Tiffany Wilding

Markets and observers weren’t surprised when the Federal Reserve held its policy rate steady at the April meeting. More notable, in our view, were the three dissents by voting participants who did not support keeping the implicit easing bias in the policy statement’s forward guidance language. We presume their preference would have been a stronger signal that the next interest rate move, whenever it occurs, could be either a hike or a cut.

Our view remains that the next move will be a rate cut, but the timing is far from clear. 

Chair Jerome Powell’s press conference emphasized the wide range of possible outcomes associated with the Middle East conflict, along with generally high uncertainty. He suggested that changes to the statement were a close call – more committee members supported more hawkish changes than during the previous meeting in March. Powell also argued that Fed policy is in a good place to react to the economic implications of the energy supply shock, which poses risks to both sides of the Fed’s dual mandate: maximum employment and price stability. 

Markets thus far seem to have interpreted the Fed’s signals as a hawkish shift, though the reaction seems tempered by expectations that Kevin Warsh, the incoming Fed chair, will be able to keep the Fed on hold despite stagflationary pressures from the Middle East conflict.

We still think there is a high bar for the Fed to reverse course and hike rates. Given the significant uncertainty over energy prices and energy supply (for details, read Macro Signposts, “Temporary Disruption – or the Start of a Global Supply Shock?”^[1]), the Fed is likely to hold rates steady until it sees the inflation/unemployment trade-off becoming clearer.

Why the tone skewed a bit more hawkish

With the Fed widely expected to be on hold, the meeting was always going to be about communications. The statement kept its implicit easing bias – which garnered the three dissents – while Governor Stephen Miran continued his pattern of dissenting in favour of easier policy.

The easing bias in the statement is subtle and centers around the forward guidance sentence: “In considering the extent and timing of additional adjustments to the target range for the federal funds rate …” The word “additional” in this context has been interpreted to mean additional cuts. The dissenters would have presumably preferred to more strongly suggest that the next rate move could be either a cut or a hike – we see a hawkish (or at least less dovish) leaning implied in their dissents. That forward guidance language could be changed or removed as soon as the next meeting, if developments warrant it.

At the press conference, Powell articulated a modest shift in Fed views in a more hawkish direction. In practice, this likely translates to a period of holding rates steady until the economic data, outlook, and balance of risks paint a clearer picture for the policy path.

Baseline still implies cuts, but timing looks more conditional

Despite all of this, we still expect the next rate move will eventually be a cut, and we still pinpoint roughly 3% as the neutral policy rate. However, the timing is uncertain. If the Iran conflict and energy shock appear more persistent, it could take longer for core inflation to more clearly begin to moderate back toward the Fed’s target, complicating the decision to ease monetary policy.

Many observers and policymakers remember the pain of the sharp inflation spike in 2021–2022. We see important differences between now and then that should help mitigate core goods price inflation spillovers into broader services categories. The widespread inflation during the post-pandemic episode was also related to large fiscal transfers (such as federal spending packages to support households and businesses) and compounded by an extremely tight labor market – factors that aren’t present today. 

Eventually, as energy prices moderate (assuming they do), the Fed could still cut a few more times to align the current policy range of 3.5%–3.75% with the Fed’s median estimate for neutral policy of roughly 3%.

On the other hand, in a risk scenario where there is a more prolonged disruption in physical energy supplies out of the Middle East, the trade-offs look starker. Even though the U.S. is relatively insulated as a net energy exporter, the higher global recession risks, and likely tightening financial conditions, would eventually lead to rate cuts, in our view – although an initial surge in global inflation would likely delay the central bank’s reaction to weaker activity.

Warsh transition unlikely to shift policy outlook

This was likely Jerome Powell’s final meeting as Fed chair. He committed to staying on as a governor until the legal investigations into him and the Fed building renovation costs were over with “transparency and finality.” He also said that Fed officials should be able to “make monetary policy without political considerations.” He did commit to stepping down, but his comments leave plenty of room for interpretation on when he might feel comfortable with leaving. He also committed to maintaining a “low profile” as a governor and to aiding soon-to-be Chair Warsh where he can.

Powell also shared that Fed officials are worried about a continuation of challenges against the Fed or its people, and he specifically noted that the removal of Federal Reserve Bank presidents due to policy choices would be “the beginning of the end.”

In our view, the Warsh transition should mainly affect Fed communication – and market interpretation – rather than interest rates themselves. Warsh did not seem overtly dovish in his Senate hearing. Indeed, he criticized the Fed for being late to act on inflation in 2022. He did point to trimmed mean and median inflation measures, which are currently running under core personal consumption expenditures (PCE) inflation – a modestly dovish lean. These measures have historically tended to run above core inflation and will likely accelerate if higher energy prices broadly push core goods inflation higher.

Our working assumption remains that Warsh’s current bias (similar to the Fed’s median) is toward cuts, and that the Fed will remain an independent institution under his watch.

By Tiffany Wilding, Economist

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Notes:
[1] “Temporary Disruption – or the Start of a Global Supply Shock?”)

The post Fed’s holding pattern continues amid competing risks appeared first on AdviserVoice.

Tiffany Wilding

U.S. headline employment rebounded strongly in March, posting the largest monthly gain since late 2024. The jobs rebound, which was broad-based across industries, was a welcome sign after February’s data showed a sharp decline not usually seen outside of recessions. Weather-related disruptions and a healthcare workers’ strike likely contributed to the monthly volatility.

Beneath these swings, however, we’re seeing a more consequential shift: Structural changes in the U.S. labor market are changing the composition of U.S. real GDP growth – and therefore changing how we should interpret labor market data when assessing the broader health of the economy.

More restrictive U.S. immigration policies along with long-running demographic trends are reducing labor supply growth and employment trends essentially to zero. This means that the U.S. economy now relies solely on real productivity growth to maintain its 1.5% to 2% trend in overall GDP growth – an unprecedented dynamic.

In the near term, stagnant labor force growth will likely provide a strong incentive for businesses to invest in labor-saving technology. Indeed, AI investment and implementation accelerated dramatically in 2025, and investment trends are likely to remain strong. In terms of monetary policy, weaker headline payrolls figures aren’t likely to garner the reaction they have in the recent past, as larger and more sustained employment contractions are now needed to increase the unemployment rate.

Over the medium term, economic growth may largely depend on how quickly and effectively AI implementation can contribute to sustainably higher productivity growth. At this point, AI’s trajectory is an open question. Without a significant boost from AI, stagnant labor force trends could eventually lead to lower investment, slower growth, and lower rates.

Declining size of the U.S. labor force

At its most basic level, real GDP growth can be broken down into two factors – growth in aggregate hours of employed labor (which depends on population and labor force trends) and the productivity of workers during their hours worked. Changes in labor force growth – or those individuals who are currently employed or looking for a job – will have important implications for broader growth trends.

Since the 1960s, trend labor force growth in the U.S. has shifted due to demographic trends. At its peak in the 1970s, trend labor force growth was 2%–3% per year as more women joined the workforce and as both men and women from the post-WWII baby boom reached working age. Since then, labor force growth has slowly declined along with fertility rates, and the aging population has meant more retired workers – see Figure 1.

These demographic trends left the U.S. increasingly reliant on net immigration to sustain labor force expansion. Over the past decade, foreign‑born workers accounted for roughly half to two‑thirds of net U.S. labor force and employment growth – nearly all of it in the post‑pandemic period.

Humanitarian immigration – mainly asylum seekers – surged in the wake of the pandemic and contributed to a reacceleration in U.S. labor force growth from 2022 to 2024. More recent policy changes have not only reduced the inflows of immigrants, but also increased the outflows. Research by Wendy Edelberg and other labor economists at Brookings1 has found that net migration was likely close to zero or negative over calendar year 2025 and is very likely to be net negative in 2026.

Changing U.S. growth composition

Unless immigration policy returns to a less restrictive stance, labor force growth will likely remain stagnant or even decline. Recent Federal Reserve staff research2 highlights two important implications: First, near-zero labor force growth implies that average monthly job gains needed to keep the unemployment rate stable are also near zero – making negative job growth as likely as positive in any given month. Second, growth in potential GDP is likely to depend entirely on productivity gains.

In its latest economic outlook, the U.S. Congressional Budget Office (CBO) projected the trend in productivity growth to be 1.5%, while under pre-pandemic immigration policies the trend labor force growth was 0.5%. Combining these components left trend real GDP growth at 2%. If labor force growth is now zero, that should mechanically lower trend GDP growth as well – see Figure 2.

Why the productivity offset is not automatic

It may not be as simple as adjusting trend growth down by the now lower contribution of the labor force. An economy generating moderate productivity growth with little or no labor force expansion would be historically rare, in part because labor and capital trends are linked in two important ways:

First, production of goods and services requires both people and tools. Capital makes labor productive and labor makes capital useful. More specifically, people (labor) do the work, but how much they can produce depends on the tools, machines, software, and structures they have to work with (capital). Higher productivity growth requires continued investment in capital per worker, but the extent to which labor makes capital useful tends to diminish at higher levels of investment. As a result, stagnant labor force growth could eventually slow investment and productivity trends.

Second, the economy needs a stream of new ideas to guide productivity-enhancing investments, and people generate those ideas. As Paul Romer asserted in his 1990 paper,3 new ideas are the heart of economic growth because ideas are “non-rival” – no matter how many people use the idea, there is not less of the idea to go around. If more people are participating in the labor market, then there are more people who can use old ideas to create new ones, which in turn can drive investment and future productivity. With fewer people, the pace of innovation could slow, reducing investment in future productivity growth.

Artificial intelligence to the rescue?

AI offers the potential to support continued innovation that drives investment and future productivity growth, despite a stagnant labor force. Unlike past technologies that have given humans faster and better tools, AI also has the potential to replace humans across a range of tasks, including new idea generation. To the extent that AI is a substitute for labor (in addition to complementing it), it could also at least in theory drive sustainably stronger capital deepening trends for a time.

