Cracks forming in the credit markets and more uncertainty about rates and the Federal Reserve have added a dose of volatility. Bonds, however, remain attractive, even if income-oriented investors should make some adjustments to their portfolios to prepare for the year ahead.
This has been a good year for bonds. Every major subcategory, from such emerging market and high-yield bonds to Treasuries and bank loans, has generated positive returns.
Good things always make investors nervous—and there are reasons to be if you look hard enough. Credit spreads—the difference between higher- and lower-rated bonds—are as tight as they have been in 25-plus years. At the same time, corporate bond issuance is accelerating amid an artificial-intelligence-fueled capital spending boom. There are also signs of stress emerging. In September, subprime auto lender Tricolor filed for Chapter 7 bankruptcy protection, sending shock waves through the credit markets.
Warning signs such as these can cause investors to think it’s time to sell bonds and batten down the hatches. “Surely, it can’t go on like this,” says Morgan Stanley strategist Andrew Sheets, imitating their possible reaction.
And they won’t. Spreads are expected to widen, which means lower-rated credit assets will struggle relative to more highly rated bonds. Goldman Sachs forecasts that investment-grade corporate and high-yield bond spreads will rise by about 0.1% and 0.4%, respectively, by the end of 2026, giving higher-quality bonds an edge heading into the new year.
Duration risk is also increasing, says IDX Advisors chief investment officer Ben McMillan. Duration describes how long bond investors have to wait to get their money back. Longer-term bonds have higher duration than shorter-term bonds, all else being equal. And short-term bond yields have come in more during the year than longer-term yields, giving shorter-term strategies a leg up. The Vanguard Short-Term Treasury exchange-traded fund, for instance, had a marginally better year than the Vanguard Long-Term Treasury ETF.
Yet despite the risks, bonds should be fine in 2026. A combination of easing monetary, fiscal, and regulatory policies creates a “triple easing” that will create the conditions for another good year, says Morgan Stanley’s Sheets.
But the current setup requires a shift in strategy. At the start of 2025, more risk in a credit portfolio was the answer. Heavier weightings to higher-yielding, lower-grade, longer-duration bonds made sense. Now, with credit spreads tighter, investors should be asking if they are being compensated well enough for any extra credit risk they are taking, adds IDX’s McMillan.
He favors edging into higher-rated bonds over lower-rated ones, agency mortgage securities over corporates, and shorter-duration over longer-duration. For investors, that can mean shifting some capital into ETFs like iShares MBS, Schwab Short-Term Treasury, or Vanguard Short-Term Corporate Bond. McMillan’s IDX runs IDX Dynamic Fixed Income, which aims to adjust for credit conditions on the fly.
Morgan Stanley, for its part, sees European bonds as marginally more attractive than U.S. bonds, and the financial sector as more attractive than other sectors. The Invesco International Corporate Bond ETF is one option to express that view. Sector bond ETFs are tougher to find, but Invesco Financial Preferred holds preferred stock in many financial institutions.
Yes, the picture could change. Aggressive quantitative easing-like policies by the Federal Reserve could revise the outlook for longer-duration assets or spreads. Investors, however, can react to policy shifts when the time comes.
For now, some changes at the margin look prudent as the calendar turns to 2026.
Write to Al Root at allen.root@dowjones.com
