2026 Mid-Year Outlook: Taxable Fixed Income

It's been a bumpy ride in the bond markets so far this year, and that trend may continue in the second half of the year. Inflation remains sticky, the Federal Reserve appears likely to stay patient, and we believe the 10-year Treasury yield may hold in the 4% to 4.5% range it has mostly held since early March, although there are risks to the upside. But keep in mind that past performance is no guarantee of future results. Geopolitical risks, especially in the Middle East, have also become more important for bond investors because of their potential impact on oil prices, inflation, and Fed policy.

Our broad message for the second half of 2026 is this: Income still matters, but investors should be selective. Despite the recent rise in Treasury yields, we suggest investors favor a below-benchmark average duration with their bond holdings, favoring short- and intermediate-term maturities. In our view, now is not the time to favor long-duration investments just yet.

Our more favorable areas of the fixed income market today include investment grade corporate bonds, high-yield bonds, and preferred securities. Each comes with risks, like the risk that prices fall relative to Treasuries if the economic outlook deteriorates, but we believe that all three offer compelling income opportunities in a market where Treasury yields may stay relatively elevated.

The Fed now appears to be in wait-and-see mode. Our base case is that the Fed remains on an extended pause for now, holding its benchmark interest rate steady through the end of the year. With the labor market having stabilized lately, the Fed will be paying attention to inflation for guidance on its next move, whether that's a hike or a cut down the road.

Most inflation indicators have been above the Fed's 2% target for five years and counting, and they are now moving in the wrong direction. With inflation expected to remain elevated, rate cuts do not seem likely anytime soon. Price stability is one of the Fed's dual mandates, so the fight against inflation is not yet done. Rate cuts when inflation remains elevated could pull it even higher if it spurs more spending.

That does not mean that the next move will necessarily be a hike, however. The risk of a rate hike has risen lately, but it is not our base case. The risks are two-sided—the next move by the Fed, whenever it comes, could be a hike or a cut.

The chart below highlights how much the outlook has changed since earlier this year. At the end of February, the Fed funds futures market was pricing in nearly three cuts by June 2027. Market expectations now point to a hike, but the implied probability has been fluctuating given so much uncertainty around the conflict in the Middle East and how various Fed officials have reacted to the recent increase in inflation in their recent speeches and interviews.

Here are some factors that the Fed would likely consider before raising rates:

• If core inflation continues to move higher. The core personal consumption  expenditures (PCE) index rose by 3.3% year over year in April, its highest reading since November 2023.
• Whether inflation expectations become unanchored. Rising inflation expectations can make inflation a self-fulfilling prophecy if it pulls forward consumer spending. So far, intermediate- and long-term inflation expectations remain somewhat anchored, although they've increased a bit over the last few months.
• If the labor market strengthens. Lately it's been "stable" rather than "strong," and the Fed might want to see a stronger labor market to handle tighter policy.

In other words, the Fed likely needs a clear reason to hike. Sticky inflation alone may keep the Fed on hold, but a more meaningful and sustained rise in inflation, or inflation expectations, would likely be needed to push policymakers toward a more hawkish stance.

The Middle East is an important risk to this outlook. A prolonged conflict could keep oil prices elevated, which would likely put upward pressure on inflation. Higher energy prices can work their way through the economy in a number of ways, from higher gasoline prices to transportation costs to broader input costs for businesses. If those pressures persist, the Fed may worry that inflation will take longer to return to its target. In that scenario, the risks would tilt more toward a rate hike.

On the other hand, a de-escalation in the Middle East could reduce that pressure. If tensions ease and oil prices fall, inflation concerns could moderate and the probability of a Fed hike would likely decline. That is one reason investors should pay attention not only to traditional economic data, such as inflation and jobs reports, but also to geopolitical developments and oil prices.

For investors, this outlook likely means short-term rates may remain stable.

We believe the 10-year Treasury yield will remain mostly in a 4% to 4.5% range over the near term. We see more risks to the upside than the downside, as there are a number of factors discussed below that should put upward pressure on yields. While a rising risk of recession is a key factor that could pull yields lower, that's not our base case.

The same factors that we expected to keep long-term Treasury yields elevated coming into the year are still present: sticky inflation, fiscal concerns, rising global bond yields, and the term premium. With inflation elevated, we think investors may continue to demand higher yields to compensate for the risk that it might not move lower anytime soon. Inflation can pose a meaningful risk to bond investors because even though the coupon rates are often fixed, rising inflation can eat away at the value of those coupon payments.

Oil prices are also part of the story. Treasury yields and oil prices have recently moved in the same general direction because oil has become a key signal for inflation risk. When oil prices rise, investors may worry that inflation will stay higher for longer, which can push Treasury yields up.

Another factor that could keep long-term yields elevated is the term premium. Put simply, the term premium is the extra yield investors demand to own a longer-term bond instead of a series of short-term bonds. For many years following the global financial crisis, the term premium was very low, likely driven by relatively low and stable inflation as well as the Fed's large bond-buying programs. Today, the environment looks different. Inflation uncertainty has risen, and the Fed is unlikely to use its balance sheet as aggressively as it did in the past. The term premium has risen from March 2020 lows but is still below the long-term average and well short of previous peaks. That could mean that the term premium continues to rise as investors require more compensation to hold long-term bonds, keeping long-term Treasury yields "higher for longer."

For the 10-year Treasury yield to fall back below 4%, we think the economic backdrop would likely need to deteriorate with a rising risk of recession. In that environment, investors would likely seek the safety of Treasury bonds, and markets might begin to price in a greater chance that the Fed eventually cuts rates. That's not our base case, however.