Companies are racing to implement AI in hopes of transforming their businesses in ways that increase productivity and efficiency. However, the timing and magnitude of the productivity gains are highly uncertain. In the near term, if AI-driven productivity is slow to materialise, then consensus expectations for above 2% U.S. growth over the next several years are likely too high. In the medium term, low labor supply increases the burden on AI (or other technologies) to maintain recent trend growth levels.

Bottom line

With labor force growth grinding to a halt, job gains no longer carry the same signal they once did. Investors should expect the frequency of monthly employment contractions to increase as the U.S. job market adjusts to limited labor supply.

The U.S. economy is increasingly reliant on productivity. That makes AI not just a cyclical force, but a structural one that shapes investment, productivity, and long-run growth prospects.

For the medium-term outlook, this is yet another layer of uncertainty that increases the attractiveness of high quality bonds as a generally stable source of income and store of value.

By Tiffany Wilding, Economist

The post U.S. employment volatility masks structural shift appeared first on AdviserVoice.

Layered uncertainty across global markets highlights rising geopolitical risks, shifting growth dynamics, and the need for resilient, diversified investment strategies.

Resilient global headline growth has continued masking widening divergence across countries, industries, and households, as AI-fueled investment and wealth have offset tariff-related pressures. What has changed is the addition of a major new source of risk: the conflict in the Middle East. If this proves to be a short-term disruption, as markets are currently pricing, then the baseline outlook still assumes moderate global growth. However, a prolonged disruption would pose more significant challenges and increase global recession risks.

Geopolitical risks tend to transmit to the economy through changes to consumer and business confidence, financial conditions, and – most importantly today – energy prices. The Strait of Hormuz, a critical waterway for oil and energy shipments, remains effectively blocked. Similar to Russia’s invasion of Ukraine in 2022, this threatens to spark a global energy supply shock.

Energy supply shocks are stagflationary

Unlike in 2025, when divergent trends left global growth broadly unchanged, the Middle East conflict is likely to be stagflationary, lifting inflation while hurting growth. We see four main transmission channels:

• higher energy and food prices
• disrupted supply chains and trade flows
• tighter financial conditions
• lower business and consumer confidence.

Negative oil supply shocks are inflationary for all economies, while growth effects will differ. Higher energy prices are stagflationary for net oil importers – transferring income abroad through more expensive energy imports while reducing household real (inflation-adjusted) income and business real profit – and expansionary for net oil exporters.

Within developed markets (DM), Europe, the U.K., and Japan are energy importers and face larger downside growth risks. Canada and Australia should benefit from their net energy export status.

Two decades of shale production increases have turned the U.S. from a net energy importer to a slight exporter. However, the U.S. is still a large economy with an energy sector as opposed to a commodity economy. Since energy is an important input into all goods it imports, the U.S. will likely still behave as a net energy importer to some extent.

The U.S. also enters this period with vulnerabilities. The energy shock will exacerbate K-shaped economic trends for households – with potential for a larger pullback in real consumption. Higher energy prices act as a transfer from households (via lower real incomes) to energy companies and their capital owners. Low- and middle-income households, with the highest propensity to consume relative to their real income, will be hurt the most.

Beyond the global drag from lower oil production, indirect effects – confidence and financial conditions – will also likely weigh on growth. Markets have reacted by tightening global financial conditions. The shortest-dated interest rates across DM have shifted toward pricing central bank rate hikes, along with generally higher real yields and lower equity prices.

A prolonged closure of the Strait of Hormuz also risks disruption to Asian manufacturing, the dominant supplier of goods to the rest of the world, which is particularly reliant on Middle East oil. Products across chemical, plastics, autos, electric vehicles, construction materials, and other sectors risk supply disruption, not just higher manufacturing costs.

Central banks face a tug of war – but this isn’t 2022

The risk of higher inflation alongside lower growth puts central banks in a tricky spot. Conventionally, central banks tend to look through supply shocks, especially in economies that are net energy importers. After the elevated post-pandemic inflation period, however, central banks will be closely focused on the risk that a large supply shock could lead to more persistent pressures as inflation expectations and wages also adjust higher.

Yet economies are in much different positions than they were in 2022, when Russia’s invasion of Ukraine sent energy prices soaring and central banks hiked rates aggressively. At that time, the world was still dealing with pandemic-related pent-up demand, and governments had injected trillions of dollars into the private sector. The result was a large demand shock on top of a large supply shock. Labor markets were also extremely tight as the pandemic spurred early retirements and job hiatuses, prompting one of the largest-ever mismatches in labor supply and demand. Across economies, job openings relative to the number of unemployed accelerated, driving both nominal wages and prices higher.

Today, by contrast, fiscal policy is tight across many regions as elevated post-pandemic sovereign debt forces restraint. The global economy doesn’t have a similar stockpile of savings from fiscal transfers. Labor markets are much looser. Monetary policy is already neutral to slightly restrictive across most DM economies. In emerging markets (EM), real rates have remained elevated despite moderating inflation. As a result, economies are much more likely to adjust to the current shock through lower real incomes, weaker nominal wage adjustments, and greater recessionary risks.

In practice, the knee-jerk market reaction toward tighter financial conditions and more hawkish monetary policy is already doing much of the hawkish work for policymakers. In the end, if inflation does prove temporary while downside growth risks materialise, central banks may need to ease more aggressively.

The Bank of England and the European Central Bank have been at the eye of the storm in terms of the repricing of central bank expectations (see Figure 1). But there has been a general move across DM, including the pricing out of the previously expected rate cuts by the Federal Reserve.

Similarly, in EM economies, prospective easing has mostly been priced out – again with greater differentiation between energy importers and exporters. EM central banks will have an even harder task than their DM counterparts in looking through the first-round inflation impacts of the energy shock, but most also started off with a greater real yield buffer owing to elevated policy rates going into the shock.

In the baseline of energy markets moving in line with the forwards, we anticipate significant reverses of the sell-off in front-end rates across DM and EM economies. But in line with the tone of central banks’ commentary at their March meetings, there is a lot of uncertainty in the immediate outlook.

Investment outlook: Repositioning portfolios toward quality and liquidity

This is not an environment set up to reward bold forecasts or narrow bets. Instead, today’s conditions favor more liquid, high quality portfolios built to weather shifts in market sentiment and a range of potential outcomes.

Markets rarely price geopolitical risk well. When there is a global shock, portfolio liquidity can allow investors to take advantage of market inefficiencies and valuation gaps that arise. Similar to the volatility that followed U.S. tariff announcements in April 2025, the rapid repricing of central bank expectations in response to the Middle East conflict has created localised volatility and opportunities to invest against the prevailing narrative.

Treat liquidity as an asset

After a decade of strong private credit returns supported by rapid growth (see Figure 2), imbalances are coming into view. Signs of late‑cycle conditions are already visible within corporate direct lending, including elevated shadow default rates and greater reliance on payment‑in‑kind features. Smaller and midsize companies, the main borrowers within this market, are vulnerable to rising energy input costs, tariff pressures, and technology disruption, including from AI.

For investors, the trade‑off looks far less compelling in direct lending, the segment that has driven much of private credit’s growth, as financial conditions tighten. There is nothing inherently wrong with owning private assets – provided investors are adequately compensated for illiquidity. But in direct lending, that illiquidity premium has compressed just as refinancing risk, underwriting slippage, and questions around pricing transparency have become more pronounced. Direct lending strategies rely on reported price stability rather than market-based price discovery and may appear resilient until stress emerges – as it has lately.

As investors reconsider illiquidity risk, the disconnect between public and private market valuations has deepened. Publicly traded business development companies (BDCs) – investment vehicles for private direct lending – are trading at significant discounts to their net asset values (see Figure 3). This is a direct lending problem, in our view, not an indictment of private credit as a whole, which still encompasses strategies where illiquidity is better compensated and risks are more explicitly priced.

From a relative value perspective, this favors a shift out of direct lending and into high quality public fixed income. Many investments with attractive liquidity profiles and transparent pricing now offer yields comparable to private credit. As volatility rises and dispersion widens, the ability to manage downside risk and redeploy capital as conditions evolve matters more than trying to capture incremental yield by forfeiting liquidity.

Private credit does not pose a systemic risk, in our view, and there are many areas of the market that remain attractive (for more, see our publication, “Private Credit’s Other Lanes Still Offer Value”^[1]). Still, stress in private credit could contribute to tighter financial conditions and weigh on hiring and investment.

As the cycle matures, credit markets – private and public – increasingly reward bottom-up analysis and differentiation. Balance sheet strength, durable cash flows, and high quality collateral matter more than headline yield, particularly in sectors undergoing structural change. It’s critical to focus on maximising investment outcomes rather than simply deploying capital into an asset manager’s area of focus.

At PIMCO, we’ve managed through credit cycles for more than five decades. Looking across the continuum of public and private credit today, we see the greatest value in areas including U.S. agency mortgage-backed securities (MBS), investment grade issuers with stable, predictable cash flows, and high quality securitised credit.

In private credit, we favour asset‑based finance (ABF) and senior commercial real estate debt. While competition in ABF has grown, it remains a large and attractive market that offers collateral backing and is less correlated with the corporate earnings cycle than direct lending. Because global real estate has already gone through a cyclical downturn, investors can lend against assets that may be 15%–40% below peak values.

By contrast, we are cautious on direct lending and bank loans with weak covenants, lower‑quality high yield issuers, and many vehicle structures offering liquidity that doesn’t match the underlying assets.

Across credit markets, risk has been repriced only modestly in the wake of the Middle East conflict. Our emphasis is on adding downside mitigation, given risks have grown more than market pricing may reflect.

Fixed income is back at the centre of portfolio construction

High quality bonds once again play a meaningful role in portfolios and look attractive across a variety of economic scenarios. For portfolios that have drifted heavily toward equities (see Figure 4), this is a practical moment to consider rebalancing. Yields across more liquid fixed income remain attractive, laying a solid foundation for market-driven income and return. When you overlay opportunities arising from volatility and mispricing, it creates an exceptional environment for active management to seek alpha, or outperformance versus the broader market.

