Fixed Income in a Disruptive World

Ladies and gentlemen, we are experiencing a time when geopolitics strongly influences the macroeconomic environment and capital markets. How much do these changes alter the framework conditions for institutional investors, especially regarding investments in Fixed Income?

Laura Cooper: Currently, geopolitical power dynamics are shifting as established global orders falter. This marks the end of the liberal trade and security order that has existed for the past several decades. At the same time, we are entering a period of potentially isolationist, tariff-driven policies, that in turn, risks economic autarky with market implicationsFrom a Fixed Income perspective, the impact on global supply chainscould increase inflationary pressure over a longer period, leaving a higher for longer yield backdrop.

What signals are coming from Germany, which is currently experiencing coalition negotiations following the federal election?

Laura Cooper: In my view, the markets reacted somewhat optimistically to the outcome of the federal election, expecting short-term fiscal incentives. We will likely see fiscal reforms abetted by pressure from the USA towards Germany to significantly increase defense spending. However, the near-term growth impact of fiscal shifts is likely to be limited, with scope for a greater lift over the medium-term after years of underinvestment.

Justin Jewell: I agree with Laura on many points, but we should always keep in mind the consequences of the things that are currently changing significantly and rapidly at the geopolitical level. We are not talking about gradual, incremental shifts, but possibly profound shocks. The discussion about the German debt brake has been going on for a long time, but few would have actually believed in its reform two or three years ago. A world of tariffs, into which we may enter, could only be compared in its effects to the protectionism at the beginning of World War I in 1914. We are talking about epochal changes that may lie ahead. Regarding Fixed Income, I can only reliably say that we currently see the political will in many countries to take on new government debt to tackle enormous problems in many areas. For Fixed-Income investors, this could mean a larger market supply, possibly more funding – and that in an environment with perhaps still sticky inflation.

David Hulme: The defense spending of many states will definitely increase. The money for this must come from somewhere, either through cuts in other fiscal expenditures or by taking on new debt. The Trump administration is trying to achieve higher revenues through tariffs and offset their negative consequences for the population with tax cuts. Of course, every new US government makes a course change at the beginning. Therefore, it is difficult to determine at which stage of this government’s realignment we are currently. The only certainty is that a lot is changing quickly at the moment. This uncertainty prompts companies and individuals to pull back a bit, in order to assess the situation.

Shannon Kirwin: Germany has a perspective for a two-party coalition after the election, but the opposition parties are opposing the agreement required for a reform of the debt brake.

Hartmut Leser: As much as I care about the debt brake: Due to the new geopolitical situation, the NATO target regarding defense spending of 2% of GDP for Germany and other European countries is long outdated. If we look at the build-up of the Bundeswehr in the 1950s and 60s and the subsequent spending until the end of the Cold War, 4-5% of GDP in the coming years and later 3% are realistic. Additionally, considering the enormous expenditures for infrastructure and the development of a future-proof energy system, the debt brake in its current form cannot be maintained. However, we should ensure that we do not abolish it permanently.

Justin Jewell: It is a geopolitical and defense policy imperative for Europe – alongside expanding defense itself – to expand its own energy infrastructure to meet industrial energy needs without relying on oil and gas supplies from Russia. These investments are likely to be larger than the necessary defense expenditures and other important investments. As a Fixed-Income investor, I have to ask myself whether Germany and Europe as a whole will be willing to open the checkbook wide enough to finance all these investments through new debt. But how important is this question to the US government?

Shannon Kirwin: It should be important to them. At the moment, it seems that many norms are being thrown overboard. In fact, many policymakers and investors face the challenge of predicting to what extent the aggressive rhetoric of the Trump administration will be moderated and calibrated once it actually becomes reality. Take the example of tariffs! In his first term, Donald Trump made serious tariff threats. When the tariffs were then introduced, they came in a diluted form that did not massively disrupt supply chains. So there is hope that things could run similarly this time. On the other hand, there are indications that the US government is indeed seeking a paradigm shift in security policy, in supporting its European allies, and in its commitments to NATO.

Laura Cooper: This time, the objective of the US government imposing tariffs appears different than with the first Trump administration. Back then, tariff threats werea negotiation tactic to get a deal, and markets had ostensibly been anticipating the same outcome. But the motivations appear different this time around where tariffs are used as an economic instrument to achieve a political outcome. There is a tail risk of the US becoming more isolationist and no longer the hegemonic power it has been for decades, focusing on prioritizing industrial production power.

