Written by: Advisor Asset Management
Fixed income investors are at a crossroads. U.S. tariff policies are likely to have significant implications towards growth, inflation, and interest rates. The playing field for fixed income has changed, and dynamically allocating towards a defensive posture may be necessary. Below are four questions fixed income investors should be asking themselves when seeking change in their allocations for the foreseeable future.
1. ARE INTEREST RATES NEAR THEIR PEAK?
As the Fed signals a cautious interest rate path with inflation remaining sticky, investors are debating whether current yields represent an attractive entry point or if further delays in rate cuts could cause more volatility. The case for interest rates to go in either direction is strong as the Fed seeks to balance its dual mandate of maximum employment and price stability, competently. 10-year U.S. treasury yields have personified this confusion as they have stayed elevated and choppy as trade deal progress changes daily.
The likelihood of further rate cuts could be driven by an increased expectation that the employment rate in the U.S. could be strained at a level that is more concerning beyond the potential inflationary impacts of tariffs. However, evidence to suggest a weak labor market is still low as initial jobless claims, a leading indicator, have stayed anchored to historical medians.1 We believe economic growth will likely slow, but stay positive, paired with sticky inflation.2 This may leave the Fed with little motivation to lower rates.
(Sources: FRED, PBS, The Economic Times; 09/18/2024 through 04/30/2025)
2. IS IT TIME TO EXTEND OR SHORTEN DURATION?
Staying defensive by minimizing interest rate risk may be crucial during periods of sticky inflation, a potential byproduct of tariffs. Long duration bets have been positive as investors were potentially anticipating a significant slowdown in the aftermath of the prior hiking cycle. However, growth stayed above trend while rate choppiness ensued. Long duration ETF flows stayed positive but have tapered off, cumulatively, since the Fed started cutting interest rates at the end of Q4 of 2024. This potentially personifies investors’ fears of persistent inflation. Meanwhile, short duration flows in 2025 are likely to surpass their 2022 yearly flows. This quick pivot to short duration may continue as the Fed exhibits a “wait-and-see” approach to tariff impacts.
(Source: AAM, measured monthly from 12/2022 to 04/2025)
3. CURRENTLY, HOW VULNERABLE ARE CREDIT MARKETS IN A SLOWING ECONOMY?
As growth shows signs of cooling, there’s renewed focus on credit risk amidst historically tight credit spreads. Since widening this past month, investors are weighing whether spreads adequately reflect economic risks. A good place to look is the health of the U.S. consumer, the backbone of the U.S. economy.
While the dollar amount of consumer loans has increased since the end of the global financial crisis, coincidently, consumer debt payments as a percentage of disposable income have decreased. Currently near pre-COVID levels, this signifies a decrease in leverage and a strong consumer pre- Liberation Day. Consumer behavior in the face of tariffs will offer clues as to the expected economic impact moving forward. Many are likely to speed up their major purchases while others may hold off until there is more clarity surrounding the outcomes of expected, bilateral trade deals, potentially increasing the volatility of future hard, economic data.3
(Source: FRED, with data measured quarterly from Q4 2000 to Q4 2024)
4. WHERE CAN I FIND MEANINGFUL & DURABLE INCOME WITHOUT TOO MUCH RISK?
After being historically tight at the end of 2024, credit spreads have widened and may offer fixed income investors an opportunity to take on a level of credit risk at the short end of the curve. We believe this may create an intriguing entry point for investors to increase exposure in shorter duration credit instruments.
Securitized assets have historically maintained comparable levels of income potential and credit risk with lower interest rate risk. This occurs due to key features. Auto loans, credit card receivables and equipment leases have low life spans ranging from 1-to-5 years and are the largest sub-sectors of ABS.
Commercial mortgage-backed securities (CMBS) loans are typically much shorter than their residential counterparts with lifespans typically ranging from 5-to-10 years. Meanwhile, collateralized loan obligations (CLOs) are structured as floating rate instruments, limiting a significant level of duration risk. Credit enhancements such as excess spread and overcollateralization are explicit protections that seek to maintain each tranche’s credit worthiness, thus enabling improved credit quality relative to the loans that underpin them. Credit spreads of asset backed securities (ABS) are one area of interest, in which they’ve risen by 28% from their pre-Liberation Day, lows.4
Source: ICE Data Services and S&P DJI with data measured from 04/30/2015 through 04/30/2025. Asset class representations: ABS, ICE BofA AA-BBB US Asset Backed Securities Index; Single-A CMBS, ICE BofA Single-A US Fixed Rate CMBS Index; US Corporates, ICE BofA US Corporate Index
Low duration preferred securities offer an opportunity to personify a similar view while potentially increasing qualified dividend income potential. Low duration preferreds have outperformed both the broader exchange-listed U.S. preferred market and bank sector common equities since the Fed started to cut interest rates. If rates were to remain elevated, skewing towards low duration preferreds may limit downside volatility further. Equity investors seeking to diversify bank sector exposure can move up the capital stack into preferreds as well. This industry appears to be well-cushioned against potential economic growth deterioration as larger banks, the largest issuers of preferred stocks, have continued to maintain robust capital ratios above their regulatory minimums.5,6
Source: ICE Data Services and S&P DJI with data measured from 09/18/2024 through 04/30/2025. Asset class representations: Low Duration Preferreds, ICE 0-5 Year Duration Exchange-Listed Preferred & Hybrid Securities Index; Broad Preferreds, ICE Exchange-Listed Preferred & Hybrid Securities Index; Bank Common Equities, S&P Bank Select Industry Index.
Conclusion
A ‘Stagflation Lite” environment is a thorn at the side of the Fed’s dual mandate. Fixed income investors shouldn’t be relying on a ‘Fed Put’ to save them and may want to prepare their portfolios for continued volatility in the face of high, economic uncertainty.
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For more information, please contact your financial professional or visit www.aamlive.com/etf.
1. AAM with data from FRED measured from 01/01/67 to 05/01/25. The historical median initial jobless claims report of 340k claims is higher than the latest report of 241k claims.
2. Corso, Cliff (2025, April 03) Viewpoints Special Edition — How to Invest for an Era of Elevated Volatility.
3. Repko, Melissa (2025, April 25) Buy now, stock up or delay: Here’s what consumers are snapping up or putting off in the face of tariffs
4. AM with data from ICE Data Services, LLC measured from 04/25/2022 to 04/25/2025. ABS is represented by the ICE BofA AA-BBB US Asset Backed Securities Index.
5. Investing.com (2025, April 11) JPMorgan Q1 2025 slides: Beats forecasts, builds reserves amid uncertainty.
6. Bandhakavi, Swagath (2025, April 16) Bank of America Q1 2025 net income rises 10.5% to $7.4bn