High quality bonds can serve as a return generator, cushion against equity volatility, offer valuable diversification if growth disappoints or risk sentiment deteriorates, and provide liquidity that can be redeployed when markets dislocate.

We prefer a modest overweight to duration. In the U.S., the Treasury market is still a source of perceived “safe haven” yield and portfolio diversification benefits. We prefer more balanced curve exposure as yields look attractive across a range of maturities.

The case for global diversification also remains strong. Differences across countries are widening, creating both risks and opportunities. Rather than assuming correlated global outcomes, investors can potentially benefit from targeted exposures to select DM and EM countries with attractive real yields and credible policy frameworks.

Currency positioning matters more in this environment, particularly given the growing divergence between energy exporters and importers. Inflation‑sensitive assets also deserve a more deliberate role in portfolios today. Commodities, real assets, and Treasury Inflation-Protected Securities (TIPS) can help hedge real‑world purchasing power and diversify returns when traditional asset relationships become less reliable. These exposures may help improve portfolio resilience.

Conclusion

This is a market that rewards preparation for an uncertain set of outcomes. Higher yields, wider dispersion, and greater volatility create a favourable backdrop for active management, in our view, when portfolios are built with liquidity and flexibility in mind.

For investors, we believe it’s a compelling time to consider recentreing portfolios toward fixed income, to use global diversification and inflation tools intentionally, to treat liquidity as an asset, and to emphasise quality and collateral in credit.

In short, this is a moment to consider rebalancing toward resilience – positioning portfolios to navigate dispersion while staying ready to act when opportunities arise.

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References:
[1] Private Credit’s Other Lanes Still Offer Value

The post CPD: Layered uncertainty – conflict, credit stress, and AI appeared first on AdviserVoice.

Lotfi Karoui

Concerns about private credit have intensified in recent months. Investors are grappling with questions about weakening credit quality, stale valuations, looser underwriting, redemption risk in certain types of funds, and the impact of AI‑driven disruption. Much of the anxiety has centered on corporate direct lending – especially business development companies (BDCs) and semi-liquid vehicles1.

This narrow focus, however, can miss the bigger picture. Private credit is a broader and more diversified asset class, offering a range of differentiated risk exposures. Beyond traditional corporate senior secured lending, private credit spans asset-based finance (ABF) and specialty finance, real estate, and special situations2, each with distinct drivers of risk and return. Taken together, these distinctions point to a more nuanced set of investment implications, which can be grouped into a few key themes.

That broader private credit universe still earns its place in portfolios. ABF and high quality consumer and mortgage credit has continued to offer meaningful diversification and more attractive value than direct lending. ABF is generally less correlated with the corporate earnings cycle and benefits from structural downside protection. Selective exposure to consumer and mortgage credit, particularly related to higher-income households, can offer a more attractive risk/reward profile.

Direct lending will ultimately meet the credit cycle … Like every mature segment of leveraged finance, direct lending should eventually face a full‑blown default cycle – one that would test its resilience to both sector‑specific and macroeconomic shocks. Early loan vintages, originated soon after the global financial crisis, benefited from stronger documentation and lender control. In the ensuing years, record fundraising has steadily eroded underwriting standards. As overlap with public markets has grown, direct lending funds have increasingly offered terms comparable to those in public leveraged finance – without providing any meaningful compensation for illiquidity. Persistent opacity and weak disclosure around issuer fundamentals are therefore likely to keep concerns about credit quality and portfolio price marks firmly in focus.

… While AI disruption risk and portfolio concentration will likely continue to cap performance. Heavy exposure to the software industry in direct lending portfolios is likely to constrain relative performance versus both public markets and other segments of private credit. At the same time, the rise in portfolio overlap across managers has compressed performance dispersion, limiting the scope for manager‑selection outperformance (alpha), a dynamic increasingly evident in the relative performance of recent vintages.

Mind the liquidity gap. Across private markets, semi‑liquid vehicles have expanded rapidly in recent years. While the risk of a “bank‑run” style event escalating into a systemic shock remains low, given the structural safeguards embedded in these vehicles, recent episodes are likely to prompt investors to reassess both the amount of illiquidity they are accepting and the compensation they receive for it. They also underscore the importance of understanding how liquidity is accessed across different types of semi‑liquid structures.

Direct lending fundamentals: Opaque by design, signaling caution by proxy

By design, direct lending portfolios – and private assets more broadly – are not publicly disclosed, which makes it harder to assess their underlying fundamentals. In the absence of transparency, market participants have relied on proxies. BDCs have emerged as a particularly useful reference point, given that they report quarterly and provide relatively detailed information on their holdings.

Figure 1 shows that the share of payment-in-kind (PIK) loans, in which borrowers pay interest with additional debt, has been rising since 2022. Meanwhile, recent price action in public BDCs suggests investors are demanding higher compensation to guard against a variety of risks, including potential stale price marks and deteriorating fundamentals. As shown in Figure 2, BDCs now trade at the largest discount to their book value since the post-COVID recovery began.

Larger deals, software heavy and alpha light

Total assets under management (AUM) in North American direct lending portfolios has increased roughly sevenfold over the past decade, from $93 billion in 2015 to about $644 billion by year-end 2025, according to Preqin. Any asset class that experiences such rapid growth is prone to developing imbalances, and direct lending is no exception.

As capital inflows surged, demand for loans increasingly outpaced supply, fueling greater borrower- and sponsor-friendliness – and thus a gradual weakening of underwriting standards. At the same time, the sheer volume of capital committed to direct lending has supported larger transactions since 2023 – deals that would historically have been financed in the broadly syndicated loan market.

This shift has increased overlap in the borrower base, a dynamic often loosely described as “convergence.” What was once a market almost entirely dedicated to middle-market borrowers has thus taken on quasi-syndicated characteristics, with large deals often underwritten by a group of lenders.

This evolution has mechanically increased portfolio overlap across managers. Here again, BDC portfolio data corroborate this dynamic. The share of traditional single-borrower/single-lender transactions, long the hallmark of middle-market lending, has declined in recent years, while larger loans involving multiple lenders have become increasingly prevalent (see Figures 3 and 4).

In parallel, two other shifts have also taken place. First, portfolio overlap across managers has been on a steady rise. Figure 5 illustrates this trend by mapping the intersection of portfolio holdings for the median pair of BDCs, highlighting the commonality of exposures.

For each pair of BDCs, we sum up the minimum weights of overlapping issuers in both portfolios. We then calculate the average across all pairs.

Second, the heavy involvement of private equity sponsors in software companies, combined with their reliance on direct lending as a preferred financing channel, has driven pronounced sector concentration, with the share of software more than doubling in a decade (see Figure 6).

For investors, the combined impact of these forces is weaker diversification and higher cross‑portfolio correlation across managers.

Semi-liquid structures: No systemic threat in U.S., but a wake-up call on selectivity

In addition to non-traded BDCs and private real estate investment trusts (REITs), the semi-liquid universe expanded rapidly from 2019 to 2023 to include evergreen and interval funds3 (see Figure 7). This growth has been driven by the uptick in investors’ appetite to deploy capital into private markets in real time rather than to be constrained by discrete vintage cycles, though the bulk of private assets continue to be largely invested in vintage funds (see Figure 8).

Total AUM in semi-liquid vehicles, including non-traded BDCs and private real estate investment trusts (REITs), versus vintage funds. We only include funds with at least $100 million of AUM.

While the risk of a true “bank-run” dynamic in these vehicles is generally low, given explicit contractual limits on redemptions and the ability of managers to gate flows, semi-liquid does not mean fully liquid. As with traditional vintage funds, investors must still assess their own liquidity needs and tolerance for constrained access to capital, particularly during periods of elevated volatility. The recent scrutiny on redemptions in semi-liquid direct lending funds has brought this distinction into focus, underscoring that liquidity is conditional, rather than guaranteed.

What is often less appreciated, however, are the meaningful differences within the semi-liquid universe itself. While these vehicles offer investors the option to deploy capital on a rolling basis, they operate under different regulatory regimes and differ when it comes to giving investors access to liquidity.

For non-traded BDCs, private REITs, and evergreen funds, access to liquidity ultimately sits at the manager’s discretion. In effect, investors are short a put option4 to the manager. The value of this put option rises precisely in states of the world when aggregate liquidity demand increases, or market conditions deteriorate. In those moments, the gap between stated redemption terms and realizable liquidity can widen materially.

By contrast, interval funds eliminate this optionality. Repurchases occur at pre-determined intervals and are capped at a fixed percentage of the stated net asset value (NAV), providing investors with certainty of execution on the terms offered.

To be clear, interval funds are not more liquid. Rather, they are less ambiguous and more transparent: Liquidity is explicitly limited, rule-based, and applied systematically rather than discretionarily.

Private credit’s other lanes still offer value

Private credit extends well beyond direct lending and continues to merit a place in well‑diversified portfolios. As the cycle matures, the relative appeal of ABF as a diversifier is likely to continue to increase, precisely because returns are driven more by collateral and structural protections than by pure earnings growth.

The opportunity set spans a wide range of exposures across the economy, including residential and commercial real estate, consumer credit, and specialty finance. And unlike direct lending, which is predominantly non‑investment‑grade corporate credit, ABF may provide investment‑grade‑like risk profiles that are less capital‑intensive for large allocators such as insurance companies. The result is a large and still underappreciated opportunity where diversification and downside resilience, rather than headline yield alone, underpin the investment case.

Recent PIMCO research using public securitized products as rough beta proxies for ABF – an approach that abstracts from both liquidity premia and manager selection alpha – suggests that potential ABF risk-adjusted returns are not only more attractive than direct lending but also exhibit greater resilience to market downturns and lower sensitivity to fluctuations in risk sentiment, as proxied by equity returns.