How will the US economy develop this year?

Laura Cooper: We still see the US economy as robust given the strong starting point. If we assume 10 percent unilateral tariffs, this could weigh on US economic activity by 1 to 1.5 percent this year, leaving us with still positive growth Our base case currently does not include a recession, but what worries us most is the uncertainty about whether these tariffs will come through or not, and how long the policy uncertainty prevails. Due to these delays, companies will start cutting investments. Consumer confidence will weaken. We will see potential ripple effects, such as ongoing layoffs by the government. All of this will add up. Some offset is likely to come through tax cuts later this year with our forecast for a 0.5% lift to growth, but there is still a lot of uncertainty about the tariff impact.

How will the inflation rate in the US develop, which is slightly higher than in Europe at around 3 percent?

Justin Jewell: If I filter out all the noise, it seems to me that the Fed is looking at whether the not particularly high inflation remains persistent or whether it dissipates on its own. From a policy perspective, this attitude may be uncomfortable and challenging. We expect inflation to remain stubbornly elevated this year.

Hartmut Leser: I see two possible interpretations for the current inflation situation: Due to the high inflation rates in 2021 and 2022, real wage losses have occurred worldwide, which are currently being offset by higher wage increases. This would be a temporary process that could be completed in the next 1-2 years and bring the high core inflation rates towards the central banks‘ 2% target. This is the prevailing opinion at the moment. The second interpretation suggests permanently higher inflation rates due to structural changes in the industrialized world. Since the mid-1990s, we have been seeing an increasing shortage of skilled labor in industrialized countries and, after a 20-year stagnation, rising real wages. The demographic development will further exacerbate the situation and possibly lead to further dynamic growth in wages. Additionally, the geopolitical fragmentation of the global economy subjects the global production infrastructure to regional restrictions, resulting in deglobalization. This also leads to higher production costs for companies. Both developments lead to structurally higher inflation. If there is no dynamization in productivity development, this could indeed mean an inflation rate in the OECD of 3-4% instead of 2%. Since this would be an expression of a new equilibrium path for the economy, central banks might not be able to do much about it.

Last year, we saw a new interest rate cut cycle in Europe and the USA. Will this cycle continue?

David Hulme: In the USA, the interest rate cut cycle will certainly slow down. The market is pricing in one to two cuts by the end of the year, but that depends very much on what the US government does with tariffs. The Fed will incorporate certain tariff increases into its projections when it comes to slowing down interest rate cuts. If inflation, on the other hand, falls, then a few rate cuts for the rest of the year are conceivable.

Justin Jewell: In the UK, the monetary policy of the Bank of England is difficult to predict. Political uncertainty has largely disappeared, but the government has not yet clarified what its further policy will look like. The country is still struggling with a sticky inflation profile. This could be exacerbated by currency fluctuations. At the same time, the government needs more fiscal leeway. This is not a good starting position, especially since interest rates are relatively high compared to many other countries. We will probably know more in the fall about which path the UK will take in fiscal policy decisions.

Laura Cooper: We see a greater risk of stagflation for the UK than elsewhere. This is mainly due to the persistent inflation you mentioned. Another driver on the growth side is the increase in the National Employer Insurance Tax this spring. This higher tax burden for employers could significantly weigh on the labor market outlook. This, in turn, could prompt the Bank of England to cut rates more aggressively despite the still elevated inflation backdrop.

Justin Jewell: The UK is in a difficult position with public finances. In addition, there is a real growth blockage that could require fiscal measures at a later date. The government is struggling with various priorities, especially expanding defense, and that with persistent inflation. The easiest way out would be new borrowing as high as the market allows.

David Hulme: Certainly, the trade deficit also contributes to British weakness. The fact that the UK is no longer part of the EU plays a role in this.

Justin Jewell: For that, the UK buys more from the USA, which puts us in a different position vis-à-vis the United States than most EU countries.

Whether USA, UK, or EU: Public debt has risen in many countries in recent years, and the government financing needs will remain high. What does this mean for institutional investors regarding new government bond issuances?

Justin Jewell: New issuances will definitely increase. But the states issuing new bonds face the challenge of deciding where on the curve their offering comes. Many funding programs theoretically include a fairly long-term offer, while the demand from foreign central banks is much shorter-term.

