As 2025 draws to a close, a sense of unease is creeping into the bond markets. Volatility has increased due to cracks in credit markets and lingering uncertainty about interest rates and the Federal Reserve's path. Yet, financial experts are cautioning investors against a knee-jerk reaction to sell. A deeper analysis reveals that bonds are poised to remain an attractive asset class in 2026, provided investors make some prudent strategic adjustments to their portfolios.
A Strong Year Faces Emerging Headwinds
The year 2025 has been remarkably positive for fixed-income investments. Every major category, from US Treasuries and high-yield bonds to emerging market debt and bank loans, has delivered positive returns to investors. This broad-based strength, however, is making some market participants nervous, and there are tangible reasons for caution.
Credit spreads, which measure the extra yield investors demand to hold riskier corporate bonds over safer government securities, are at their tightest levels in over 25 years. This indicates high investor confidence and low perceived risk. Simultaneously, corporate bond issuance is accelerating, fueled by a capital spending boom linked to artificial intelligence investments. Signs of stress are also appearing, exemplified by the Chapter 7 bankruptcy filing of subprime auto lender Tricolor in September, which sent ripples through the credit markets.
Strategic Shifts for the New Year
These warning signs might tempt investors to exit bond positions and move to safety. Morgan Stanley strategist Andrew Sheets acknowledges this sentiment, noting investors might think, "Surely, it can't go on like this." Experts agree that the environment is shifting. Spreads are expected to widen in 2026, meaning lower-rated bonds will likely underperform their higher-quality counterparts. Goldman Sachs forecasts investment-grade corporate bond spreads to rise by about 0.1% and high-yield spreads by 0.4% by the end of 2026.
Duration risk is another growing concern. Ben McMillan, Chief Investment Officer at IDX Advisors, explains that duration measures a bond's sensitivity to interest rate changes. With short-term bond yields having fallen more than long-term yields this year, shorter-duration strategies have gained an edge. For instance, the Vanguard Short-Term Treasury ETF marginally outperformed its long-term counterpart in 2025.
Consequently, the optimal strategy is evolving. While loading up on higher-yielding, longer-duration bonds made sense earlier in 2025, the current tight spread environment demands a more discerning approach. Investors must now ask if they are being adequately compensated for the extra credit risk they are taking.
The "Triple Easing" Tailwind for 2026
Despite these risks, the overarching outlook for bonds in 2026 is stable. Morgan Stanley's Sheets points to a powerful supportive backdrop: a combination of easing monetary policy (from the Federal Reserve), fiscal policy, and regulatory policies. This "triple easing" scenario is expected to create favourable conditions for the credit cycle to continue, supporting another decent year for bonds.
The key is tactical positioning. McMillan of IDX Advisors now favours shifting towards higher-rated bonds over lower-rated ones, agency mortgage securities over corporates, and shorter-duration bonds over longer-duration ones. For retail investors, this can mean reallocating some capital into exchange-traded funds (ETFs) like iShares MBS, Schwab Short-Term Treasury, or Vanguard Short-Term Corporate Bond.
Morgan Stanley offers additional geographic and sector insights, viewing European bonds as slightly more attractive than US bonds and favouring the financial sector over others. ETFs like the Invesco International Corporate Bond ETF or the Invesco Financial Preferred (which holds preferred stock in financial institutions) are potential vehicles to express these views.
The picture could change if the Federal Reserve embarks on aggressive quantitative easing, altering the outlook for spreads and longer-duration assets. However, investors can adjust to such policy shifts as they occur. For now, as the calendar turns to 2026, making measured adjustments at the margin—favoring quality and shorter duration—appears to be the most prudent course of action for bond investors.
