Brendan Murphy

Insight Investment’s outlook for 2026 is one of caution with select opportunities. Many credit markets look expensive, with spreads leaving little room for shocks, but persistent investor demand continues to provide support.

We see better value in areas such as local-currency emerging market debt and parts of secured finance, while investment grade, high yield and municipals call for careful credit selection.

Currency markets, meanwhile, remain shaped by U.S. policy and fiscal dynamics.

Investment grade credit

With spreads remaining as low as they are, we have reduced our perspective on investment grade credit to neutral overall, with valuations being tight, offset by a modestly positive cyclical position, although the strength of that cyclical support may be more tenuous than it previously was.

Overall, we are exercising caution in our credit positioning as we do not believe that spreads at current levels offer sufficient risk premium to cover for any large shock, geopolitical or otherwise, that may occur.

However, we recognise that investors remain hungry for yield, with higher government bond yields underpinning that appetite. From a technical standpoint, as long as the investor demand remains as strong as it has been, it is difficult to envisage a material widening of credit spreads from the current lows.

One feature we remain aware of is that swap rates have fallen through government yields lately, which means that credit may appear to be more expensively valued when viewed against government bonds, than when one views it against swap rates.

High yield credit

Similar to the investment grade market, high yield (HY) valuations appear expensive to us, with spreads as tight as they are. However, that negative is being offset by a modestly positive, though potentially fragile, cyclical driver.

We believe investors should not discount the improvement in credit quality that has taken place in HY over time. All other things equal, such an improvement would naturally precipitate a reduction in the market-wide level of credit spread.

We retain a preference for short duration areas of the HY market as we believe these offer less vulnerability to what we see is the most likely type of shock, namely an unexpectedly sharp setback in economic activity.

We continue to see relatively strong demand from investors wanting to lock in attractive yield levels, which helps us retain an optimistic stance for the asset class.

Emerging market debt

We currently view local currency emerging market (EM) debt favourably for several reasons.

We believe a US rate cut will make local rates more appealing given an observed correlation between US interest rates and local currency debt.

We are also seeing stronger flows for emerging market debt. Conditions for emerging market corporate debt have improved, partly as structural weakness in the US dollar is a tailwind for all assets. US policy and trade uncertainty appears to be encouraging investors to allocate less to US assets and more to regional emerging markets. Generally, spreads are tight partly as net supply is negative.

We see more value from high yield parts of the EM markets over investment grade.

Secured finance (structured credit)

Mortgage-backed securities (MBS) have caught up to other high quality spread sectors recently. A key factor was remarks made by Fed chair Jerome Powell at Jackson Hole indicating that rates would be cut soon.

Spreads have tended to be relatively steady recently, but as they have moved close to 30bp we believe that could warrant a reduction in the prevailing overweight position. Conversely, if spreads widen to 40bp, we will likely view that as an opportunity to increase our weighting.

Considering US Treasuries, if 10-year yields were to rise we would not view that as being supportive for MBS.

Looking ahead to the first quarter of 2026, we believe a relaxation of Basel II capital rules for banks would likely lead to increased purchases of MBS.

US municipal bonds

In our view, municipal credit conditions remain solid, supported by very high reserves and cash balances that have accumulated over the last few years.

Some of the executive actions taken by the Trump administration could have negative credit implications across large segments of public finance.

Tariffs and reductions in the federal workforce could slow economic growth, which could have a negative impact on income and sales tax receipts. At the same time, cuts in federal spending in areas such as Medicaid, “green” infrastructure initiatives, and federal disaster relief could add to pressure on state/local budgets.

Uncertain changes to federal policy could drive heightened volatility in credit conditions ahead. We believe a more cautious approach to credit selection would be prudent, with an increased emphasis on balance sheet strength, liquidity and operating flexibility.

Currencies

From a structural perspective, we believe there are a number of negative influences capable of putting pressure on the USD.

• First, the USD is seen as being moderately expensive and is not supported by the outlook for fiscal policy and apparent attacks on the independence of the Fed, all of which could also help undermine the perception of American exceptionalism.
• In addition, we believe the market is long US assets with limited currency hedging in place.