Laura Cooper: The supply of US government bonds could increase by the fourth quarter of 2025 or the first quarter of next year. But there is a lingering question of who will be the marginal buyer of this US debt. In a world of greater fragmentation, the foreign buyer base could slow with China offloading some of its US Treasuries. We could see more domestic, price-sensitive buyers of US Treasuries in the future who demand greater compensation through higher yields. While our base case remains that the safe haven status of US Treasuries is likely to prevail, there will no doubt be elevated bouts of volatility as markets grapple with global developments.

Justin Jewell: Such a shift from one buyer base to another does not seem so dramatic at first glance, but it can have a disruptive effect for a long time. Take, for example, the asset class Agency Debt and the increase in their spreads over the past six months since the Fed pulled back from it! Agency Bonds are now traded in spreads up to Investment Grade and are rated AA+ because there is obviously option value in the vault. Something like this could be a component of the new fragmented world, but it will be quite difficult to anticipate how things will change in asset management and how to derive new principles from it. Such disruptive changes could hit a market like the UK much harder in the future because no investor necessarily has to buy British government bonds. On the other hand, investors will still want to buy the USA. Accordingly, the fiscal leeway for countries that are not so large could be limited in the future.

Shannon Kirwin: In some ways, investor expectations for 2025 echo those of last year. Many investors thought 2024 would be the year of government bonds and duration to really boost yields. In the end, it didn’t really happen. This year, too, investors are seeing falling interest rates and wondering whether to buy duration. At the same time, many market factors make it difficult to have a clear outlook on how investors should position their fixed income portfolios. Recently, the yields of European government bonds have risen as the discussions about defense spending become more concrete, for example.

Laura Cooper: The example of France and its public debt burden shows that policymakers are certainly aware of the challenges of running large budget deficits. However, without a push towards fiscal consolidation, we expect Fixed-Income investors to demand higher yields in French government bonds, keeping us structurally underweight the asset class.

Hartmut Leser: This can indeed develop over a longer period of time. Additionally, in the future, the demographic-induced shrinking of Western savings will make the globally available funds for financing investments scarcer. On the other hand, we must anticipate dynamic growth in capital demand, for example, due to necessary infrastructure investments and numerous private projects resulting from the current breathtaking pace of innovation. This could lead to a permanently higher real interest rate level. In conjunction with potentially higher inflation rates, this could indeed result in us approaching a significantly higher nominal interest rate level over the coming decade, similar to the 6-8% seen in the first half of the 1990s for ten-year US Treasuries.

David Hulme: To increase productivity, governments should deregulate the economy and reduce the bureaucratic burden on businesses. Growth could also be accelerated in Europe with less bureaucracy so that we could grow out of some of these debt burdens.

Justin Jewell: Even the thought of deregulation is political suicide in many countries. Perhaps the market would have to force fiscal decisions – for example, in France. The idea is crazy, but I don’t know where the necessary impetus should come from to change the prevailing mentality. There are role models like Greece and Italy, which made significant structural changes ten to fifteen years ago. We don’t see that in France.

What types of bonds are institutional investors currently in high demand?

Justin Jewell: Here we should first differentiate by region. In the USA, the Fixed-Income allocation was growth-oriented because it was relatively small among many large institutional investors. Currently, demand is shifting towards generic Investment Grade. Investors can earn their return with it without having to take high risks like with experimental investments in the past ten years. This can also be observed in Australia. Fixed-income securities still attract investors due to the low equity risk premium. In Europe, we see a home bias. Domestic government or corporate bonds displace the demand for international fixed-income allocations. This makes sense given tight spreads and tax advantages for domestic government bonds.

Shannon Kirwin: In addition, we continue to see demand for ESG-compliant funds from institutional investors, even though the topic of sustainability has currently fallen out of public discussions. The demand is certainly also driven by regulations that portfolio and pension managers must comply with.

Do others share the observation that investors continue to demand ESG-compliant investments?

Hartmut Leser: In the German market, I still see an interest in ESG-compliant bonds and other assets. But not all institutional investors are enthusiastic about it because considering ESG aspects in the portfolio is intellectually challenging. It is primarily about political correctness. If you dig a little deeper and ask whether ESG-compliant investments actually help E, S, and G, then the net effect of this regulation shows that investors simply implement it because they have to, less because they want to.

