Inflation, rates, AI to shape fixed-income strategy for 2026

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Aaron Young, executive director, client portfolio management, CIBC Asset Management 

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Fixed-income markets were driven by, really, two key macroeconomic drivers this year in 2025. The first one — more front-loaded to the start of the year but having a huge impact — was a lot of the unknowns around tariffs and trade policy coming out of the Trump White House. This really fed into worries about impacts to inflation in the market. How do those increased costs from tariffs — wherever they may land— get passed on through to consumers? Does the consumer foot the bill? Or are companies going to eat that and see some margin compression? That unknown really led to volatility in the market, especially if we look at the first half of 2025, whether we’re talking about rates or credit. 

And then the other looming macroeconomic theme or driver was does this also lead to a slowing in the economy to the point of recession? You know, it’s not talked about as much these days, but really, we have to remind ourselves that the entire market, and fixed-income participants, and really everyone across asset classes, was waiting for a recession that never really came to fruition within the U.S. So it was a bit of waiting for Godot for the recession that never showed up. 

For fixed income, the real impact around these macroeconomic drivers was how that feeds into inflation. So where is inflation going to print in the near and long term? And how does that feed through to monetary policy? Waiting to see is the Fed going to move to lower rates. Up here in Canada, we had moved earlier, we had seen that impact. So really, what’s going to happen around interest rate policy? 

The other element that was really a focus on the markets and — much like waiting for a recession — never really came to fruition was stresses on corporate balance sheets, corporate strength. If I’m invested in corporate bonds, whether it be investment grade, high yield, etc., how well can those companies weather the unknowns of tariffs, possible slow down, other geopolitical risks? That was a main driver of some spread volatility. But the markets kind of shrugged it off as well, and looked past the short-term unknowns to say, you know, even as a fixed-income investor, if I’m going into credit risk, there’s not that much to worry about, and markets are pricing it that way. 

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2025 was really defined by what we call the Fed kickoff. The Fed made its first move to cut interest rates. As Canadian investors, for a while now, we’ve been acutely aware of the policy rate differential between Canada and the U.S., with Canada cutting earlier and deeper. As with any element of cutting of interest rates, that’s good for bond markets, especially if you have some duration in your portfolios. 

So, if we look at the two cuts we got from the Fed, that really supported U.S. markets. So if you had U.S. fixed-income exposure, that was a plus. And especially if you focused in the mid-section of the market to the longer end, with rates parallel shifting down, you would have benefited quite a bit there. 

Just to give some general numbers around it, if you look at the U.S. aggregate bond market in U.S. dollar terms, 7.5% total return as of around end of November 2025? That’s really good upside for a core bond-market exposure and really speaks to the upside you can get from fixed income as bank policy rates shift and move lower. 

If you compare that to Canada — again around end of November, roughly 3.5% for the Canadian aggregate, or the Canadian core bond market? That shows the dynamic, where in Canada we’ve already had those kind of deep, higher velocity cuts, and now we’re starting to get into the balance zone where, you know, we still call for a few more cuts, but it’s not going to be as impactful as we saw, say, in 2024 or 2023. 

Really, what the question is going forward is still the unknowns around future paths of policy rates. So although we have seen the Fed move and deliver those two cuts, the read on future cuts is relatively hawkish, meaning it’s not as certain that we’re in a longer-term cutting regime. That’s the Fed hedging its bets a bit, because we don’t really know if inflation is going to continue downwards. Are we going to see something flatline around this kind of 2.5%, 3% range that we’re in right now, and the Fed doesn’t want to be cutting into a reinflation environment. So although, as we say, the easy money has been won, especially if you had some U.S. exposure in your fixed-income portfolios, the question is now, where do we go from here? Are rates going to stay where they are? We don’t think you’re going to get as many cuts as some market participants are expecting. That’s not a bad place for fixed income going forward from a bank interest-rate policy perspective, because at the end of the day, you’re kind of clipping a still-attractive coupon. Fixed income operates the way it should be by generating income for your portfolio. It’s really not a bad place to land there. But there is some question marks around where do policy rates go from here? 

