The power to adapt when uncertainty reigns

Financial markets have been a rollercoaster in recent years; and no-one knows the twists and turns of the track ahead. The volatility, largely shaped by geopolitical and economic events, sees no sign of abating – uncertainty seems to be the new certainty.

Current market dynamics also threaten higher interest rates due to upward pressure on prices – this can be a very challenging situation for fixed income investors.

In today’s market environment, we believe flexibility is key to capturing potential opportunities and mitigating risks across the diverse fixed income spectrum.

For example, government bonds can offer valuable risk-offsetting features in risk-off environments driven by recession fears. Other types of bonds, particularly those that contain credit risk, may provide better returns in environments with stable growth and corporate health, but also may come under pressure when market participants become worried about risks of downgrades and defaults. Lastly, bonds issued by emerging market countries typically offer additional yield due to higher political and geopolitical risk but may underperform when conflicts arise.

The market movers and shakers

If we look at annual returns across six key fixed income markets over the past 10 years, there have been significant variations in performance in both high and low interest rate environments. The below chart shows this data, ranking returns from the highest (1) to lowest (6).

The following chart shows the return differential between the top-performing market and the worst-performing fixed income market on a calendar year basis, using the same data as the return matrix above. The lowest differential in the past 10 years was 5% in 2018, and the highest was 15% in 2016, 2017 and 2019, three years in a low-interest rate environment, with an average of 10%.

We believe there is a clear theme. Given all the idiosyncratic risks facing markets, it may be more prudent to adopt an agnostic and pragmatic approach by exploring opportunities in fixed income markets globally, rather than focusing on one sector or region. This approach might have better potential to drive consistent returns compared to strategies which are focused on individual markets.

A keen interest in rates

Interest-rate risk is one of the main risks facing fixed income investors, and in an uncertain and volatile world, that risk is likely to be heightened.

Owning bonds with longer duration can be valuable over time but is also a considerable risk for fixed income portfolios. We have analysed the drivers of return volatility across different credit sectors and found that duration is a key driver of return volatility for many credit assets over the past 10 years.

For example, bonds with a maturity of 25+ years face double the return volatility risk from duration than credit risk. In contrast, more credit-sensitive areas such as high yield BB-rated bonds are less affected by duration.

Changing macroeconomic dynamics, persistently above target inflation and the return of fiscal spend have also led to much more volatility in government bond markets, which has fuelled an increase in volatility in duration-sensitive assets.

The evidence that duration is a good hedge for credit risk can also be debatable. Our analysis of monthly credit spread and government bond yield series since 2002 up to July 2025 also showed that 42% of the time, credit spreads and government bond yields move in the same direction.

This reinforces the view that managing the duration of fixed income portfolios in a more dynamic fashion might be beneficial in the current market environment. Over the 40 years to 2021, duration was something to ‘buy and hold’. However, a more volatile, shorter-cycle backdrop will require a sharper focus not only on duration management for the entire portfolio, but also on its interaction with risk assets.

An unconstrained approach can offer more flexibility and can seek to actively position duration considering the correlation of returns between government bonds and credit spreads.

An unconstrained approach for uncertain times

With markets continuing to look unpredictable, it may be worthwhile for investors to consider a wider opportunity set in fixed income, focusing on diversification* to potentially generate returns from a wide range of sources. Additionally, in light of more volatility on the horizon, we believe flexible duration management will remain key to adapting to future market moves.

 

*It should be noted that diversification is no guarantee against a loss in a declining market