Justin Jewell: The regulatory implementation of ESG at the EU level was and is chaotic. Many institutions are simply afraid of being accused of being invested in some unethical business with 0.1 percent of their portfolio. With this fear, they then implement the ESG regulations. Fundamentally, the idea that European institutions invest in sustainable technology and support sustainable growth and green energy is well anchored among institutional investors. But the implementation process has become messy. The tension between some SFDR regulations and implementation through UN PRI sets a process in motion. The fear of being on the wrong side causes unintended consequences. Everyone is just trying to be regulatory perfect. Investments in defense are a perfect example of this. Many European investors would feel uncomfortable investing in the defense sector because it does not fit well into an ESG framework. As a result, these investors do not hold defense stocks or bonds in their portfolio. And now that Europe has to try to expand its own defense infrastructure, a tension suddenly emerges – in the sense that the industry needs more materiality and investors need higher flexibility in ESG regulation and more courage in the face of bad press without panicking.

Shannon Kirwin: Indeed, the discussion about ESG has changed. In 2021, people talked about ESG almost as if it were a magical way to increase alpha without being able to explain the how behind it. In the crisis year 2022, the performance no longer worked, and disillusionment set in. Of course, investors want to ensure they are on the right side of ESG regulatory and potential controversies. In addition, many government agencies have the desire to push solutions for climate change. However, these initiatives do not have to come solely from governments.

Justin Jewell: Many pension funds know that their members also support sustainability. In reality, however, the implementation of ESG regulation can lead to inefficient, sometimes bizarre results, even though many people support the basic idea of building a sustainable future. But with such results, you lose people’s support.

David Hulme: Our European clients are still very focused on a proactive approach. They have exclusion lists that continuously grow. They want to encourage us as asset managers to be more active and interact with portfolio companies to improve their ESG ratings. This is often a positive way because it can reduce some risk factors for companies. On the other hand, today many US state pension plans or other organizations are moving in the opposite direction. You have to be very careful depending on which organization you are talking to. The attitude towards sustainability has changed so dramatically in the USA that many companies that previously had Diversity, Equity, and Inclusion policies – DEI for short – are now quickly withdrawing them.

Let’s look at individual asset classes in the Fixed-Income universe! How is the market for convertible bonds developing?

David Hulme: Long-term returns for convertible bonds were slightly higher last year than in previous years. On the global side, we saw about 8.5 percent returns. In the US, last year’s performance of +11% was above the historical average of about +10% from the past 15 years. In the past three years, the underlying stocks in the convertible bond market have lagged broader indices. This now opens up favorable opportunities for investors for the future. In the past six months, the underlying stocks in the market have outperformed some of the major indices.

Where do you see further opportunities in the convertible bond market?

David Hulme: Mega-cap stocks are too large to issue convertible bonds today, although many have issued when they were smaller companies. We find opportunities in various regions, and new issuance in the convertible bond market last year was strong. The global convertible bond market is about half a trillion dollars, with about two-thirds in the USA. In 2024, global issuance amounted to about $120 billion. This is above the pre-pandemic level, which was mostly between $80 and $100 billion. Recent changes in US accounting rules contribute to convertible bonds being less dilutive to issuers‘ earnings. Many issuers issued many bonds during the early phase of the pandemic because they were uncertain about the future. These bonds typically had a maturity of five years and are now maturing. Some companies are buying back bonds that are currently maturing and issuing new ones. The macroeconomic background is uncertain, but convertible bonds benefit from volatility. A dispersion of returns or volatility can be favorable for the performance of convertible bonds.

Hartmut Leser: The implied volatilities in convertible bonds are still relatively low. In many cases, the embedded call options are still relatively inexpensive.

What’s happening in the Japanese convertible bond market?

David Hulme: The Japanese market used to be the largest convertible bond market in the world and is now one of the smallest, with about 4 percent of the global market size in this asset class. The USA, conversely, was initially much smaller and has gradually grown as the average size of deals has increased. Japanese issuers tend to be medium-sized companies in the range of $1 to $10 billion. The deals are not huge in size but are generally well diversified across industries, technology, and consumer goods. We have recently seen more issuances from Asia, particularly from China. Last year, a number of Chinese companies entered the US market. Notable was Alibaba with a convertible bond of over $5 billion. The company used the proceeds from the convertible bond to buy back its own shares. This allowed Alibaba to leverage its balance sheet and make it more efficient without needing the Chinese government’s approval to transfer money abroad.

Let’s move on to High Yield! How is the demand for this asset class shaping up?