Given this outlook, we favor a below-benchmark average duration.¹ Since we believe the 10-year  Treasury yield may stay in that 4% to 4.5% range and the risks are tilted somewhat to the upside, we do not think now is the time to aggressively add duration. If Treasury yields continue to move higher, there may be an opportunity for investors to consider more longer-term bonds, but we're not there yet.

That said, we also don't think investors should focus only on very short-term investments. Those investments can play a role in a portfolio, especially for liquidity needs, but it might mean investors sacrifice yield today. The yield curve is currently positively sloped, meaning investors can generally earn more income by moving somewhat further out in maturity. The largest yield increases since the end of February have been with yields in the two- to five-year part of the yield curve. Staying too short may come with an opportunity cost.

We see opportunities for investors to consider adding risk in moderation with investment grade corporate bonds, high-yield corporate bonds, and preferred securities.

Investment grade corporate bonds are one of our more favorable areas of the fixed income market. These are bonds issued by companies with higher credit ratings, and we believe they can play an important role for investors seeking income with a relatively higher-quality profile.

Two key factors supporting our view are attractive yields and relatively strong corporate fundamentals. The average yield on the Bloomberg US Corporate Bond Index is currently north of 5%, which is appealing relative to much of the post-financial-crisis period.

The yield advantage that investment grade corporates offer above Treasuries, known as the credit spread, is very low, however, and likely due to those strong fundamentals. Many investment grade companies have solid balance sheets, manageable debt levels, and access to capital markets. They have investment grade ratings for a reason.² While the economy could slow, we do not currently see broad signs of stress among higher-quality corporate issuers.

That does not mean there are no risks. Corporate bond spreads—the extra yield investors receive relative to Treasuries—are low. If the economy weakens or risk appetite deteriorates, spreads could widen and corporate bond prices could fall relative to Treasuries. But for investors focused on income, we believe investment grade corporates remain attractive. We expect much of the potential return in the second half of the year to come from income payments, not price appreciation.

Investors with an even greater risk tolerance can also consider high-yield bonds today, in our view. The story here is similar to our investment grade outlook: spreads are low but the absolute yields appear attractive. In an environment where the economy continues to grow near its trend growth rate, modest exposure to high-yield bonds may be appropriate.

High-yield bonds carry lower credit ratings than investment grade bonds, which means they are more sensitive to changes in the economic outlook and investor sentiment, and as such, they might not be appropriate for all investors. The biggest concern with high-yield bonds today is valuation. Because spreads are low, investors are not being paid as much extra yield as they have been in the past. That suggests investors should not expect much return from spread compression, meaning there's little room for high-yield bond prices to rise relative to Treasuries. And if spreads rise, their prices can fall relative to Treasuries.

Despite low spreads, we believe two important factors make high-yield bonds a bit more favorable today. First, the credit ratings in the Bloomberg US Corporate High-Yield Bond Index have been improving over the years, with bonds rated Ba making up more than 55% of the index. Much of that increase has come at the expense of Caa rated bonds, which we view as the junkiest of the junk. That makes the index relatively high quality within the broader high-yield universe.

The high-yield bond index also has a relatively low average duration. The Bloomberg US Corporate High-Yield Bond Index has an average duration of roughly three years, much lower than the average duration of the Bloomberg US Aggregate Index, which is just shy of six years. Our more favorable view on high-yield bonds is also in line with our "below benchmark" guidance on duration.

Preferred securities are another area we view more favorably today. At first glance, this may seem inconsistent with our view that investors should be cautious about adding long-duration exposure. While preferred securities often have long maturities, or no stated maturity at all, which can make them sensitive to changes in long-term yields, they are not simply long-term bonds. They are hybrid securities that share characteristics of both stocks and bonds. Their performance can be influenced by interest rates, credit conditions, bank and financial-sector fundamentals, and broader equity-market sentiment. In fact, preferred securities have historically been less correlated with long-term U.S. Treasuries than with the S&P 500, investment grade corporate bonds, and high-yield bonds.

Preferred yields have also risen more than the yields on investment grade corporate bonds lately. They come with different risks of course—subordination risk and lower average credit ratings—but the yield advantage makes the entry point attractive for investors willing to take a little extra risk today.

Preferreds may also offer tax advantages. Many preferred securities pay qualified dividend income, which can be taxed at lower rates than ordinary bond income for some investors. That can make preferreds especially attractive in taxable accounts, particularly for investors in higher tax brackets. Investors should be careful, though: not all preferred securities receive the same tax treatment, and individual circumstances matter. Clients should consult a tax advisor when evaluating after-tax income opportunities.

The risks are important. Preferred securities generally rank below traditional corporate bonds in an issuer's capital structure, meaning bondholders typically have a higher claim on assets than preferred holders if a company runs into financial trouble. Preferreds can also be volatile, particularly when long-term yields rise or financial-sector stress increases. Many preferred issuers are financial companies, so investors should understand their sector exposure.

Even with those risks, we believe preferreds look more attractive today than they have in some time. For income-oriented investors who can tolerate volatility, preferreds may offer a compelling combination of yield and potential tax benefits.

Based on our outlook for the second half of 2026 above, Treasury yields may continue to stay in their recent range. Currently, yields across many fixed income investments still appear attractive, but we see more risk that yields move higher. We expect the Fed to hold rates steady for the next few meetings, and we favor a below-benchmark average duration, generally favoring short- and intermediate-term maturities. We do not believe now is the time to add too much duration to a portfolio given the potential upside risks to yields.

We have a more favorable view on investment grade corporate bonds, high-yield corporate bonds, and preferred securities. We acknowledge that spreads are low for many corporate bond investments, and that a resilient economy may keep spreads low. We encourage investors to focus on the yields that they offer, rather than potential price appreciation, and to be prepared for occasional volatility.