Vigilance needed

The Federated Hermes 2026 outlook series continues with two of our thought leaders in fixed income discussing what the new year might bring for the economy, financial markets and investors.

Kathryn Glass, Co-Head of Domestic High Yield GroupWhat is your 2026 outlook?

Our view is that a coupon-clipping year is the best-case scenario. With weakening economic conditions, there is heightened risk that spread-widening could generate a “coupon-minus” outcome. We note that much of the riskier lending has shifted to the bank-loan and private-credit markets, in which some high-profile cracks have started to show.  

The labor market will be a key area to watch in 2026 to gauge if the US economy can stay on track. It is benefitting from favorable wealth effects from the stock market and rising home values. Higher-income consumers are enthusiastic spenders, while the lower-income cohort is more reserved. Moody’s reports that the wealthiest 10% of Americans account for half of all consumer spending; as long as their wallets remain open, the economy has a level of support.   

What is a contrarian view you hold for the coming year?  

Morningstar data indicates the high-yield market has seen inflows of nearly $18 billion through the end of September. Of that, less than $2.5 billion has been into active products. If the tide turns and money flows out of these products, watch out — passive products may be forced sellers.  

On valuations, the US market is tight on a spread basis. The “high” in high yield is coming from US Treasurys, not the incremental spread that market participants expect to be paid for taking on junk-bond credit risk. During October, we saw modest spread widening to 336 basis points over Treasurys, well below the historical median of about 468. As of this writing, there’s a lack of visibility into some key economic statistics. As clarity emerges, there is potential for further repricing of risk. 

High-yield spreads seem to be asking us to assume conditions are more benign than usual. Should they deteriorate, they would likely limit the upside and expose unwary investors to significant risk. With recent headlines over troubled credits, we believe a cautious stance is appropriate and defensive positioning will be rewarded when spreads widen. Valuation is a terrible timing tool, but history has shown that when spreads move wider, it is often swift and painful.   

Jason DeVito, Senior Portfolio Manager, Global Fixed Income

What is a contrarian opinion you hold about emerging market debt in 2026? 

Oversupply in key value-add manufactured goods should continue into the new year. Despite the constant talk and worry, we anticipate that it will take some time for supply coming from China to decrease. In the meantime, imbalances continue to exist in critical areas and products, such as steel and petrochemicals.  

What’s a current consensus view with which you disagree? 

There are concerns that Indonesia has a spending problem. While we believe fiscal expenditure will increase, we think it will do so in a targeted, pro-growth manner. This should recontextualize the anxiety and should change the perception of "overspending" into a positive view of productive, growth-supporting fiscal stimulus.