Justin Jewell: Demand is good, markets are expensive. Overall, investors continue to engage in High Yield. The demand for it comes from less traditional areas like fixed maturity funds funds. Look at the products banks are mediating, where you get Cash plus 150 or Cash plus 200 in a short-term structure! Look at the inflows into Investment Grade that could go into higher allocations in Core Plus! Asset-Liability insurance funds also seem to have higher purchases in their programs. So there is a strong force of buying flows in a market that still sees a negative net supply. So this set up is technically in a really good condition, but at a point where the spreads are historically very expensive. It is difficult because such expensive spread levels cannot be maintained without very good demand in the background.

David Hulme: In the USA, the markets are open for refinancing because default rates in High Yield are low. We have seen a significant narrowing of spreads, especially in the Single B and Triple C area.

Justin Jewell: The net supply in High Yield is an M&A-driven supply. Between the High yield bond and syndicated loan market 60% of the companies there are owned by Private Equity. These channels have been somewhat displaced by Private Credit portfolios over the past ten years. The High Yield Market has shrunk a bit. The big question for the High-Yield markets this year is what happens next. How does Private Equity deal with the current situation? The Private Equity community needs to return some cash flow to investors. We currently see more divestments from sponsors than before. But when will some of the unused capital be deployed? This factor is relevant for the future of High Yield and the future balance between supply and demand. It’s unlikely the supply balances changes this year.

At the end of the discussion, let’s venture a forecast for the performance of Fixed Income this year and next year.

Laura Cooper: Given the backdrop of heightened uncertainty, we hold an up-in-quality bias in fixed income, seeking exposures offering attractive income opportunities. This includes senior loans against a backdrop of higher for longer yields, pockets of securitized credit where there remain dislocations, and municipal governments bonds for investors wanting to extend duration. We are also increasingly seeing opportunities across the public-private credit spectrum. Investors are blending Public and Private fixed income, seeking more Multi-Asset Credit opportunities in an ongoing search for yield and downside protection.

Justin Jewell: In terms of return expectations, Trump would quickly make me look foolish if I predict too much now. Basically, we expect a growing economy and no major rise in inflation. You should expect positive but modest returns on fixed income. Especially with credit products with tight spreads, it is to be expected that some spreads will widen over the course of the year. This means: If you start from a baseline of 5 to 6 percent depending on the asset class in dollars, then you will probably erode some of it because the Fed has little room to further lower interest rates. At the same time, spreads will probably be higher, as growth in the US is likely to fall short of expectations. This means positive returns but no exciting real returns in 2025 if you buy the major asset classes. Therefore, I agree with Laura Cooper that investors should be creative to avoid buying the major asset classes that have become expensive. It is important to find ways to extract returns from the corners that are not captured by ETFs, that are not part of the major passive strategies, and that do not align with insurance companies and their solvency rules or with simple global aggregate funds.

Shannon Kirwin: For bond investors, below-average growth–especially if central banks take supportive measures–is generally positive for returns. In this respect, these investors are currently well-positioned, even if all the storm clouds we have talked about, especially the uncertainty about tariffs and geopolitical concerns, are gathering. At the same time, valuations are currently very tight, whether in high yield or investment grade credit. From this perspective, one could be cautiously optimistic while expecting some price dislocations, perhaps also selective buying opportunities, over the course of the year.

David Hulme: My forecast for convertible bonds depends heavily on the underlying stock returns. If we get a broadening of stock market yields, then interesting buying opportunities arise for convertible bonds. Current returns on the convertible bond market are around 1.8 to 2 percent worldwide, slightly higher in the USA at 2.5 to 3 percent. They give you the coupon, plus participation in higher stock values – depending on how the stock markets develop.

Hartmut Leser: For me, there are two scenarios: Due to the changed American policy, the expected normalization of inflation developments and central bank behavior will be delayed, possibly until the second half of 2026. In the meantime, higher inflation rates and the focus on rising national debt could cause disruptions in the bond market, with 10-year US Treasuries at 4.75 – 5%. If this scenario holds true, it would be worthwhile to take advantage of the situation. The second scenario assumes that the mentioned vision of a permanently higher nominal interest rate level begins to concern the markets. In this case, the interest rate markets will be very volatile. Although the second scenario is less likely than the first, it carries significant risk. Therefore, I would say that the expected return of the asset class bonds in 2025 and 2026 lies in a manageable positive range.