Anticipating another solid year for core fixed income, despite greater volatility 

Key Takeaways

• In our 2026 Annual Outlook, we labeled core fixed income as this year’s potential “consistent hitter.” We expect another year of solid performance in higher-quality bonds following strong results in 2025.
• The main driver of bonds’ total returns is their starting yields, which remain high relative to the past two decades despite their declines in 2025.
• The opportunity to secure attractive income streams is likely to come with higher interest rate volatility compared to the calm market conditions in the second half of last year.

Current yield environment supports a constructive outlook

As measured by the Bloomberg U.S. Aggregate Bond Index (“Agg”), core bonds rallied 7.3% in 2025, their strongest year since 2020. Roughly two-thirds of last year’s performance was attributable to the income provided by the elevated interest rate environment. Today, the Agg Index is yielding roughly 4.4%, 50 basis points (0.5%) lower than the start of 2025. Still, that remains elevated versus recent history, averaging 2.9% over the past 15 years. The current yield environment provides investment grade fixed income with a solid foundation to deliver the two primary benefits many fixed income investors seek: 1) a reliable income stream, and 2) improved portfolio stability during bouts of risk-off market sentiment.

Price returns via falling yields may be more muted this year

The remaining one-third of total returns in 2025 were generated via yield declines across most of the yield curve (bond yields move inversely to bond prices). The sharpest absolute yield declines were concentrated in short-dated fixed income, which are very sensitive to the Federal Reserve’s (Fed) rate cuts. However, their lower sensitivity to interest rates (i.e., duration) dampened the impact on price returns. The biggest price gains were generally centered around the 7- to 10-year maturity range.

In the year ahead, we expect the Fed to cautiously lower the federal funds rate towards 3%, implying a few more rate cuts still to come. However, declines in yields beyond 2-year maturities may be hampered by ongoing fiscal, monetary, and trade policy uncertainty, robust U.S. government debt issuance, federal budget deficits, and geopolitical risks.

Over the past two years, bond investors have demanded incrementally higher yields in compensation for these concerns, creating a “stickiness” among longer-dated bond yields. Although we expect some of the fog around these issues to marginally improve in 2026, it is unlikely to dissipate altogether. This has several implications. First, longer-dated yields should decline a bit this year; however, though those declines may be muted by the factors just discussed. Assuming the Fed carries out a bit more policy easing, we expect the yield curve to steepen further, extending an almost three-year trend. In this scenario, core fixed income performance would be driven more by its income generation and less by price gains.

Volatility should rise from unsustainably low levels

In recent trading days, interest rate volatility touched to its lowest levels in more than four years. Tariff rollbacks, steady demand for U.S. Treasuries, and the end of the Fed’s balance sheet reductions have been important contributors. However, current volatility in the bond market appears unsustainably low. Geopolitical tensions, composition changes within the Fed, and economic data catch-up from last year’s government shutdown all pose unique threats to the market’s placidity

Bottom line

Our near-term outlook for core fixed income returns remains positive, primarily due to the productive income backdrop, but also expectations for modest yield declines. However, investors should expect a bumpier rate path relative to the second half of 2025.