By Lotfi Karoui and Gabriel Cazaubieilh

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Notes:
[1] BDCs are funds that invest in small and midsized private U.S. businesses. Semi-liquid vehicles are investment funds that offer periodic redemption opportunities rather than daily liquidity.
[2] ABF and specialty finance are terms that are often used interchangeably to describe private lending secured by specific assets and collateral such as aircraft, auto loans, and mortgages. Special situations refer to unique, often one-off events that affect asset valuations and present investment opportunities.
[3]Evergreen funds are investment funds with no fixed termination date that continuously raise capital and recycle proceeds from exits into new investments, allowing investors to enter and exit periodically rather than at a single fund maturity. Interval funds are closed-end investment funds that offer liquidity to investors only at scheduled intervals (such as quarterly or semiannually) through limited share repurchase offers rather than daily redemptions.
[4] A put option is a financial contract that gives the holder the right, but not the obligation, to sell an underlying asset at a specified price on or before a specified expiration date.

The post Private credit’s other lanes still offer value appeared first on AdviserVoice.

Investment managers can leverage global economic dispersion and two-way risk to enhance portfolio resilience.

The Trump administration’s sweeping tax, trade, and immigration policy overhauls – including quadrupling the effective U.S. tariff rate – were widely expected to stifle global growth, trade and investment. In response, various DM and EM governments announced preemptive yet targeted fiscal measures to buffer the economic transitions, while central banks focused on downside risks.

It turns out that economic growth has been surprisingly resilient as these policy trends intersected with a new general-purpose technology: AI. The result has been a lasting expansion with notable divergence under the surface. “K-shaped” economic trends are apparent across households, companies, and regions. Indeed, those who are better positioned to benefit from the AI race and associated wealth effects are fueling growth.

Several key macro trends have unfolded:

• In the U.S., elevated competition has limited corporate pricing power and muted tariff-related price increases. Large companies are focusing on gaining market share by competing on price and absorbing tariff costs, fueling a productivity push to protect margins. Small and midsize labor-intensive companies exposed to trade sectors or immigration policy changes have been relative losers.
• To defend margins, companies accelerated AI adoption to manage labor costs. In the U.S., AI-related software and R&D investment accelerated, while data center investment, including structures, servers, chips, and other components doubled.
• Policy and technology changes also contributed to a U.S. household divide. The wealth effect of AI-led stock market gains has helped sustain consumption, but the benefits haven’t reached lower- and middle-income households (see Figure 1). As elevated uncertainty has stifled hiring and trade- and AI-exposed sectors shed jobs, real labor income growth has stalled. The AI related build-out also appears to be crowding out other investment, including residential housing, further reducing housing affordability.

• AI trends have supported global industrial output and trade despite tariff drags, although gains remain uneven. Growth is concentrated in computers and components tied to AI infrastructure. Asian economies, including Taiwan, Japan, South Korea, and China, have shared the U.S.’s resilience as they dominate production of chips, servers, and related hardware. Production elsewhere has slowed as earlier inventory stocking ahead of tariffs unwinds.
• China is being pushed to find other markets for its goods, while also accelerating its AI infrastructure build-out and further improving manufacturing productivity. U.S. tariffs have reduced trade between the two nations. Lower export prices have facilitated a smoother-than-expected trade rotation to EM. Still, sluggish consumption and falling investment have left China overly reliant on exports and inventory building to maintain growth.

Technology and fiscal policy bolster demand

We expect overall economic resilience to continue in 2026. There are also good reasons to expect some broadening in growth, but the trend toward winners and losers is likely to persist.

First, fiscal policy is set to diverge across countries. Fiscal policy easing in several regions should further offset trade drags. China, Japan, Germany, Canada, and the U.S. are all poised to loosen fiscal policy – China through central government support, and the U.S. via large, front-loaded business and household tax cuts. But many countries lack fiscal space, leaving policy tight in the U.K., France, and parts of EM.

Second, the AI investment cycle should keep supporting global growth as AI adoption spreads, but winners and losers will abound. In the U.S., broader corporate spending on AI implementation, software, and R&D could offset cooling data‑center capital spending from high 2025 levels. An additional tailwind could come from other countries stepping up infrastructure investment amid national security concerns. In the race for AI dominance, regional and industry laggards are at risk.

Third, trade uncertainty and tariff-related drags should also diminish in 2026, but not without further policy shifts as the legality of U.S. tariffs is tested. The U.S. Supreme Court could potentially strike down some or all tariffs implemented under the International Emergency Economic Powers Act. As the Trump administration shifts tariff policy to a more stable and legally secure framework, various regions and sectors will need to adjust, while reduced uncertainty reaccelerates investment and hiring, both in the U.S. and globally.

Monetary policy set to diverge

Most central banks embarked on rate-cutting cycles over the past few years, albeit at differing speeds based on inflation progress. With global inflation now broadly benign, we expect most central banks to reach neutral policy levels by the end of 2026. However, the outlook for additional cuts is now more nuanced.

Central banks with still-high real rates and tight fiscal policy are poised to cut more aggressively, particularly in countries more exposed to downside inflation risks from Chinese exports. This includes various EM central banks, as well as the Bank of England.

Elsewhere, where monetary policy is already near neutral and fiscal policy is poised to expand – notably Canada and, to a lesser extent, Europe – there is limited need for additional cuts. The Bank of Japan, meanwhile, with still-easy monetary policy and where fiscal policy is set to expand, is expected to hike rates further (see Figure 2), while in China both monetary and fiscal policy are expected to ease substantially, as policymakers manage debt deflation and overcapacity.

Finally, markets are pricing expectations for the U.S. Federal Reserve to lower its policy rate further, to 3%. We also expect Fed cuts in 2026, likely in the latter half of the year.

Uncertainty remains about the terminal rate amid a transition to a new Fed chair and as the White House pushes for lower rates. While there is a range of possible outcomes, the market has consistently priced a continuation with orthodoxy, reflecting the fairly conventional candidates and checks and balances inherent in the Fed policy-setting process.

The risks around U.S. inflation also look more two-sided. AI-fueled productivity and stagnant housing market trends could help keep overall prices in check. Tariffs, demand-augmenting fiscal policy, and technological infrastructure buildout could push prices higher.

Durability alongside vulnerability

While we expect economic resilience to continue, clashing forces and widespread haves-versus-have-nots dynamics create risks:

• U.S. risk-asset valuations: Traditional valuation metrics suggest U.S. stocks are expensive, both relative to history and to other markets. How much AI adoption accelerates and how much value can be created by AI (and when) – along with which companies will capture that value – remain key questions. Meanwhile, credit spreads continue to look tight.
• Sustainability of the K-shaped economy: Wealth-fueled consumption depends on additional equity and housing market appreciation, but high valuations and affordability pressures make this challenging. Areas of private credit look particularly vulnerable to policy- and AI-related transformations.
• Government deficit and debt dynamics: We haven’t changed our secular outlook for challenging debt and deficit dynamics across many DM economies, including the U.S., U.K., France, and Japan (for more, see our June 2025 Secular Outlook, “The Fragmentation Era”). While debt appears sustainable now – the average interest rate paid on government debt is still below trend growth levels – AI and trade policies could drive investment trends that prompt higher interest rates, adding pressure to sovereign debt.
• China challenges: A multiyear housing sector bust and already high global manufacturing share add to questions about how long China can sustain its production- and export-led growth model. Without materially more direct central government support for domestic demand, China will find it harder to reach growth targets, with disinflationary implications for the rest of the world.

Investment implications: Take advantage of the fixed income opportunity

After years of strong risk-asset returns, equity valuations remain elevated and credit spreads are tight. While our base case calls for growth to remain solid and potentially even reaccelerate in some regions, such optimism is already priced into most risk-asset markets. History suggests that these starting valuations will influence forward returns, which may be lower than investors have come to expect.

By contrast, bonds are cheap versus stocks at current valuations. After a sharp post-pandemic repricing, starting yields on high quality bonds remain attractive, highlighting the sustainable return potential in fixed income. Investors today have a rare opportunity to increase quality, liquidity, and portfolio diversification without giving up equity-like return potential.

Even after broadly strong bond market returns in 2025, the yield on the benchmark 10-year U.S. Treasury note – about 4.19% as of 12 January 2026 – remains in the middle of the 3.5%–5% range that it has occupied for more than three years. Other DM sovereign 10-year yields tell a similar story (see Figure 3). This illustrates that robust bond returns don’t depend on a broad rally in rates.

Rather, attractive starting yields provide a baseline from which active managers can seek to construct portfolios potentially yielding about 5%–7% by capitalizing on alpha opportunities. (Learn more in our recent article, “Calculating the Active Advantage in Fixed Income.”) Active fixed income strategies delivered their best results in years in 2025 – and the outlook ahead is just as compelling amid one of the most exciting environments for alpha generation in recent memory.

Our 2026 playbook remains similar to 2025 in many respects. Amid a generally benign global growth outlook, and with attractive yields available in many countries, we favor a diversified portfolio of exposures across regions with different economic and policy paths, including DM and select EM local markets. Overall, our approach remains flexible. We expect to add and trim exposures based on valuations and market dislocations.

Rates, duration, and global opportunities

As yield curves have steepened, we believe investors who continue holding excess cash are missing a potential opportunity. By turning to fixed income, which has outperformed cash, investors can lock in more attractive yields over a longer period while also benefiting from potential price appreciation for a modest increase in risk.

We maintain a modest overweight to duration – a gauge of interest rate exposure – with a focus on global diversification. (Explore other opportunities to bolster portfolio diversification and resilience in our recent article, “Charting the Year Ahead: Investment Ideas for 2026.”) While we continue to favor 2- to 5-year bond maturities, our curve positioning has grown more balanced as longer-term yields have become more attractive.

U.S. duration still looks attractive and can help hedge portfolios against a potential slowdown in the U.S. labor market or AI-related equity volatility. European duration looks comparatively less attractive.

