Bonds are back and 2026 could be one of the best set-ups in years

While recent inflation prints were slightly firmer than expected, it’s too early to conclude that the easing cycle is over. However, an extended pause is expected until sufficient additional data becomes available. 

Growth remains subdued as the economy transitions from public-led to private-led expansion, a shift that typically generates fewer jobs. Some labour market softness has persisted, reinforcing the need for policy support.

Against this backdrop, bonds are not just relevant again; they’re compelling, and well-positioned to play a stronger role in portfolio construction. For many Australian investors, fixed income has long been viewed as a defensive allocation, useful primarily in times of crisis. 

But today, bonds offer more than just downside protection. Elevated starting yields combined with falling policy rates have driven attractive income and capital gains. 

Over the 12 months to the end of October, bonds have returned an impressive 6.47%, as measured by the Bloomberg AusBond Composite 0+ Yr Index.

What to expect in 2026

Looking ahead to 2026, the conditions that favoured bonds in 2025 are likely to persist.

In Australia, growth is expected to remain subdued, and unemployment may edge higher as the private sector struggles to fully offset the retreat in public spending.

Ultimately, as inflation settles within the target band, the cash rate will need to return to neutral, which we estimate at around 3.0%. 

Globally, inflation has moved closer to the upper end of central banks’ target ranges, prompting rate cuts across many economies. 

However, policy rates in many developed markets remain above neutral, and further easing is expected from major central banks, including the Federal Reserve and the Bank of England.

For investors, this environment reinforces the strategic importance of fixed income. Low cash rates relative to elevated bond yields will make traditional savings vehicles less attractive, a development that carries significant implications for savers reliant on consistent income streams. 

Bonds, by contrast, offer a way to lock in higher yields today and benefit from capital appreciation when rates decline further. With inflation expectations anchored and correlations between bonds and equities low, fixed income should continue to provide diversification benefits.

What looks good? (Where is the value?)

What to avoid? (Risks)

Fixed income offers a wealth of opportunities today, but Australian investors must remain vigilant regarding potential risks, particularly where valuations are stretched and risk premiums are low in a world of heightened uncertainty and volatility.

While the material rise in yields since the pandemic has made core bond valuations appear attractive relative to historical levels, this is not true of all asset classes as we head into 2026.

Rich equity valuations, as evident in high CAPE (cyclically adjusted price-to-earnings) ratios, and tight corporate credit spreads relative to history, are key risks for next year.

While it is difficult to predict exactly when these rich valuations will correct, long-term investors should recognise that such conditions are typically associated with weaker long- term returns.

Another area of concern is liquidity. 

The growth of private markets and the trend toward reducing perceived portfolio volatility by holding assets that are marked to market less frequently have led to signs that investors are no longer being adequately compensated for illiquidity. 

In fact, in some sectors, it is questionable whether a liquidity risk premium exists at all.

Sacrificing too much liquidity, or sacrificing it too cheaply, represents a key portfolio risk for investors in 2026.

Example of best-in-class opportunities

Duration and yield curve

Investors do not need to compromise on credit quality or liquidity to achieve strong returns. We prefer high-quality spread sectors over generic corporate credit, where valuations remain tight.

Key opportunities include:

• U.S. agency mortgages: resilient, highly liquid and backed by government-sponsored entities like Fannie Mae or Freddie Mac. 
• AA rated Australian state government bonds: 10-year bond spreads ranging 55-95 bps over Commonwealth bonds and yields well above 5%. 
• AAA rated RMBS and structured products: Australia’s public securitisation market is now the second-largest globally outside the U.S. in terms of primary issuance, with spreads of 80-120 bps over cash and floating-rate structures that self-liquidate within 1–3 years.

Currencies

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