However, real rates in the US are relatively high, which is supportive, and they may not decline significantly unless there is real evidence of economic damage taking place. While a weaker USD may be considered beneficial for US growth, if it prevents inflation declining quickly enough, the Fed may not feel able to cut rates as quickly as the US administration would like.

Balancing caution with opportunity

Fixed income investors face a market where valuations leave little room for error, making caution essential. Yet opportunities remain in local-currency emerging market debt, selected secured finance, and shorter-duration high yield. With spreads tight across investment grade, high yield, and municipals, disciplined credit selection and focus on balance-sheet strength are critical.

A cautious stance on valuations, paired with readiness to act when dislocations arise, is the most effective way to navigate the current fixed income environment.

By Brendan Murphy, Head of Fixed Income, North America

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However, we are yet to see a detailed roadmap to Eurozone fiscal and political union and further policy action from the ECB is likely in an attempt to boosts the European Stability Mechanism’s (ESM) effectiveness.

“We view the measures taken at the EU Summit last week in Brussels as a significant step forward in stabilising European financial markets,” says Murphy.

“These measures should go a long way towards breaking the negative feedback loop between banks and sovereigns and be supportive of risky assets in the near term. However, they do not solve the problems of excessive debt and weak economic growth that are likely to continue to weigh on the Eurozone. More will be needed to permanently bring down funding costs for sovereigns to more sustainable levels,” he adds.

“While volatility is likely to persist in financial markets, the steps taken at the summit, combined with evidence of more supportive policy shifts from major central banks, give us confidence to increase the amount of risk we are willing to take, in particular in areas like corporate credit and emerging markets where valuations are attractive and fundamentals remain solid,” says Murphy.

Plans afoot
The following proposals have been made and will be considered by national governments:

The European Stability Mechanism (ESM) can be used to recapitalise banks directly

“This provision attacks the most contentious aspect of Eurozone policy coordination: explicit debt mutualisation,” explains Murphy.

“Core Eurozone countries have been reluctant to use the ESM as a direct bank recapitalisation tool because the liabilities within the banking system can be large, thus rendering them politically untenable. Yet, if handled properly – we are scant on details for the moment – this could break the financial links between banks and sovereigns, thereby freeing up sovereigns to focus on credible macroeconomic reform,” he adds.

“It is possible that this provision can be extended retrospectively to previous bank recapitalisations in Ireland, Portugal, Greece, and Spain. Furthermore, in reading the statement, we do not believe that this will require full ratification of the treaty by national parliaments. Nevertheless, the ESM itself still needs to be ratified by the parliaments of the majority of Eurozone governments.”

Establish a single supervisory mechanism for the banks in the Eurozone, which should involve the European Central Bank (ECB)

“We believe that this is a positive step in preventing future crises. However, critical measures to prevent inter-regional contagion are still missing, such as pan-European deposit guarantees.”

He continues, “The fact that the ECB is involved suggests that these regulatory efforts will pertain solely to the 17 countries participating in the monetary union, rather than the 27 members of the European Union as a whole.”

The Spanish bank recapitalisation will be financed through the European Financial Stability Facility (EFSF) and transferred to the ESM without assuming senior status

“The Spanish bank bailout will move from the EFSF onto the balance sheet of the ESM when it becomes functional, but the ESM will not hold senior status on the Spanish loan programme,” says Murphy.

“At this time, this provision is specific to the Spanish recapitalisation programme only,” he adds.

Establish a €120 billion fund for immediate growth measures. These measures will be financed via the European Investment Bank (€60 billion), the EU budget (€55 billion), and the new Project Bond issuance (€5 billion)

“The European Commission has pushed for growth financing for investment projects and jobs. While the amount is small and does nothing to alter the near-term outlook for the region as a whole – these funds represent just 1.3% of 2011 Eurozone nominal GDP – it could be helpful to the smaller programme countries,” explains Murphy.

“On balance, we believe that material progress has been made on breaking the financial link between the sovereigns and their banks, but there are few signs of a detailed roadmap to fiscal and political union.”

He continues, “We expect further easing from the ECB in response to this positive Summit outcome in order to provide the national governments time to implement the new measures related to the ESM’s expanded capabilities and create a new regulator. Our view is that these measures are a step forward in stabilising European financial markets and welcome this demonstration of policy coordination.”

10 July 2012

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