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How you’re positioned in your fixed-income portfolios in 2025, is really dependent on if you’re taking advantage of the major themes we’ve been talking about in the podcast today. Having some duration risk on — so moving away from that zero interest-rate risk in your fixed-income portfolio, especially again, with some U.S. exposure — really benefited there. So if you were still thinking about we’re in the 2022 environment, where rates went up, I don’t want any interest-rate risk, put me in very short duration cash, you would have missed out on another really good year for fixed income generally. 

So duration was a contributor, which again investors and advisors need to think about. Duration is not always your enemy. We’re not saying go out and buy long bonds, but it’s a good way to capture those shifts in policy divergence between Canada/U.S. 

The other element is continued curve steepening for the market. And for us in our portfolios, we were positioned for relatively persistent curve steepening throughout the year, and that has played out much to what we were looking for; 2s-30s, 2s-10s [comparing the yield curves of 2-year bonds to 30-year-bonds and 2-year bonds to 10-year bonds, respectively], those parts of the curve did relatively well, positioned for a curve steepener. 

So as we always say, duration is one thing. How you get that duration or interest-rate risk profile is very important. This was the year of curve steepener. Lots of people had that trade on, and it worked out well. Less so now. [We’re] thinking that that trade’s kind of played out a bit. 

And then from a sector standpoint, really what I would point to is investment-grade corporates — whether we’re talking U.S., Europe, Canada — perform quite well. You know, anywhere from, let’s call it 4% or 5% in Canada near the end of November, 7%+ if you’re looking at U.S. corporates, little bit lower in Europe. But what we like to point to is the delta between owning corporates over, say, governments, U.S. Treasuries, provincials, Government of Canadas. You picked up extra basis points, but we would argue that the difference wasn’t enough to make it worthwhile to go all out on corporate credit. 

So if you look at our portfolios, what we’ve done — and it’s been a good trade — is continued strength in corporates, sell down that risk more, take some chips off the table, redeploy into higher-yielding governments, really safe positions, not because we think there’s a big blowout in corporate credit coming, but just the risk-reward doesn’t make as much sense. [It’s] more prudent to move to that safer part of the sector-allocation decision, whether it be governments, agency MBS, provincials, etc. We can get just as good a yield in return without overly exposing ourselves to credit risk. So, really, at the end of the day, a bit more duration of the portfolio, curve steepener was the trade, and de-risking throughout 2025. You would have done very well as a fixed-income investor. 

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The main themes for 2026 will likely be similar to 2025, in the sense of, as a fixed-income portfolio manager, the unknowns around inflation, the future path of the economy, and what’s really driving that are the question marks that lead us to, are we stabilizing in terms of interest rate policy and developed markets? Are we possibly at risk of re-inflation at some point? 

And one of the main drivers of that we’ve been thinking about quite a bit is the AI boom and spending, and that impact on the global economy, but especially in the U.S. 

And then also looking at where is the best risk-adjusted dollar allocated within a fixed-income portfolio? And for us, that’s really a valuation exercise. 

So, I go back to corporate credit — everything from investment grade to high yield to leveraged loans to lower-rated CLOs to private credit — our biggest question is, valuations, by any measure, are relatively rich. And does that really call for quite a bit of overweight to credit? And especially credit beta? So credit without the active component of picking those best idiosyncratic stories you can find. We would argue no. There’s lots of yields still in fixed-income markets in lower-risk portions. 

The question for us, really, is what causes some point of spread widening? Does it happen from an exogenous event that causes spreads to blow up very quickly? Is it just a grind wider as the market reprices? Or can we stay at these very tight levels for a long period of time? 

No one knows the answer to that. I think the key thing in this environment, when credit in its formats is trading relatively rich, it’s a bit cliche to say, but active management — looking at, kind of micro cycles within different sectors, being very selective in where you’re allocating there. Something like private credit, thinking about the tenure, the experience of your private credit manager, going through different cycles, different rate environments.  

For us, especially going into the credit space, the focus should be on really, highly risk-adjusted total return, and more focus on possible downside than trying to capture upside. We do think that’s going to be the playbook for success in 2026.

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