The Current Fixed Income Landscape
The fixed income market is currently experiencing elevated volatility. We have seen a flattening yield curve following a hawkish pivot under the new Federal Reserve chair, Kevin Warsh. Yields have come down off their recent highs, yet excellent opportunities still remain across the fixed income landscape. The central task for investors is deciding where on the curve to find the most compelling risk-adjusted entry points.
The Fed is one of the biggest forces expected to shape the fixed income market over the second half of the year. The prevailing market bias right now leans toward a potential rate hike. However, we are not there yet. There appears to be a genuine "wait-and-see" mode at the Fed, and it would not be surprising if the Fed remains on hold for the remainder of the year.
Duration Positioning
The recommended stance is a slightly shorter-than-benchmark duration. To frame this: the average fixed income investor often uses roughly a six-year benchmark duration, closely tied to the duration of the Bloomberg US Aggregate Bond Index, which serves as a proxy for many fixed income portfolios. Against that backdrop, a duration of about four to five years is currently appropriate.
The reasoning is that there is limited upside in longer-term yields going forward. While yields are a little off their highs, a case can be made for potentially higher yields over the rest of the year. This is not a call for a blowout in yields, but it would not be surprising if yields drift modestly. With the Fed likely on hold — and possibly biased toward hiking — there is less of a penalty for being positioned a little shorter-term. Importantly, "shorter" does not mean going all the way to cash. There are still real opportunities in intermediate- and longer-term bonds, but they should be pursued in moderation.
Why Lock In Longer Duration When Cash and T-Bills Pay So Well?
A key question: Why would a conservative investor lock in a longer-duration bond when cash and T-bills are offering highly competitive, low-risk yields right now?
This is a favorite question among strategists, and it became especially prominent when the yield curve was inverted and shorter-term investments paid higher yields than longer-term ones. The answer centers on reinvestment risk. By buying a longer-term bond, you lock in that yield and remove your income stream from the whims of the Federal Reserve.
The mechanics matter here. If you plot the yield on very short-term investments against the federal funds rate, they track one another very closely. The 10-year Treasury, by contrast, moves differently and is not so tightly bound to the Fed's decisions. For investors who hold fixed income specifically for the income stream, it does not make sense to leave that income at the mercy of Fed policy.
Consider the scenario in which conditions improve — the situation with Iran resolves more concretely, and the Fed shifts back into a cutting bias over the rest of the year. That is regarded as a high bar, but it remains possible. In that case, yields on short-term investments would move lower, and the income from cash and T-bills would fall with them. This is precisely why it makes sense to lock in some longer-term bonds now, capturing attractive income across the yield curve rather than exposing the income stream to future Fed moves.
Oil Prices as a Driver of Rates
Oil prices have become a major driver of rate expectations. The reason the fixed income market has grown so hyper-sensitive to oil, more than to other economic indicators, comes down to one thing: inflation. Inflation has been the dominant story in fixed income since the onset of the Iranian crisis.
There has been a very close correlation between the 10-year Treasury yield and oil prices, driven by inflationary concerns. Higher oil prices do not just mean higher prices at the pump; they also mean higher shipping costs, higher fertilizer costs, and higher packaging costs. The market's core worry is that these inflationary pressures will become embedded, producing higher long-term inflation and therefore higher long-term yields. This dynamic pushed yields higher through the first half of the year. There has been a recent pullback in yields, but notably it has been far smaller than the corresponding drop in the price of oil — a divergence that reflects the underlying concern that inflation may become entrenched going forward.
The Floor and Range for the 10-Year Treasury
If sticky inflation keeps the front end of the curve pinned down, where might the 10-year Treasury yield settle in the second half of 2026?
Over the next half of the year, it would not be surprising to see the 10-year Treasury trade in a range of roughly 4% to 4.5%. Yields have already been within that range for quite a while. If forced to identify which direction a breakout would take, the greater likelihood is a break to the upside.
The reasoning comes from decomposing the 10-year Treasury into its three major components:
- The Fed funds rate
- Inflation expectations
- The term premium — the uncertainty compensation for rolling over shorter-term bonds, tied to uncertainty about the Fed
There is more upside than downside to all three. Sticky inflation is a concern for longer-term yields. The term premium is likely to move a little higher, or at least not fall anytime soon. Together, these factors should keep longer-term yields relatively elevated. This is not a forecast of an outright breakout to the upside — the base case is that yields remain range-bound — but if they were to move, higher is the more probable direction.
Portfolio Structure: Core and Aggressive
Given the "higher for longer" environment and the potential for a Fed hike, the recommended portfolio structure splits between a core allocation and an aggressive allocation, with the aggressive sleeve capped at 20%.
The aggressive income sleeve includes:
- Preferred securities
- High-yield corporate bonds
- Emerging market debt
The guidance is not to avoid aggressive income altogether, but to be a little cautious with it. Within the aggressive sleeve, preferreds and high-yield corporate bonds are favored. The rationale is that the absolute yields on offer are relatively attractive. Candidly, spreads are relatively tight, but the absolute yield being offered can compensate for that tightness in spreads.
The relative fundamentals of corporations also support this view — especially banks, which issue many preferred securities and are currently in pretty good shape. There are no major concerns of a blow-up in that space.
One caveat deserves attention: preferred securities usually carry longer durations, which makes them more sensitive to rising interest rates. In an environment where the risk to yields skews higher, that interest-rate sensitivity is something investors must remain aware of and cognizant of going forward.
