Capital Ideas^™ 
Investment insights from Capital Group

The bond market is well positioned to provide investors with attractive income potential and relative stability, should equity markets swing lower in the second half of the year. Given slowing U.S. economic growth and cooling inflation, bonds should offer a smoother ride for investors amid high uncertainty over U.S. trade and immigration policies, rising debt levels and worsening conflicts in Ukraine and the Middle East.

“Economic conditions are steady but softening, with labour markets and consumer spending gradually slowing,” says fixed income portfolio manager Chitrang Purani. “Ongoing uncertainty around tariff levels — as well as the time it takes to reach these agreements — will continue to weigh on business and consumer sentiment. It could also negatively impact economic data during the second half of this year.”

Building a core bond portfolio that balances seeking return against minimizing exposure to elevated market volatility is important to Purani. “I currently favour an up-in-quality tilt toward credit exposures across bond sectors and issuers, as you’re not getting paid appropriately to take on riskier investments. The market has priced in a very optimistic outlook, and while recession is not my base case, it’s crucial for bond portfolios to serve as a ballast when volatility hits.”

Meanwhile, inflation risks continue to plague markets — and the U.S. Federal Reserve. At the June 2025 meeting, the Fed extended the pause on rate cuts and left the target range unchanged at 4.25% to 4.50%. The latest projections show rates to end the year at 3.9%, which suggests modest rate cuts for the remainder of the year.

Waking a sleeping giant

Moves in the rapidly growing US$28 trillion U.S. Treasury market have emerged as a flashpoint for policymakers and investors.

Yields on the 10-year Treasury, arguably the most important interest rate in the world, reached 4.39% as of June 18, 2025, compared to 4% in early April. The upward march came even as yields on shorter dated Treasuries declined, steepening the yield curve.

“Investors are balancing concerns of higher inflation and a potential downturn, both stemming from a tariff policy that continues to evolve,” says Tim Ng, a portfolio manager for Capital Group Canadian Core Plus Fixed Income Fund™ (Canada). Expectations of a growing U.S. federal budget deficit amid potential tax cuts and other spending plans also play a role in keeping long-term yields high.

“There’s room for the curve to further steepen in several scenarios,” explains Ng, who is maintaining flexibility considering recent market swings. “While the worst of trade policy uncertainty may be behind us, I want to be positioned to take advantage of any major shifts in valuations.”

Investors count on bonds to zig when stock markets zag. That’s exactly what happened during the policy-induced stock market volatility. Specifically, when the S&P 500 Index fell 18.7% from the record high set on February 19, 2025, to the recent low on April 8, 2025, the Bloomberg U.S. Aggregate Bond Index gained 1%. The return of this time-honoured relationship, which disappeared in 2022 during the Fed’s rate-hiking spree, is crucial as Trump’s policy initiatives raise the risk of a recession. Specifically, should economic conditions weaken abruptly, the Fed can lower interest rates beyond expectations and provide a tailwind for bond returns since bond prices increase as yields decline.

Securitized credit offers competitive income potential

In a world where ongoing periods of volatility are likely, exposure to securitized assets including agency mortgage-backed securities (MBS) could benefit portfolios given their higher quality and attractive nominal yields and spreads compared to corporate credit. The appeal of agency MBS is further bolstered by the sector’s liquidity and relative resilience in past downturns.

Active coupon selection is an important factor in mortgage portfolios. Higher coupons offer compelling income opportunities with low sensitivity to rates even if interest rates and volatility remain elevated. In contrast, low coupons, which are more prevalent in the Bloomberg U.S. Mortgage Backed Securities Index, have higher interest rate sensitivity and lower nominal spreads and yields.

Many areas of securitized credit look appealing, such as the senior tranches of subprime auto asset-backed securities. “The underlying loans have shorter maturities compared to mortgages, and lending standards have tightened over the past decade,” says Xavier Goss, a portfolio manager for Capital Group Multi-Sector Fixed Income Fund™ (Canada).

Some commercial mortgage-backed securities, particularly higher segments of the capital structure, also offer strong income with reasonable valuations. While some office properties still face challenges in the post-COVID era, multifamily housing, warehouses and other segments of the market have solid balance sheets, steady cash flows and strong demand.

Corporate bonds show continued resilience

Healthy corporate fundamentals and attractive yields should help corporate investment-grade (BBB/Baa and above) and high-yield bonds weather potential headwinds to growth.

“Corporate earnings are reasonable, though rising costs and weaker consumer sentiment muddy the general economic outlook,” says portfolio manager Tom Chow. “In periods of declining growth expectations, established entities with strong credit metrics, low refinancing risk and sizable equity cushions are better positioned to weather the storm,” Chow explains.

Companies with non-cyclical businesses are still capable of improving their financial profile and reducing refinancing risk. For example, within investment-grade rated companies, certain pharmaceuticals, such as Amgen, are reducing debt following recent acquisitions. In high yield, telecom company Charter Communications has recurring revenue streams, while security and defence companies including Axon Enterprises may be less affected by the economic cycle.

Today’s starting yields for higher income sectors such as investment-grade, high-yield and emerging markets debt offer attractive entry points for long-term investors. Even if spreads to U.S. Treasuries widen to impact price, the income component should help support positive returns. Moreover, rate cuts expected from the Fed later this year could be tailwinds for bond returns, particularly those with longer maturities.

Corporate defaults are expected to remain low relative to the historical average of roughly 3%. “Many high-yield companies refinanced debt ahead of tariff-induced volatility, so a ‘maturity wall’ is not a major, imminent concern,” Chow adds.

Bonds are in better shape for a changing world

The U.S. economy has proven to be resilient through high inflation and elevated yields, which remain near multi-decade highs, but ongoing trade negotiations and other policy initiatives complicate the economic outlook. Though most economists and investors don’t expect a recession, they agree the chance of one has increased.

“Growth remains solid due to healthy labour markets and corporate profits in the U.S., but near-term risks to growth appear tilted modestly to the downside,” Purani says. “Over the long run, shifts in global economic and political alliances are likely to force changes to traditional economic growth drivers across regions, which may increase dispersion among winners and losers. This is an environment which supports the role of bonds as a portfolio ballast and highlights the potential value of active management.”