While Australian duration has underperformed, it remains a useful diversifier within a broader basket, especially now that markets are pricing in potential rate hikes in 2026 – a policy move we believe is unlikely.

Despite inflation above central bank targets and near-term risk of reacceleration, longer-term breakevens remain low. We continue to like Treasury Inflation-Protected Securities (TIPS), commodities, and real asset exposures.

We see select opportunities in countries with higher real policy rates, tighter fiscal settings, and more balanced inflation risks. This includes the U.K. and select EM countries.

Emerging markets: Asymmetric opportunities in a fragmented world

The EM investment landscape has structurally transformed, with lower aggregate government debt-to-GDP than DM, improved monetary policy frameworks and current accounts, and deepening local capital markets. In a twist, several advanced economies now exhibit fiscal dynamics once considered “EM-style risks.”

For active managers, dispersion creates opportunity. Unlike the 2010s when EM moved as a bloc, today’s environment rewards granular country selection across rates, currencies, and credit – generating alpha through structural analysis rather than beta timing. Across EM, we find attractive starting yields and a variety of idiosyncratic, diversifiable risks.

EM central banks are expected to continue to cut rates amid low inflation and resilient foreign exchange. We prefer duration overweights in South Africa and Peru, where yield curves are steeper than domestic fundamentals warrant, and Brazil, where we see room for a large and extended rate-cutting cycle.

We continue to see the potential for U.S. dollar weakness, reflecting the ongoing Fed easing cycle, secular fiscal concerns, and starting valuations that favor an overweight to EM currencies versus DM counterparts. EM currencies provide a liquid way to access the asset class outside of our dedicated EM strategies, and we can potentially generate attractive income with a carefully managed and well-diversified basket of EM country exposures.

Credit: Constructive but selective

Our stance toward credit remains constructive but has grown more selective. At PIMCO, we have witnessed many credit cycles across the five-plus decades since the firm’s founding. We are seeing signs of later-cycle behavior as strong recent returns have fueled complacency.

We expect continued deterioration in credit fundamentals, especially in floating-rate sectors of corporate markets, given weaker underwriting standards in recent years. Industry and single name exposure will matter, as we see fundamental pressure in areas such as healthcare, retail, and technology.

We have seen an increase in amendment activity, such as payment in kind (PIK) provisions that allow borrowers to repay debt with more debt. Such trends can mask underlying stress by keeping headline default rates low (see Figure 4).

We have also observed overreliance on rating agency ratings as a barometer for risk, and vehicles promising more liquidity than their underlying investment strategies may be able to deliver. These conditions are occurring in the wake of rapid growth in private credit markets in recent years.

During such periods, we look to reduce generic credit exposure – or beta – and focus on independent, bottom-up analysis and security selection.

We continue to favor U.S. agency mortgage-backed securities (MBS). Agencies remain a preferred partial substitute for corporate credit beta, supported by strong structural features, robust liquidity, and attractive spreads.

Rather than regarding credit markets as separate public and private segments, we continue to evaluate investments along continuums of economic sensitivity and liquidity risk, and we focus on ensuring adequate compensation for these risks. We consider the reasons companies turn to private versus public credit, such as greater flexibility or less restrictive regulation, and what that means for investors.

Investment grade issuers with stable cash flow and strong balance sheets remain the core of our credit positioning. We value the robust liquidity in public investment grade markets and believe investors should be selective when venturing into private investment grade, especially when incremental spread over more liquid opportunities is limited.

We continue to seek unique, well-structured credit opportunities that leverage PIMCO’s scale. We look to avoid lower-quality deals with less attractive spreads, weak collateral, and fewer lender protections. We expect secured lending in areas such as asset-based finance, real estate credit, and well-structured infrastructure debt to outperform. Lower-quality segments of corporate markets are more likely to disappoint given tight spreads, weak underwriting, and broader signs of overall complacency.

We continue to see value in areas offering robust collateral and clear structural protections. We see these opportunities in both liquid securitized markets and less liquid asset-based finance areas, especially those linked to higher-income consumers. Real estate debt, while out of favor, benefits from asset values that are well below peak levels.

Within high yield markets, we are cautious where covenant erosion or sponsor behavior creates greater downside risk. Direct lending, bank loans, and weaker high yield segments require particular caution, given questions about the quality of lender safeguards and potential liquidity challenges. Excess capital formation in these markets has resulted in programmatic lending activity that resembles more passive investment strategies.

Conclusion

In recent decades, abundant capital, low interest rates, and a stable global order reduced the need for diversification. In contrast, today’s environment is defined by dispersion, two-way risk, and economies across regions moving at different speeds. This creates a wide range of opportunities across global rates, EM, high quality credit, and securitized markets, reinforcing the value of an active approach.

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Sam Watkins

PIMCO, a global leader in active fixed income management, has announced the launch of the PIMCO Short Term Active Yield Active ETF (EARN), its fifth active exchange-traded fund (ETF) in Australia. Designed to meet the evolving needs of investors, EARN offers a compelling alternative to traditional cash and term deposits by combining capital preservation, liquidity, and enhanced return potential in a short-duration, actively managed strategy.

The launch of EARN follows the successful introduction of four active fixed income ETFs in February — PGBF, PDFI, PCRD, and PAUS — each designed to offer Australian investors institutional-grade access to global and domestic bond markets. Together, these strategies reflect PIMCO’s commitment to delivering innovative fixed income solutions tailored to local investor needs.

EARN invests in a portfolio of high-quality, investment-grade bonds, and is built for investors seeking a modest shift from traditional savings vehicles, offering attractive monthly income and daily liquidity without compromising on credit quality. Active management is central to the strategy, drawing on PIMCO’s global credit research and macroeconomic insights to navigate short-term fixed income markets.

The launch of EARN responds directly to the evolving needs of Australian investors amid falling cash rates and increasing demand for low-duration, actively managed fixed income strategies. It fills a gap in the Australian ETF market by offering a local fixed interest strategy with a minimum of 50% AUD-denominated bonds, making it highly relevant for domestic investors.

“EARN is designed to provide a compelling alternative to cash and money market funds — helping investors put their money to work while maintaining capital stability and liquidity,” said Sam Watkins, Managing Director and Head of PIMCO Australia and New Zealand. “It complements our existing suite of active fixed income ETFs and, as one of Australia’s biggest fund managers, reflects our commitment to delivering innovative solutions tailored to investors here.”

Positioned as a flexible income solution, EARN offers:

• A yield advantage over traditional cash and term deposits
• Capital preservation through exposure to investment-grade bonds
• Daily liquidity for easy access to funds
• An active edge in short-term fixed income, powered by PIMCO’s global expertise

EARN is suitable for both retail and adviser-led portfolios, offering income with flexibility and the potential for stronger returns relative to traditional cash investments, in exchange for a modest increase in risk.

The fund is available for trading on the Australian Securities Exchange.

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Together, bond yield capture, global diversification, and credit continuum analysis can form a robust investment framework.

Economic outlook: A clash of forces tests conventional frameworks

The Trump administration aims to reshape the U.S.’s global role while improving the country’s trade balance. In previous Cyclical Outlooks, we argued that addressing these imbalances would require difficult-to-implement reforms in both the U.S. and its trading partners (for more, see our April 2025 Cyclical Outlook, “Seeking Stability”).

Since our last Cyclical Forum in March, the administration has enacted sweeping overhauls. The impact on the trade balance remains uncertain. However, we believe three forces – tariff effects, the technology investment boom, and challenges to institutions – will likely drive greater economic and capital market volatility within the U.S. and globally (for more, see our June 2025 Secular Outlook, “The Fragmentation Era”).

Tariff effects set to bite

Since President Donald Trump’s term began in January, the U.S. has raised tariffs on every major trading partner. The result has been the largest effective average U.S. tariff rate increase in over a century – from under 3% in 2024 to about 11% as of September 2025, according to the U.S. International Trade Commission. Tariffs remain an administration priority even as legal challenges could delay or disrupt implementation.

Trade theory suggests that U.S. tariffs tend to raise U.S. import prices, depress foreign export prices, reduce real trade volumes, and weigh on real incomes globally. So far, that hasn’t happened. Global growth in trade flows and goods production has accelerated. Global goods inflation has firmed while U.S. inflation has been contained.

Nevertheless, there are reasons to believe that we may be nearing a transition, and that what has been a mini boom could give way to a mini bust:

• First, consumers and businesses accelerated activity earlier this year to front-run tariffs. The inventory buildup boosted global industrial production and trade (see Figure 1). Now that tariffs have been implemented, accelerated goods production could give way to a period of weak growth or contraction.

• Second, high effective tariffs have not suppressed Chinese production and trade. Instead, they initially stimulated growth in Southeast Asian economies that are now intermediating more trade to the U.S. The U.S. is cracking down through additional tariffs on goods routed through connector countries.
• Third, rather than primarily raising prices, many U.S. companies appear to be focused on cost management and gaining market share, with a potential pickup in layoffs from small and midsize businesses that can’t pass on additional costs.

The outlook improves in 2026. U.S. households and businesses will likely benefit from new tax cuts and credits. In countries such as Germany, China, Japan, and Canada, we expect targeted fiscal easing – including infrastructure investment, defence spending, and tax cuts – to offset some drag from U.S. trade policy.

In countries with tighter fiscal constraints, the burden will fall more heavily on central banks. Those with high trade exposure and elevated policy rates – such as Brazil, Mexico, and South Africa – are likely to cut rates more aggressively, especially if the trade-weighted U.S. dollar continues to weaken.

The AI investment boom rolls on

Technology investment continues to power U.S. economic resilience and seemingly boundless equity market performance. AI-related capital spending (see Figure 2) will likely remain a driver of U.S. investment growth through 2026. With AI adoption broadening, investment in infrastructure including data centres and specialised chips will likely remain robust. China is also aggressively building out AI infrastructure with government incentives and industry adoption targets.

