The new bond playbook: Fed credibility, fiscal risk, AI investment, and opportunity

The labor market has cooled without deteriorating materially. Payroll growth has slowed toward a monthly breakeven pace that we estimate at roughly 50,000 jobs, while unemployment remains in the low 4% range. That stability allows the Fed to place more weight on inflation, where progress is less reassuring.

Recent inflation data show limited improvement toward the Fed’s 2% target, and, at the Jackson Hole Economic Policy Symposium in August, Fed Chairman Kevin Warsh notably said he would be “hard pressed to describe broad financial conditions as restrictive.”¹ At the same time, growth is near-trend, and energy prices remain elevated.

This mix of factors led the Fed to increase its policy rate at its meeting on Wednesday, to a range of 3.75%–4%. We believe that this rate change should be viewed as a modest recalibration as opposed to the start of an extended hiking cycle—removing the so-called “insurance” cuts of 2025 to ensure that policy is restrictive and to reinforce Fed credibility.

Beyond the rate hike itself, the Fed saw enough resilience in its updated economic projections to remove some accommodation, but not enough to commit to a more aggressive hiking path. Warsh once again committed to a “timelier return” to the Fed’s inflation objective, but he offered little forward guidance beyond the committee’s data-dependent approach.

For some investors, Fed hikes may evoke the pain of 2022; however, the current backdrop is decidedly different. Inflation, while still elevated, is far below the shock levels of 2021. And, most importantly, bond investors’ starting point is different, with much more room for income to potentially safeguard returns against rate increases and continue driving positive total returns into the future.² 

Persistent fiscal deficits in the U.S. and globally are likely to be a feature of the investment landscape for the foreseeable future. As overall debt levels and government bond issuance remain elevated, investors may demand additional compensation to hold long-maturity Treasuries, driving a larger term premium and supporting a structurally steeper curve. U.S. Treasury buybacks have drawn considerable attention as a tool. Buybacks may improve liquidity and influence relative value, such as swap spreads or the 20-year segment of the yield curve, but they are unlikely to offset underlying fiscal pressures and longer-term concerns.

For investors, this challenge may warrant selective duration positioning. Limiting exposure to the longest-maturity bonds is reasonable for those concerned about fiscal risk. However, short- and intermediate-duration bonds offer attractive compensation relative to history, as well as the benefit of more directly responding to Fed rate cuts, should the growth environment turn less favorable.

Fiscal pressures are a challenge globally, but divergences across key developed markets create opportunities for active investors. Today, we are cautious on French and Italian sovereign bonds, where high debt and political uncertainty create asymmetric risks. We also see gilts as vulnerable due to budget dynamics in the U.K. By contrast, German bunds offer relative value versus Treasuries as growth, policy, and term-premium dynamics in the U.S. and Germany diverge.

AI has important implications across the economy, most notably in driving a significant share of GDP growth in the U.S., which we expect to continue in the near term. But it’s also creating new investment opportunities across markets. AI is no longer just an equity story; it’s increasingly an important driver of new fixed income issuance and market performance. The enormous capital required to build the infrastructure behind AI is generating issuance across corporate bonds, asset-backed securities, securitized bonds, and even municipals, expanding the opportunity available to investors.

While this issuance is increasing technology’s footprint within the bond market, AI-related issuers still represent a relatively modest share of the overall credit universe. That means investors get the opportunity to participate in this powerful secular trend without taking on the same degree of concentration risk seen in equity markets. For example, eight hyperscalers currently account for almost one-third of the S&P 500’s market cap, yet their fixed income exposure is more diffused, representing approximately 2% of the Bloomberg U.S. Aggregate Bond Index (Agg).³

In our view, some of the most compelling opportunities in the AI buildout can be identified by applying deep research and relative value analysis across the broad landscape of AI-related bonds across sectors, currencies, and curves to identify similar risks across structures and select those offering the most attractive compensation for investors. 

Higher yields have materially improved the opportunity set for bond investors. With the high-quality Agg yielding greater than 5% since August 31, 2026, investors can earn attractive income without taking on excessive credit or duration risk. Further, high yields are a cushion against further rate increases. At today’s yields, rates would have to rise nearly a full percentage point to drive a flat 1-year return for those who own the Agg.

Short-to-intermediate maturities offer attractive carry, rolldown, and sensitivity to potential future easing. Investors should be selective in duration, as inflation, fiscal risk, and rising term premiums may put pressure on yields, especially for long-term bonds. In credit sectors, attractive all-in yields must be separated from spread risk, which remains in a tight trading range. As the market moves forward, record issuance and sector dispersion continue to reinforce the importance of security selection, liquidity management, and downside resilience.

In a market shaped by Fed uncertainty, fiscal pressure, AI investment, and global divergence, active fixed income has more ways to add value. Today’s higher yields provide a stronger foundation for bond market returns.