Fixed income outlook: Bond investing opportunities and risks

The U.S. dollar’s (USD) status as the world’s reserve currency has come under renewed scrutiny amid the trade turmoil. The USD experienced its second-weakest two-month period since the financial crisis earlier this year — unlike the dollar’s strength through the tariff announcements in the first Trump administration. This marks the first time since 2002 that a weakening dollar has coincided with a major risk-off event, prompting institutions to question traditional correlations and reconsider reliance on U.S. assets.

That said, speculation about the dollar losing its reserve currency status remains far-fetched. No viable alternative currently meets the scale and systemic requirements to underpin global trade. The dollar taking a marginally less prominent share of foreign reserves, especially relative to the rising share of gold, is possible. Full-scale de-dollarization, if it ever comes, is still a long way away, but there is one dynamic playing out that could significantly raise that risk: increasing government debt.

If left unchecked, we view debt as the single greatest risk to the “special status” of the U.S. in financial markets. The U.S. has the highest financing needs (as a percentage of GDP) among the G7, coupled with the shortest average debt maturity, meaning America has to continually issue new debt to fund its obligations.

Despite proposed spending cuts, deficits are still climbing — and more of that spending is now going toward interest payments. With foreign investors stepping back and the government issuing more than half a trillion dollars of debt weekly, the risk of private markets being unable to absorb this debt, and consequently pushing government borrowing costs higher, is tangible.

For more analysis on current bond market trends and potential opportunities, check out our quarterly Fixed Income Outlook, featuring views from colleagues across BlackRock’s fixed income platform.

With the potential to achieve consistently high levels of income, and with contained drawdowns, we believe the current fixed income landscape provides a generational opportunity for bond allocations, particularly given its income recognition and stability in this unstable world. From 2013 to 2021, only emerging market and high yield debt provided yields over 4%; now, over 80% of fixed income sectors are yielding 4% or greater.¹ (Figure 2)

Although we believe the U.S. is unlikely to be displaced as the global hub of innovation and the economy is positioned to remain resilient over the intermediate term, the short-term picture may be bumpy. In a sense, the ability to deliver consistently high coupons to global portfolios can serve as something of a bulwark against equity market drawdowns, especially at a time when duration itself has failed to serve its traditional function.

Markets have moved away from excessive expectations of Fed cuts for the year. In our estimation, growth should slow from the first quarter’s robust readings even with tariff de-escalation, making the front-end a good core holding.

Meanwhile, the global rate-cutting cycle is likely to continue — and could even be accelerated — due to deflationary pressures from the rerouting of global trade in goods. In contrast to the U.S., lending opportunities in Europe and parts of Asia offer compelling ways to gain longer-duration exposure. In a market environment marked by heightened uncertainty and unreliable correlations, the case for a larger allocation to stable, income-generating investments has never been stronger.

In the current environment, we are swayed by a desire to hedge against potential near-term tariff-driven inflation surprises, while building in resilience against possible slower growth and more pronounced disinflation later in the year. Here are some observations from the fixed-income team on where opportunities may present themselves:

Duration, Less Is More:

Within large parts of the fixed income universe, duration is no longer the reliable hedge it once was. Given today’s macro backdrop, we don’t expect that to change. Still, with the Federal Reserve likely to keep rates above neutral for longer, debt markets are offering historically high income levels to investors once again.

In this environment, we believe investors should prioritize income over duration. Yields across the board have rarely been this high, especially at the front-end of the yield curve, giving investors the chance to earn very attractive returns from high-quality borrowers with little duration risk. Even with inflation running higher than it has this century, these nominal yields dramatically eclipse run-rate inflation, something rarely seen over the prior few decades. And for the duration we do own in the U.S., we prefer to own in the front to belly of the curve. There, rates are unlikely to move higher and the Fed has more room to move in the event of any shock, making convexity increasingly attractive.

The iShares 0-3 Month Treasury Bond ETF (SGOV) seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities less than or equal to three months. Short-term Treasury Inflation Protected Securities (TIPS) may also play a role here and can be accessed via the iShares 0-5 Year TIPS Bond ETF (STIP).

Be Active, Think Globally:

In a market characterized by higher rates and elevated volatility, the uncertainty from tariff negotiations, geopolitical tensions, and a U.S. fiscal conundrum warrant active investment. Regional expertise from dedicated resources is going to be a crucial driver of performance, trumping global market themes. Consistent with overall macro themes at play, one area where we have seen opportunity to enhance the diversification characteristics in portfolios is with international bonds. Access to a deep bench of local research analysts, traders and capital markets experts is crucial in bottom-up investment idea generation. Portfolio managers need flexibility and conviction to take targeted positions and focus on relative value opportunities as large directional bets will be less effective in this market environment.

The iShares Flexible Income Active ETF (BINC) is an example of an active ETF that seeks to outperform an index,  also known as alpha-seeking. Launched in May 2023, BINC seeks to offer investors access to sectors of the fixed income market that can be challenging to reach, including European credit, high yield, and securitized products. The ETF is managed by an experienced team led by Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income and Head of the Global Allocation Investment Team.

BINC focuses on utilizing “plus” fixed income sectors, beyond the traditional, well-known “core” markets, to seek income and manage risk through different market environments, which can make it complementary to core strategies. “Core” refers to the traditional fixed income asset classes with the highest credit quality, such as U.S. Treasuries, U.S. agency mortgages, and U.S. investment grade corporate debt. Conversely, "plus" refers to fixed income asset classes outside of the "core" universe, such as U.S. high yield corporate debt, securitized products, and global debt.

The fund has the ability to invest across the full extent of global fixed income opportunities in an effort to create a portfolio that generates “plus” income with less volatility.

Muni Spotlight:

U.S. municipal bonds (munis) are prized for their tax advantages, but their historic tendency to provide a stable source of return also makes them valuable amid market volatility and uncertainty. Munis are generally less vulnerable to inflation shocks or the crossfire of global trade policies because they are often linked to public authorities that provide fee-based essential services, such as waste collection and public transportation, or secured by taxes on sales, property and income.

Munis have also shown historically low default rates and high credit ratings (Aa3 versus Ba1 for global corporate debt, on average) thanks to the disciplined finances and stable revenues of most state and local governments.

Tax equivalent yields of munis have reset to levels not seen consistently in over a decade — 6.79% and 9.86% for investment grade and high yield respectively.² Against this backdrop, we see opportunity to increase allocations, particularly as the outlook for limited supply relative to demand in July and August could bolster performance.

We believe municipal bonds’ long-term record of stable return provides a unique opportunity to enhance portfolio resilience in what is likely to remain a less-than-stable macro environment. Their attractive yields relative to taxable counterparts and potential ballast to equity risk make munis particularly compelling, with a favorable supply/demand picture in the summer months setting the stage for strong performance.

The iShares Intermediate Muni Income Active ETF (INMU) seeks to maximize tax free current income through an actively managed, diversified portfolio of municipal bonds.

We believe the current fixed income landscape provides a generational opportunity for bond allocations, particularly given its income recognition and stability in this unstable world. In an environment marked by heightened uncertainty and unreliable stock-bond correlations, the case for a larger allocation to stable, income-generating investments has never been stronger.

For more analysis on current bond market trends and potential opportunities, check out our quarterly Fixed Income Outlook, featuring views from colleagues across BlackRock’s fixed income platform.