Muted, positive returns for fixed income in an eventful quarter

De-escalation of the conflict in Iran and the Fed leadership change grabbed the headlines in Q2. Oil prices fell sharply as the US and Iran signed a Memorandum of Understanding (MoU), extending the at-times shaky cease fire and agreeing to 60 days of negotiations. This credible off-ramp from the conflict allowed Brent and West Texas Intermediate crude oil futures prices to each fall approximately 35% from peak to trough. Given the strong link between oil prices and Treasury yields since the start of the conflict, one might assume Treasury yields fell too over the quarter. Not so fast. As the US and Iran engaged in on-again/off-again negotiations, new Fed Chair Kevin Warsh took center stage, promising a renewed focus on price stability, and the US economy kept expanding amid the ongoing AI capex binge and strong corporate earnings. The hawkish Fed and buoyant economy outweighed falling oil prices. On net, Treasury yields increased and the yield curve flattened, with 2-year, 5-year, 10-year and 30-year yields rising 38, 28, 15 and 4 basis points, respectively.

The rising yields produced price losses for high quality bonds, limiting the Bloomberg US Treasury index return to just +0.32%. Adding credit risk to US fixed income portfolios boosted returns, with the Bloomberg Aggregate returning 0.67% and the Bloomberg Universal—which includes US high yield (HY) and dollar denominated emerging markets (EM)—returning 0.92% for the quarter.

Corporate debt outperformed, with spreads narrowing from already tight levels amid strong US corporate earnings and resilient US economic growth. US investment grade (IG) and HY corporate bonds posted returns of 1.40% and 2.47%, respectively, despite heavy investment grade bond issuance, much of it from so-called AI hyperscalers financing the AI build out. This capex should continue to provide tail winds to US economic growth in coming quarters. We wonder whether the eventual returns to the massive investment will disappoint, as so often has been the case for many first wave investors in periods of massive technological change. A quick look back at first wave investor experiences in the internet, telecom/fiber optic, railroad, and radio booms suggests caution is warranted, but it will take several years before the results arrive. 

Municipal bonds also outperformed this quarter, with the Bloomberg Municipal Bond Index posting a gain of 2.50% without any tax adjustment. Investors continue to respond to high taxable equivalent yields and favorable credit trends in the muni market, ploughing money into municipal mutual funds at a record pace. Demand was so strong that municipal market yields actually fell during the quarter while Treasury yields increased. In general, investor demand for bonds as an asset class has improved relative to the last few years, with strong bond fund inflows and institutional rebalancing into fixed income following years of strong equity performance. 

Monetary, fiscal and growth expectations for the third quarter

How will Chair Warsh lead the FOMC now the markets seem to have accepted his clear emphasis on price stability as a bold assertion of both his and the Fed’s independence from the White House? Chair Warsh’s repeated focus on price stability after inflation has exceeded the Fed’s 2% target for five years prompted Fed expectations to swing from an ease to one or two hikes. Though it may not please President Trump, who has blatantly campaigned for lower Fed policy rates, the FOMC may follow thru with one hike merely as a signal of Chair Warsh’s leadership commitment to tamp down inflation. Or, maybe Chair Warsh’s establishment of five task forces to review every key fundamental aspect of Fed monetary policymaking and implementation will buy time to wait and see if any hike is needed. With Chair Warsh’s task forces addressing so many foundational issues, the Fed’s reaction function is now not well understood. 

On the fiscal side, the boost from the One Big Beautiful Bill Act likely peaked earlier this year and now begins to fade. Meanwhile, the approaching midterms and President Trump’s low net approval ratings help reduce the prospects for further stimulative policies. That leaves heavy AI-related and other capital expenditures combined with improving consumer spending to drive a likely pickup in the pace of US GDP growth in Q3. 

Current positioning from the Alpha Pod Committees

Federated Hermes Yield Curve committee has maintained a neutral position recently, after having previously expected a steepening, acknowledging the success Chair Warsh has had in muting inflation expectations and flattening the yield curve. Our Duration Pod had taken a lean short relative to index as Chair Warsh’s hawkish tone, resilient growth data, and above target inflation all seemed likely to push Treasury yields modestly higher. Lately, the ceasefire and MoU seem to have broken down, lifting oil prices and yields. If the belligerents return to full scale confrontation, there is room for even higher oil prices and yields. It is obviously hard to call such things, but that does not seem most likely. Neither party benefits from resumption of full-scale conflict. Thus, we recently took profits on the small short with the 2-year and 10-year Treasury yields at or near the high of their respective ranges since the end of Q1 2026, returning to neutral.

The Sector committee continues to view credit as priced to perfection with little room for spread compression. Strong corporate earnings justify tight spreads in Investment Grade corporates, where we are neutral. Similarly, tight credit spreads in mortgage backed securities (MBS) can be explained by low-interest rate volatility, supporting a neutral call there. We are underweight US high yield, where valuation seems to outpace fundamentals and potential risks, and we are also modestly underweight emerging market debt based on valuation as we look for a cheaper point to add. While the US dollar has strengthened recently, another reaction to the Fed shift in the hawkish direction, our Currency Pod remains longer term bearish on the greenback. Large fiscal and trade deficits combined with less predictable policy making suggest gradual diversification away from the dollar—as the recent foreign central bank buying of gold illustrates—will persist.

Read more about our current views on positioning at Fixed Income Perspectives