Technology is also starting to reshape labor markets. Large firms with the resources to invest in AI can reduce reliance on labor while gaining market share. Tech firms have already reduced hiring for entry level positions, with unemployment rising for people aged 16–25, including college graduates.

Challenges to institutions contribute to uncertainty

Trump administration actions are reshaping traditional institutions including the Fed. In August, President Trump dismissed Fed Governor Lisa Cook on allegations of mortgage fraud. The case is being litigated, but it signals that President Trump may seek to rebalance the Fed Board of Governors toward his policy preferences – and to do so before the terms of Chair Jerome Powell and all regional Fed bank presidents expire in 2026.

There are good reasons to believe the Fed will continue to operate as an institution independent of short-term political influence. Markets are pricing a policy rate near 3%, in line with estimates of neutral interest rates, but a key risk scenario is a potential Trump administration reshaping of the Fed’s leadership.

Paths for economic growth, inflation, and monetary policy set to vary

In Europe, U.S. demands related to defence spending have prompted renewed commitments from NATO allies while straining budgets. Germany’s planned fiscal expansion is focused on greater defence and infrastructure investment, with implications for its debt trajectory and broader EU fiscal coordination.

Other eurozone economies have less flexibility and will likely offset defence investments with tighter policy elsewhere. These trends will further complicate France’s fiscal challenges, which require more meaningful reforms.

Globally, growth appears to be peaking. We expect it to slow in 2025 as tariffs trigger adjustments. As a baseline, these adjustments can occur without recession and with growth returning to a trend-like 3% pace in 2026. However, near-term risks are tilted to the downside as front-loading has masked weakness.

Chinese growth is already cooling. Trade pressures and domestic challenges are being partially offset by government support, but more is likely needed. In emerging markets (EM), weaker growth and stronger currencies create significant room for rate cuts amid trade shocks, limited fiscal flexibility, and slower monetary transmission.

Global inflation should remain generally benign through 2026, with regional divergence. Without a currency adjustment, tariffs should result in a relative price adjustment between the U.S. and the rest of the world.

The U.S. will likely remain a laggard in reaching its 2% inflation target. Inflation in developed markets (DM) excluding the U.S. is likely to converge to 2% central bank target levels by 2026. Excess capacity should keep Chinese inflation near zero, while China’s exports depress prices abroad as it finds new markets for goods previously sold in the U.S. In EM, inflation will stay within central bank comfort zones, with a risk of undershooting if currencies strengthen, in our view.

Globally, monetary easing is set to continue. The Bank of England and Reserve Bank of Australia are likely to cut more aggressively as disinflation resumes, while the European Central Bank and Bank of Canada – which are closer to neutral policy levels – will make smaller adjustments. The Bank of Japan remains an exception, with below-neutral policy and a rate hike anticipated. Central banks have room to cut rates more than is currently priced into markets if U.S. tariff fallout worsens and fiscal easing proves an insufficient offset.

The Fed must balance tighter immigration policy, AI-driven labor displacement, and tariff-related shocks. In the near term, a key question is whether labor market risks materialize and raise unemployment.

Over the next few years, it remains to be seen whether productivity gains from AI and automation can offset immigration-related labor supply shocks, with fiscal policy in 2026 providing more support. If productivity doesn’t accelerate, recovering economic demand amid constrained supply could lead to more persistent inflation – a tough environment for any Fed chair.

Investment implications: Take advantage of durable opportunities

Locking in today’s attractive bond yields presents a compelling opportunity to support income, returns, and potential price appreciation in the years ahead across a variety of economic scenarios. The fixed income opportunity is especially timely with central banks globally poised to cut interest rates further.

Starting yields have historically been a strong predictor of subsequent five-year returns. Looking at high quality bond benchmarks as of 26 September 2025, the Bloomberg US Aggregate Index yield is 4.42% and the Global Aggregate Index (U.S. dollar hedged) yield is 4.73%. From this baseline, active managers can seek to construct portfolios potentially yielding about 5%–7% by capitalising on attractive yields available in high grade investments.

Amid ongoing policy uncertainty, we must consider a range of possible outcomes. It makes sense to focus on a diversified set of investments and to prioritise portfolio resilience. Fixed income valuations are attractive both in absolute terms and relative to equities, which have climbed to historically lofty levels. Bond allocations remain an anchor for investment portfolios, providing stability and a potential hedge against elevated equity market risks.

As central bank policy rate cuts continue, steepness is returning to the front end of bond yield curves. Bonds appear poised to outperform cash, while active management can improve outcomes through yield curve positioning.

Rates, duration exposure, and bond yield curve positioning

Even after the strong year-to-date performance for bonds, yields on U.S. 10-year Treasuries remain well within the 3.75%–4.75% range that’s served as an anchoring reference point over the past couple of years (see Figure 3). Forward curves generally price central banks returning to the range of neutral policy rates – although with the U.K. an important exception, with the market still pricing in a terminal rate well above our neutral estimate range.

Against this backdrop, investors with exposure to duration – a gauge of price sensitivity to changes in interest rates, which tends to be higher in longer-dated bonds – have seen strong performance this year. Positions that benefit from a steepening yield curve have also delivered solid returns.

At this point, we retain an overall bias toward being overweight duration, with a tilt toward U.S. duration and selective exposure in the U.K. and Australia, although with somewhat less conviction than earlier this year given yields have moved lower within our reference range. We favor short and intermediate maturities across global markets, and we are overweight the five-year area in the U.S., as a hedge against downside risks.

We retain our curve-steepening bias but with reduced conviction. Our focus is on potential bull steepening via front-end rallies, rather than bear steepening from long-end selloffs.

Global opportunities

Diversification across regions and currencies is an increasingly important way to tap into potential sources of outperformance. Investors can take advantage of today’s unusually attractive array of global opportunities.

We favor a continued underweight to the U.S. dollar, although we still don’t forecast a shift in its status as the world’s reserve currency. Given risks to the U.S. outlook, including rising deficits, we believe diversifying positions across global markets makes sense. In EM local debt, we favor being overweight duration in Peru and South Africa.

Real assets can serve as a hedge against inflation uncertainty. High real yields and muted inflation expectations embedded in U.S. Treasury Inflation-Protected Securities (TIPS) prices make them an affordable hedge against inflation shocks. Commodities can further improve inflation hedging and diversification.

Credit

We see solid fundamentals in the corporate credit sector but believe other fixed income segments offer better risk/reward profiles. We maintain limited exposure to corporate credit amid tight spreads and economic uncertainty. We favour senior structured credit and investments linked to higher-quality consumers. We advise caution in economically sensitive sectors – especially those connected to trade – with high leverage and disruption risks.

We retain an overweight to structured credit and the investment grade credit derivatives index (IG CDX) combined with an underweight to cash corporate credit. We are overweight agency mortgage-backed securities (MBS), with a preference for higher coupons.

We continue to seek relative value across credit markets. Rather than focusing on arbitrary distinctions between public and private credit, we see a continuum of investment opportunities across these markets that should be evaluated on comparisons of liquidity and economic sensitivity.

We focus on liquid, high quality assets and see strong return potential in asset-based finance. We also favor investment themes with secular tailwinds. These include aviation finance and data infrastructure, where capital needs are large and growing, collateral fundamentals are strong, and barriers to entry for lenders are high. Finally, we also are excited to capitalise on select areas where valuations have already reset – notably real estate debt opportunities secured by high quality assets – and in sectors with resilient fundamentals.

Conclusion

In today’s complicated global environment, active managers can use a variety of tools to access broad-based opportunities. Attractive bond yields present a compelling long-term opportunity – particularly as central bank rate cuts boost the potential for fixed income total returns and diminish the potential returns for cash-like investments.

Additionally, global diversification and a more integrated view of public and private credit markets offer ways to boost portfolio resilience and expand sources of return. Active investors can access the abundance of real and nominal yields across regions and currencies, while evaluating credit opportunities along a continuum based on liquidity and economic sensitivity.

Together, these strategies – bond yield capture, global diversification, and credit continuum analysis – can form a robust investment framework.

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Disclosures
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. References to Agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. Structured products such as Collateralized Debt Obligations (CDOs), Constant Proportion Portfolio Insurance (CPPI), and Constant Proportion Debt Obligations (CPDOs) are complex instruments, typically involving a high degree of risk and intended for qualified investors only. Use of these instruments may involve derivative instruments that could lose more than the principal amount invested. The market value may also be affected by changes in economic, financial, and political environment (including, but not limited to spot and forward interest and exchange rates), maturity, market, and the credit quality of any issuer. Private credit involves an investment in non-publicly traded securities which may be subject to illiquidity risk.  Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. Diversification does not ensure against loss.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

Correlation is a statistical measure of how two securities move in relation to each other. Duration is the measure of a bond’s price sensitivity to interest rates and is expressed in years.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.

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European credit could naturally benefit from increasing numbers of investors seeking diversification away from U.S. credit.

Europe’s economic prospects look lacklustre amid structural challenges, but institutional progress, better policy coordination, and stronger political cohesion provide a stable backdrop for investors. With steady interest rates and a resilient credit market, the region offers attractive opportunities for those seeking diversification and dependable returns in an uncertain global landscape.

In our recently published Secular Outlook^[1], we argued that a fragmented global economy combined with elevated public debt levels will create an environment of high macroeconomic volatility, with risks generally skewed to the downside.

Europe is no exception. Domestic and external challenges mean that Europe’s macro outlook will remain subdued, with growth potential slowing from around 1% pre-pandemic to around 0.5% over the next five years. This slowdown is driven by weaker demographics and slower productivity growth, according to our analysis. The weak productivity outlook reflects ongoing challenges such as a lagging position in the global technology race, intense competition from China, and elevated energy prices compared with the pre-Ukraine war period – all compounded by a less favourable global trade environment (see our recent note on EU-U.S. trade relations^[2]).

