A ‘multi-engine approach’ to fixed income

Fixed income investors face a peculiar predicament heading into 2026. Credit spreads have compressed to levels not seen since before the global financial crisis, volatility has all but vanished from bond markets, and yet the underlying yields remain attractive enough to keep capital flowing into the asset class.  

Meanwhile, the old playbook like leaning into duration for diversification and holding government bonds for safety no longer commands the same confidence it once did for institutional investors. 

"People are a little bit scarred from 2022. They don't see duration as that bastion of portfolio resiliency that it used to be," said TJ Sutter, portfolio manager and head of the fixed income team at CC&L Investment Management, noting that scarring has prompted a rethink as corporate pension plans and institutional investors are looking for returns without heavy duration exposure. "People are looking at it in a more creative way," he said, adding that they also want short credit indexes, hedged duration, and uncorrelated return streams.  

He believes the fixed income sector remains too siloed in its thinking. Most investors still categorize bonds as either duration plays or long credit, with little in between. The real opportunity, he argues, lies in products that can deploy capital across multiple uncorrelated return streams within a single vehicle - what he describes as “a multi-engine” approach”. The more diverse those return sources, the more consistent the performance through different market cycles. 

"It’s still underappreciated. I think that most people are still looking at fixed income like ‘This is our duration replacement, and this is our long credit’," he said. 

According to Sutter, "credit is in the 95th percentile of tightness of credit spreads in the last couple of decades. And long credit strategies are pretty crowded," he noted.  

While he stops short of predicting a sharp reversal, he suggests investors should reconsider how much exposure they want to trade. 

Yet Darcy Briggs, senior vice president and portfolio manager for Franklin Templeton’s fixed income team has responded to stretched valuations by moving up in credit quality. He underscores spreads have compressed to levels last seen before the financial crisis, and while exiting credit entirely isn't practical, staying defensive makes sense.  

"You're back to 2007 type of spread levels. Incredibly complacent markets, but you can't be totally out of the space," he said, adding upgrading quality allows his team to maintain carry while preserving flexibility to add risk if corporates sell off relative to governments. 

Last year's winning trade centered on Canadian duration as the Bank of Canada cut rates. Now that the central bank has paused, consensus remains divided on whether further cuts are coming. But Briggs believes the more interesting opportunity may lie south of the border. 

"I think a big trade this year might be US duration, and it has to do with the Fed still considering easing rates," he said, adding the key isn't about selling US assets but rather about buying them and positioning for rates to move lower. 

When asked what he sees as the most compelling area of fixed income, James Arnold, senior vice president and portfolio manager at Burgundy Asset Management, also points to credit, regardless of whether investors focus on investment grade, high yield, or structured products across geographies.  

“Any mandate with flexibility towards credit and different types of credit markets is well positioned here," he said. 

Still, he concedes that spreads have tightened to levels that introduce valuation risk. But expensive index-level valuations don't tell the whole story because opportunities remain for those willing to dig deeper into individual issuers and sectors trading at more attractive levels. 

To that end, he sees a steady migration toward corporate credit among institutional investors, noting that allocations have increased not only to investment grade but further down the quality spectrum into high yield.  

“Broadly, higher quality has opened up a little bit more directly but it does seem as though flows into corporate bond funds are relatively positive and we're certainly seeing that, given the technicals in the marketplace,” he said, noting that new issues attract heavy oversubscription, pricing comes in tight, and spreads have held firm despite a range of risks.  

"Spreads, generally speaking, remain very resilient in the face of a number of risks that are out there," he added. 

Still, tight spreads offer reasonable absolute yields when compared to the post-financial crisis era, though Briggs notes that most of that yield now comes from the government curve rather than the credit spread component. Default risk barely registers in current pricing, and volatility has collapsed. That suppressed volatility creates an opportunity for Briggs.  

"You want to buy volatility when it's cheap and it's really cheap right now," he said. 

With corporate valuations stretched, his team focuses on idiosyncratic situations - issuers offering compelling yields or diversification benefits rather than broad market exposure. The stimulus tied to midterm elections should support risk assets near term, but surprises remain possible.  

"We're waiting for a volatility event to actually provide those opportunities. We're building in buffers or some capability to capitalize on those if and when they occur," he said. 

Carl Pelland also sees credit remaining attractive on a relative basis despite tight valuations, acknowledging the economic backdrop supports the case. Moderate growth in the 1 to 2 per cent range benefits corporate margins without overheating the economy.  

"The companies, especially in the US, have never had so much high margins," said Pelland, vice-president of fixed income and head of corporate and impact bonds at Addenda Capital. Canada, however, presents a less compelling picture, with margins lagging their American counterparts, he noted. 

While this environment favours risk assets, Pelland stops short of recommending aggressive positioning. 

"We're not being paid right now to take more risks. So being a very high-quality portfolio in corporate bonds is very interesting," he said, emphasizing the strategy centers on capturing stability through quality rather than reaching for yield in lower-rated credits. 

“It’s really about the ability to be flexible within the credit space… It increases diversification, which is a huge benefit to investors in this space as well. That’s really the area that investors should be focused on,” said Arnold.  

Sutter ultimately argues that investors need to first clarify their objectives before evaluating fixed income strategies. Duration-heavy approaches offer diversification by performing well during equity drawdowns, while credit-heavy strategies tend to move in tandem with riskier assets. The real opportunity, he suggests, lies in alternative strategies that offer uncorrelated return streams - an area he believes remains underappreciated. 

He points to evidence that skilled managers can add value in bonds in ways they can’t in equities.  

"The median manager in fixed income outperforms the market, which is unlike equities. And so what that tells me is there's evidence of skill in the fixed income market," he said, adding too often, investors fixate on headline yields without examining what's actually generating those returns.  

"I think that's the important thing - finding the strategies that are either more reliant on the alternative sources of return stream or have the wherewithal and the ability to risk budget between those return streams," he said.