US-Iran war: How to position fixed income

Investment implications

No more easing: The US-Iran war has created a significant negative supply shock for the world economy. The implication is both weaker growth and higher prices. As such, it poses challenges for central banks. Thus far, the most significant impact on fixed income markets has been a re-pricing of central bank policy expectations. Federal Reserve (Fed) rate cuts have been pushed out to late 2026 or 2027, while for the European Central Bank (ECB) and Bank of Japan, markets have priced in interest-rate hikes for this year.

US Treasuries: The Fed’s dual mandate (focused on both inflation and the labor market) positions it to be patient, given the two-sided risks to inflation and employment. But given the resilience of the US economy, above-target US inflation, and the potential for rate hikes in Europe or Japan, long-term yields are unlikely to fall soon. In terms of duration, therefore, we prefer the short- to intermediate part of the yield curve. We are only inclined to extend duration if 10-year Treasury yields rise above 4.50%.

Developed markets credit: Even during the period of maximum market stress (late March), credit spreads did not widen to extreme levels and have since narrowed again. Accordingly, credit offers attractive carry, but only marginal scope for capital appreciation. As such, we remain neutral. We believe high yield offers more attractive coupons and is consistent with our short duration preference. Within high yield, we prefer higher quality and the US versus European markets.

Emerging market (EM) debt: We remain constructive on EM debt. We believe the sector offers attractive opportunities relative to other fixed income segments (e.g., duration or corporate credit). Within EMs, we prefer local currency debt, given that we expect a stable-to-weaker US dollar. On a regional basis, we prefer Latin America (particularly Brazil), given still-attractive nominal and real yields.

Euro bonds: We are neutral on European government bonds. We have long maintained that a 2% deposit facility rate marks the low point of the ECB’s cutting cycle, and the energy supply shock has introduced a clear hiking bias. We are not persuaded, however, that the ECB will aggressively raise rates as the eurozone and global macroeconomic backdrops are very different from 2022–2023. Still, elevated uncertainty has contributed to a sharp rise in Bund yields to what we believe will be a higher trading range. The associated increase in sovereign and corporate financing costs, combined with growth challenges amid elevated energy prices, is putting upward pressure on spreads. Hence, we prefer core bonds (particularly Bunds).

Performance snapshot

Exhibit 1 depicts global fixed income performance in 2026 and over the past 12 months. This year has been marked by volatility (mostly related to the war) and the global benchmark (Bloomberg Global Agg) has only generated a half-percent return year-to-date. Still, leadership over the last 12 months has been clear—EM debt tops the list. However, this year’s volatility has made it more difficult to identify a clear leader, even if EM debt still ranks near the top. Importantly, short duration has outperformed long duration, as we expected. Inflation-linked bonds have unsurprisingly also performed, reflecting inflationary concerns which the escalation of the Middle East conflict has exacerbated.

US Treasuries

The Fed’s dual mandate positions it well to see through the US-Iran war supply shock, especially as the macroeconomic starting point for the economy is quite different from 2022. Nevertheless, the Fed will likely remain cautious in the coming months, awaiting more data on the growth and inflation outcomes. Should a more dovish stance materialize later this year, the yield curve is apt to bull steepen.

One of the most frequently asked questions we receive is when it will be appropriate to extend duration. Our data-driven framework (Exhibit 2) confirms that it is best to do so when both growth and inflation are poised to surprise to the downside.

That is not now the case. In March, inflation expectations were rising while growth expectations modestly dipped. Historical analysis suggests that these circumstances point toward only a gradual extension of duration. Moreover, we are even more conservative, given the volatile nature of unfolding events. We prefer the short-to-intermediate part of the yield curve and will only see duration as attractive when the upper end of the past 12-month trading range of 4.50% for the 10-year US Treasury yield is breached.

As noted, even before the war, US inflation had become stuck above the Fed’s 2.0% target. That “inflation problem” has now been exacerbated by the war’s supply shock, underpinning the appeal of Treasury Inflation-Protected Securities (TIPS). Notably, TIPS pricing has been particularly sensitive at short-term maturities and less so further out the TIPS curve. That primarily reflects investor confidence that the price impacts arising from the war and supply shocks will be transitory. Overall, our preference is for intermediate-term TIPS.

Developed markets credit

Within credit, our preference remains for the high-yield sector given its shorter duration profile and more attractive carry than investment grade. We also favor US high yield over European high yield. All-in yields of nearly 7% for US high yield are attractive sources of income, even if spreads inside of 300 basis points (bps) are not wide. Overall, therefore the combination of income and spreads justifies our neutral, though not overly cautious, stance.

Moreover, so long as growth and corporate cash flow fundamentals remain positive, we believe investor interest in yields (coupons) will remain intact. Presently, the default rate in US high yield, at 1.7% (as of March 2026), is historically subdued, as is the distress ratio of 5.5% (which typically leads default rates). We do not foresee imminent refinancing needs, and the well-diversified sector composition of US high yield, with energy at 11%, is also a plus.

Given that spreads inside of 300 bps are relatively narrow and introduce asymmetric spread-widening risk, we favor higher-quality issuers. A neutral allocation also permits latitude to increase allocations should spreads widen. Spreads in the 300–400 bps range have historically offered better entry points, provided that recession can be avoided (Exhibit 3).

Emerging market debt

In the prevailing fixed income environment characterized by the absence of compelling opportunities, EM debt is a solitary bright spot. Provided that renewed dollar strength can be avoided (as we expect), the US-Iran war and energy shock need not become a major concern for EM debt. Still, selectivity is important (more about our process in “The ‘end’ of emerging markets narrative—questioned (and answered”), and bouts of volatility are likely.

The case for emerging debt is reinforced by improved borrowing fundamentals and in some cases by high real yields, for example in Brazil. Indeed, we prefer local currency markets with high inflation-adjusted yields, supportive fiscal and external balances, and a relatively low reliance on energy imports. On a regional basis, our indicators point to opportunities in Latin America versus Asia. Brazil is worth highlighting, as it offers real yields near 10% (Exhibit 4), a central bank with a bias toward cutting rates, and is a net energy exporter.

Finally, portfolio considerations are positive. Over the last three and five years, the correlation between Treasuries and stocks has reduced some of the traditional diversification benefits of fixed income. However, emerging market local currency debt offers some potential diversification alongside what has been superior risk-adjusted returns.

Euro debt

In Europe, the ECB’s single target mandate (inflation) means that policy expectations have tracked oil prices. For example, German Schatz (two-year) yields have recently moved in lockstep with oil prices (Exhibit 5).