The shift in German fiscal policy toward higher defence and infrastructure spending is significant. However, we do not expect this to extend across the region, as other major countries such as France, Italy, and Spain are unlikely to increase unfunded spending due to debt sustainability constraints. Additional defensce spending outside Germany will likely be offset to a large extent by spending cuts in other areas. On balance, we expect a broadly neutral fiscal stance across the euro area over the next five years.

On the nominal side, inflation is unlikely to return to the 1% level seen in the years before the pandemic, given deglobalisation pressures and somewhat higher inflation expectations. Still, we expect inflation to settle below the European Central Bank’s 2% target. The weak growth and inflation outlook will continue to anchor equilibrium policy rates, which over time are likely to fall below the current nominal level of 2% suggested by our models.

Resilience across the region

As bleak as this may sound, there’s a silver lining: We expect the monetary union to remain stable over the secular horizon. The region has passed significant stress tests in recent years – including a pandemic and a war – demonstrating strong political commitment to unity. This resilience has been supported by meaningful institutional progress, such as the ECB asserting its role as a reliable lender of last resort for sovereigns (through various asset purchase programs and tools addressing sovereign stress), as well as improved fiscal cooperation via cross-border fiscal transfers funded by the pandemic-related Next Generation EU program. While Next Generation EU is intended as a one-off, it offers a potential template for future downturns.

Today’s political landscape also appears less disruptive. Although populist pressures remain alive and well, with far-right parties either in government or gaining support, true Euro-skepticism aimed at dismantling the EU and the monetary union has faded. For example, perceived risks over the election of a far-right government in Italy quickly dissipated as the administration adopted moderate economic policies. Support for the euro is currently at record highs, and political commitment to cohesion may strengthen further amid a more adversarial global political environment.

That said, risks remain. We are monitoring France closely due to a steeply rising debt-to-GDP path, challenges in implementing spending cuts, and an already very high tax-to-GDP ratio. Still, some fiscal adjustment is ultimately likely, and we would view this as more of an idiosyncratic French risk premium issue than an existential risk for the region.

Investment implications: Rates and FX

The challenged growth outlook and subdued inflation environment we expect suggest that European duration valuations should remain stable, with Bunds likely serving as a good diversifier in portfolios. Additionally, increased demand for European safe assets – driven by global diversification away from the U.S. – could further support duration.

The theme of steeper curves mentioned in PIMCO’s Secular Outlook also applies to Europe. Rates at the front end and the belly of the curve should remain anchored by low equilibrium policy rates, while long-end yields are likely to be held up by higher German issuance.

The stability of the monetary union should result in relatively stable sovereign spreads over Bunds, enabling investors to earn additional yield by buying a diversified basket of euro area sovereign bonds. The line between core and periphery countries is also becoming more blurred, so investors should choose sovereigns based on relative fundamentals rather than traditional bucketing.

Regarding currencies, we do not see the U.S. dollar’s role as the global reserve currency being challenged. However, global diversification could prove a modest tailwind for the euro.

Investment implications: Corporate credit

In the high quality investment grade credit space, the €4 trillion+ European market offers abundant opportunities to invest in issuers that have been tested over multiple economic cycles and are well-accustomed to operating in a low growth environment. Given the region’s muted GDP growth, many high quality corporates have typically adopted relatively conservative balance sheet strategies, providing ample financial flexibility to successfully navigate a range of macroeconomic scenarios. Active management is key to finding such select opportunities.

The European investment grade market also benefits from the embedded diversification provided by duration which, at around five years, is anchored around where we see the most compelling risk-adjusted returns. Within the global credit universe, the lower interest rate sensitivity of the European credit market has contributed to its lower volatility in recent years, positioning it advantageously amid an environment of steeper yield curves.

Outside of investment grade, the European high yield bond market has significantly improved in quality over the past 15 years, with over 65% of the market now rated BB. During this period, European high yield has delivered returns comparable to the European equity market but with markedly less volatility. As equity valuations continue to richen, credit has the potential to outperform again over the secular horizon but with only one-third to one-half of the volatility.

Finally, European credit could naturally benefit from increasing numbers of investors seeking diversification away from U.S. credit, which is overwhelmingly concentrated in U.S. corporates.

Notes:
[1] https://www.adviservoice.com.au/2025/06/cpd-the-fragmentation-era/
[2] https://www.pimco.com/au/en/insights/eu-us-trade-deal-reduced-risks-but-still-a-headwind-for-europe

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Tiffany Wilding

Despite heightened political noise surrounding the Federal Reserve, we do not anticipate dramatic shifts in monetary policy – regardless of who is confirmed as the next chair. A Trump-appointed candidate would likely favor a faster return to a neutral policy stance than the current median view of the Federal Open Market Committee (FOMC). They may also support a more aggressive approach to balance sheet normalisation, with an emphasis on gradually shifting the Fed’s holdings toward Treasury bills.

While Trump’s nominees for Fed chair would likely advocate for a faster pace of rate cuts, the administration’s optimistic growth forecasts limit the case for a policy stance below neutral or for adopting a much lower estimate of the neutral rate than the current FOMC consensus.

Furthermore, despite ongoing speculation, we believe it is highly unlikely that Trump will fire Fed Chair Jerome Powell before his term ends in May 2026. Firing Powell could be self-defeating in several respects, and besides, the legal, political, and economic ramifications loom too large. (For a more detailed analysis, see the article by my colleague and former Fed Vice Chair Richard Clarida in last month’s Economist, titled “The best check on Fed politicisation is fear of being judged a failure.”)

Overall, we believe a reasonable path forward given our economic outlook is a return to a neutral policy stance by the end of 2026, with interest rates settling near the midpoint of the Fed’s estimated neutral range of 2.6%–3.6% (down from the current level of 4.25%–4.5%). This is lower than the FOMC’s current 2026 Summary of Economic Projections median projection of 3.6%, but it remains within the central tendency range. So far, consumer price adjustments resulting from higher tariffs have been mild. If that trend continues, there is a strong case for the Powell-led FOMC to resume normalizing rates later this year.

Interest rates could reach neutral next year

Many investors are asking about the direction of Fed policy, particularly in light of Trump’s public dissatisfaction with recent decisions under Powell and next year’s expiration of key Fed appointments. In our view, economic fundamentals and institutional dynamics point to a baseline monetary policy outlook that is not meaningfully different from what would be expected with the current composition of FOMC participants – perhaps with a marginally faster return to a more neutral policy stance.

Amid the headlines surrounding Trump and Powell, recent economic data developments are strengthening the case for rate cuts. U.S. economic momentum has slowed compared to last year: Department of Commerce data show real consumption growth of approximately 1% in the first half of 2025, down significantly from the 4% pace recorded in the second half of last year. Inflationary pressures have also been milder than expected – partly because tariffs are taking time to filter through to consumer prices (see last week’s Macro Signposts, “The Economic Impact of U.S. Tariffs”^[1]). Some policymakers, including Fed Governor Christopher Waller, have made a case for an earlier move in July, while 10 FOMC participants expect two or more 25 basis-point cuts later this year.

The individuals speculated to be leading contenders to succeed Powell as Fed chair – including Waller, Kevin Hassett (Director of the National Economic Council), and Kevin Warsh (former Fed governor) – would likely advocate for faster and deeper rate cuts. Assuming sufficient consensus, the FOMC could potentially lower rates by 100 to 150 basis points (bps) from the current range of 4.25%– 4.5%.

However, this would not represent a radical departure from current policy; it’s at the lower end of current Fed estimates for the neutral rate. Thus, by cutting rates at a steady pace, the Fed under Powell could potentially reach neutral before a new chair is appointed.

Much hinges on the Fed’s estimate of neutral – and whether a Trump-nominated chair would argue for a level below the current central tendency range of 2.6 to 3.6%. While supply-side expansion could help limit inflationary pressures, higher supply-side growth is typically associated with elevated investment, which tends to raise the neutral rate. If such growth materialises, it would be difficult to justify a policy rate significantly below the Fed’s estimated neutral range.

In our view, the case for a much lower neutral rate appears inconsistent with the Trump administration’s optimistic growth projections. Both Hassett and Warsh have said that Trump’s tax and tariff policies could lift U.S. real GDP growth to around 3%.

Moreover, even if a Trump nominee pushes for a much faster return to neutral, the Fed, as always, makes policy decisions by committee. It would take more than one or two votes to sway policy dramatically away from a steady, measured return to neutral.

Why Fed Chair Powell will likely serve his full term

Despite persistent rumours and occasional threats from the president, we still believe it is highly unlikely that Trump will move to fire Powell before his term ends in May 2026. There are compelling legal, political, and practical reasons for this view.

• Legal constraints: The most significant barrier to removing Powell is legal. Earlier this year, the Supreme Court affirmed the Federal Reserve’s special status as a quasi-private institution, whose governors can only be removed for “cause” – a high threshold typically reserved for serious misconduct such as fraud. While some Republican lawmakers have tried to build a case for removal by pointing to cost overruns in the Fed’s building renovations, the Federal Reserve Board has quickly responded with reasonable rebuttals. Powell has also called for an independent Inspector General review and privately indicated that he would challenge any attempt to unseat him – likely remaining in his position while the matter is litigated.

• Political realities: Even if Trump could legally remove Powell, doing so would be politically risky and likely counterproductive. All Fed nominees require Senate confirmation, starting with the Senate Banking Committee. Given the current political landscape, it could be difficult for Trump to secure unanimous support from Republican committee members, especially if the move is perceived as an attack on the Fed’s independence. In the committee, a single Republican vote in opposition could derail a nomination. Two GOP members of the Senate Banking Committee, Thom Tillis and John Kennedy, have said that firing Chair Powell should be avoided, with Tillis saying it would “undermine the credibility of the U.S.”. Like his predecessors, Trump – in his first administration – struggled to advance controversial Fed nominees, with several high-profile withdrawals and failed confirmations in recent years.

