to provide forward guidance, with many companies opting to provide scenarios rather than concrete projections.
Corporate decision-makers are hesitant to make significant capital decisions until they have greater clarity on ‘the rules of the road’, particularly regarding tariffs. The volatility in trade policy – where tariffs on specific countries or regions can change rapidly – has made it challenging for companies to make long-term investment decisions.
All eyes on the labour market
The labour market is a crucial metric for fixed income investors to monitor in the coming months. Current expectations are that the US Federal Reserve (Fed) will remain on hold until the labour market shows clear signs of deterioration. While the unemployment rate has been holding steady at 4.2%, a meaningful increase toward 4.5% could prompt Fed action. Similarly, the year-over-year growth rate of non-farm payrolls (currently at 1.19%) bears close watching – historically, drops below current levels have coincided with economic slowdowns (Figure 1).
Figure 1: New job creation continues to step down
Non-farm payrolls (average monthly change)
Source: Bureau of Labor Statistics, as of 31 May 2025.
How is the Fed going to react to diverging signals on inflation and unemployment? We believe the Fed is likely to look through higher inflation resulting from tariffs and may feel comfortable cutting rates if the labour market deteriorates. Recent comments from Fed governor Christopher Waller support this perspective, suggesting that the Fed views tariffs as a tax outside its influence, while maintaining its mandate to support employment if weakness emerges. What may be underpriced in current market expectations is the potential magnitude of rate cuts in 2026, suggesting a ‘do less now, do more later’ approach from the Fed.
Credit compelling as spreads widen
Heading into the second half of the year, we believe there are opportunities in credit as spreads have widened from historically tight levels (Figure 2). In short-term bonds, spreads have widened from record tights to historical median levels. Investment grade corporate bonds have widened as well, but not significantly above long-term averages. Meanwhile, longer-dated investment grade bonds remain expensive for technical reasons (sustained demand from institutional investors coupled with limited supply). The spread move was most pronounced in the high-yield corporate bond market, which is more sensitive to both economic growth and risk sentiment. Specifically, higher-quality high-yield bonds (BB and B-rated) appear to present attractive opportunities, while we are selective in lower-quality credit (CCC-rated high-yield bonds), which remains the most vulnerable to an economic downturn.
Figure 2: Wider credit spreads present opportunities for bond investors
Current percentile versus 20-year average
Source: Columbia Threadneedle Investments, as of 30 April 2025.
This widening in spreads indicates that bond investors are getting compensated for taking on more risk (beyond US Treasuries). And given where spreads are today relative to history, they also provide an indication of where we are likely to see positive excess returns in the next 12 months. For example, in higher-quality high yield (BB-rated), we selectively deployed capital to capitalise on the repricing opportunity. More broadly, this has allowed us to move from being very defensive in terms of our position – focusing on corporate investment grade credit – to expand the opportunity investment set to include consumer credit such as asset-backed securities and agency mortgage-backed securities (MBS).
Globally, we have not observed significant relative value (US versus non-US) opportunities in credit markets. European credit, which appeared cheaper a few years ago, has largely converged with US valuations. And emerging market spreads have only marginally widened during recent market volatility. However, we are closely monitoring whether the pro-growth government policies in countries like Germany, China and Japan will help offset the negative impact of US tariff policy on their economies.
Assessing risk through investment scenarios
Looking forward, we see three primary scenarios that could shape fixed income markets through year-end:
Investment implications
The prolonged uncertainty scenario appears most likely and could be the most conducive to overall fixed income performance. In this environment, a combination of intermediate-maturity, high-quality US bonds complemented by high-quality overseas sovereign debt (for example, German bunds) could help diversify portfolios. Specifically, our largest weighting (and overweight) remains agency MBS, which are guaranteed by US government agencies. This is a valuation play, as agency MBS currently offer a higher spread than investment grade corporate bonds, but also serve to de-risk portfolios. We believe the catalyst to outperformance from this sector will be lower Treasury yields and interest rate volatility.
The bottom line
For fixed income investors, the primary driver of returns in the first half of the year was policy uncertainty – trying to guess what the policy would be. As we navigate the second half of 2025, the focus will shift to evaluating the tangible impact of these policies.
With an evolving economic environment, an active approach is best positioned to identify potential winners and losers amid escalating trade tensions. Some industries, and even companies, are likely to be more directly impacted by levies on imported goods. For others, there may be opportunity created to take share from competitors who face a more direct impact. A research-based approach is needed to position portfolios to identify opportunities and manage potential risks.