• Economic and market consequences: Firing Powell could carry significant market risks. Past speculation about his potential removal has led to higher long-term interest rates and declines in equity markets – outcomes contrary to the administration’s goals. Leading economists and former Fed officials have warned that such a move could undermine confidence in the central bank, raise inflation expectations, and call into question the unique global status of U.S. capital markets. The likely consequences: steeper yield curves, higher rates, and a weaker dollar.

• Institutional checks: Finally, as noted above, it is important to remember that the Fed chair holds only one of 12 votes on the policy-setting FOMC. Even if Trump were to install a politically partisan chair, it is far from certain that the rest of the committee would support a dramatic shift in policy. It’s worth noting that of the current seven-member Fed Board of Governors – all of whom vote in the FOMC – only two were nominated during Trump’s first term, while the others were nominated by President Joe Biden.

Bottom line

Over the next few years, barring an unexpected negative economic shock or more concerning underlying inflationary pressures, we expect a steady return to a neutral monetary policy stance – first under Powell’s leadership through May, and then under the next Fed chair. Fed independence, combined with economic fundamentals and institutional checks, supports this baseline outlook.

In the near term, while Trump is likely to continue criticising the Fed and advocating for lower rates, we do not expect him to attempt to fire Powell. Instead, Trump will begin shaping the Fed through upcoming appointments, beginning with the expiration of Governor Adriana Kugler’s term in January and Powell’s chairmanship in May (Powell’s term as governor, distinct from his role as chair, runs through January 2028).

Whoever Trump chooses as next chair will, like any Fed leader, have to present a credible case for monetary policy decisions that garners Senate confirmation first and then a majority FOMC support. As with other institutions of the U.S. governing system, the Fed is structured with built-in checks and balances that limit the ability of any single individual to dramatically shift its policy trajectory.

By Tiffany Wilding, Economist, (with contributions from Libby Cantrill, head of public policy).

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Notes:
[1] “The Economic Impact of U.S. Tariffs”

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The hybrid phase-out opens the door to optimised global fixed income portfolios offering competitive returns with lower risk.

Key takeaways

• Expanding beyond domestic hybrids to a global fixed income opportunity set can unlock better returns and greater diversification.
• To match the expected return from hybrids, only 25% of existing hybrid exposures need to be allocated to illiquid strategies such as private credit, with the balance invested in daily liquid bond solutions.
• A diversified approach that incorporates interest rate, yield curve, and securitised credit risks—rather than focusing solely on corporate credit—can offer a superior risk-return profile compared with Australian hybrids.

Australian bank hybrids, also known as Additional Tier 1 (AT1) capital, have long been a staple in the portfolios of Australian investors. However, the Australian Prudential Regulation Authority (APRA) announced in December 2024 the phase-out of AT1 as eligible bank capital, a move that will see the $40+ billion hybrid market effectively vanish by 2032. This impending change leaves investors facing the pressing challenge of finding suitable alternatives to replace the attractive yields and income that hybrids have traditionally provided.

Historically, the appeal of hybrids has not been solely due to their credit risk profile or the enticing spreads associated with higher-risk credit. A significant part of their yield advantage came from franking credits. As hybrids face obsolescence, investors must ask: what can effectively replace this income?

Transitioning to a global fixed income opportunity set as hybrids phase out

An analysis of 38 hybrid securities with an average call date in 3.5 years reveals current returns of 7.4%. However, these yields are expected to decline to around 6.7% over the next three to five years as cash rates fall. Investors should be aware that these hybrids carry elevated credit and tail risks, including the possibility of conversion into equity and substantial losses, even in scenarios where senior bonds recover.

As outlined in  “The “Magnificent 7” Reasons Why Now is a Good Time to Invest in Core Bonds”^[1], we believe that today’s environment presents an opportune moment to transition from concentrated corporate credit risk, such as Australian hybrids, to a diversified portfolio spanning domestic and global fixed income markets. A simple 50/50 blend of active core bond and multisector credit funds, hedged to AUD, currently yields around 6%.^[2] This compares favourably to the expected 5.6% p.a. return for global equities over the next five years, based on PIMCO’s valuation-aware capital market assumptions.

In essence, we believe that a diversified portfolio of high-quality fixed income can deliver equity-like returns over the next five years while exhibiting only one-third of the risk associated with equities.^[3]

Optimising bond portfolios for income and risk appetite

We evaluated a broad range of strategies across Australian and global bond markets to identify alternative income sources, including:

• enhanced cash strategies, which aim to outperform the RBA cash rate by around 1% p.a. with low risk
• core bonds that incorporate interest rate exposure
• multisector credit strategies spanning investment grade, high yield, emerging market debt, and global securitised credit
• niche allocations to capital securities (global equivalents of Australian hybrids), and
• up to 25% exposure to semi-liquid, multi-sector global private credit, which allows for quarterly redemptions and offers greater diversification than corporate direct lending.

We then conducted portfolio optimisations based on expected returns relative to tail risk^[4]. We capped private credit at 25% of the allocation and set other strategies’ weight between 10% and 40% to enforce meaningful diversification. (For more on expected returns and risk factors, see Appendix).

We compared a hybrid model (with and without franking credits) with two optimal portfolios (see Figure 1). The “hybrid yield matching” portfolio, which generates the same 6.7% expected return as the hybrid model, demonstrates that investors can match hybrids’ after-tax returns without franking credits, while reducing tail risk by approximately 20%.

The “lower risk” optimal portfolio allows more conservative investors to target a 6% return – close to the 6.7% return expected for hybrids and in line with our expectation for equities – while reducing their tail risk relative to hybrids by more than 50%.

Examining the composition of the two optimal portfolios

Figure 2 shows the allocation and summary statistics for the two optimal portfolios targeting 6.0% and 6.7% returns, respectively. Daily liquid core bonds and multisector credit constitute the majority of both portfolios. The “lower risk” portfolio allocates a greater proportion to enhanced cash and slightly less to private credit. Both portfolios maintain modest interest rate risk, with durations around three years, half that of the Bloomberg Global Aggregate Index, the flagship benchmark for global bonds.

These portfolios are diversified not only across asset classes, but also across risk factors. The “lower risk” portfolio, for example, sources around 40% of its risk from corporate debt, 20% from asset-based credit, and 25% from global interest rate exposure.

Hybrid investors often favour listed vehicles for their liquidity and transparency. The growing availability of active fixed income ETFs and private credit listed investment trusts (LITs) now offer accessible, liquid options that allow investors to transition smoothly from hybrids while maintaining diversified exposure. Such listed products provide a practical way to implement these proposed portfolio solutions without compromising ease of trading or portfolio flexibility.

Diversify beyond hybrids to secure equity-like expected returns in global fixed income

The phasing out of hybrids should be viewed as a catalyst for investors to explore global fixed income opportunities. When replacing hybrids, we believe that investors can maintain around 75% of their capital in daily liquid vehicles focused on multisector credit and core bonds, while allocating up to 25% to semi-liquid diversified private credit to enhance yields.

A diversified approach that extends beyond corporate credit risk to include additional risk factors such as interest rates, yield curve exposures, and securitized credit can deliver a superior risk-return profile compared to Australian hybrids.

Today’s high yields combined with attractive valuations across (predominantly non-corporate) credit markets provide an opportunity to lock in equity-like expected returns in high quality fixed income. This enables investors to de-risk portfolios without sacrificing returns, while enhancing diversification in equity-dominated portfolios.

Appendix

Understanding the risk-return profile of Australian bank hybrids

Hybrid securities carry greater credit risk than typical corporate bonds due to their subordinated status on the balance sheet. They also carry tail risk, including potential conversion to equity and material capital losses, even in scenarios where senior bondholders might recover their investments during severe crises.

By comparing the credit spread of hybrids relative to BBB-rated corporate debt with similar maturities, we estimate the credit risk premium in hybrids to be 75% higher. This risk premium difference serves as the key input for estimating risk in hybrids.^[4]

Additionally, the Australian hybrid securities market is more concentrated than diversified credit markets, with the top five issuers accounting for the majority of outstanding debt. We factor in this lack of diversification by attributing a 0.7% volatility contribution from idiosyncratic risk.

Expected returns and risk factors in global fixed income markets

As Figure 3 shows, expected returns across income sources range from 4% to 9% p.a. When considering the franking credit advantage of hybrid securities, their risk-adjusted returns are in line with diversified multisector credit, private credit, and Australian BBB-rated credit.

The risk profiles of these strategies vary significantly in magnitude and composition, offering diversification benefits at the portfolio level – unlike hybrids, which are predominantly driven by corporate credit risk.

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Notes:
[1] https://www.pimco.com/au/en/insights/the-magnificent-7-reasons-why-now-is-a-good-time-to-invest-in-core-bonds
[2] As of 30 April 2025. Yield tends to be a good predictor of future returns as the correlation between YTM and 5-year future total returns of the Bloomberg US Aggregate Index is 94% based on data from 1976 to 2025
[3] Based on valuations as of 31 March 2025 (US Aggregate Bond Index yield > 5% and the cyclically adjusted price-to-earnings ratio for the S&P 500 >30, future 5-year median returns are 7.8% p.a. for bonds and -0.8% for equities). This analysis uses data from January 1973 to the date of publication.
[4] We find tail risk to be a more valuable measure of risk, particularly for credit investments that tend to exhibit more left tail events than a normal distribution suggests. Specifically, we use the Conditional Value at Risk over a one-year horizon with 95% confidence as our tail risk measures. It estimates the worst annual return over a 20-year horizon.
[5] We follow a duration x spread approach and multiply the credit spread duration of 3.56 years in the AusBond Credit BBB 3-5 Years by ~1.75 to estimate the sensitivity of hybrid securities to Australian BBB spread levels.

Disclosures
IMPORTANT INFORMATION
All source citations are PIMCO unless stated otherwise. The information in this article is for general information only and has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of US government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the US government. Certain US government securities are backed by the full faith of the government. Obligations of US government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. 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