What’s driving bond funds into 2026?

By Darius McDermott on 2 December 2025 in Fixed income

Bond funds may not have matched the giddy gains of the stock market in 2025, but they have delivered a solid performance for investors. Emerging market bonds have been the highlight, benefiting from a weaker dollar and falling US interest rates, but most corporate and government market bond funds have also delivered high single digit returns.

Yet, as the end of the year approaches, a few cracks are starting to appear. There are problems in private credit, for example, with the failure of groups such as First Brands and Tricolor, prompting fears that it may have a knock-on effect in high yield. Corporate bond spreads over government bonds remain at lows not seen since before the financial crash, leaving little or no room for any deterioration in the economic environment.

AI spending

AI is becoming a factor for bond markets to consider as well. Rather than relying on cash flow to support their AI expansion plans, the US technology giants are increasingly tapping the corporate bond market. Jonathan Owen, fund manager on the TwentyFour Corporate Bond fund, says: “After a wave of jumbo deals from the likes of Oracle, Meta, Alphabet and Broadcom, there is growing unease about the “capex treadmill” the AI boom has created. Credit investors don’t have the luxury of waiting years for returns on AI investments to materialise the way equity investors do.

“Many of the growth assumptions feeding into net present value models justifying today’s enormous capex are, at best, educated guesses. Equities are still happy to price in the upside, despite certain names taking a breather, but bondholders are increasingly asking when and how those returns will materialise and what the consequences might be for leverage in the meantime.”

Low supply has helped keep spreads low in 2025, but a glut of issuance could change that. Jonathan says: “AI-related issuance estimates are in the region of $1-3tr over the coming years, a volume of debt that may well prove manageable, but timing is a concern; investors are asking why they should buy today’s deal when another mega-deal is likely just around the corner.”

This creates some risks for corporate bonds, particularly at the higher yielding end of the market. Thomas Hanson, manager on the Aegon High Yield Bond fund, says:

“Prudence is the watch-word in high yield. There is a lot to like in high yield, not least the all-in yield – our fund has a yield of 7.4%, but any good high yield fund manager is going to have some worries.”

He says that the core of high yield is very “well-behaved” and corporate fundamentals are good. However, leverage has been ticking up and interest coverage has been coming down, as companies have had to refinance at lower rates.

Government bonds

However, while the all-in yield remains so high, investors have a significant cushion. This makes what happens to government bond prices important. There is every reason to believe that government bonds yields could continue to fall in 2026 (and prices rise). Interest rates are likely to come down in the UK, US and across a number of major emerging markets.

Ariel Bezalel, manager on the Jupiter Strategic Bond fund says: “Things do seem to be cooling off a bit (in the US), and we are starting to see the labour market cooling down somewhat… There is a softening housing market. The consumer is in an OK place, but there could be more pressure in the coming months. That paves the way for the Federal Reserve to continue cutting rates.”

The question for bond investors is the extent to which this is priced into markets. Ariel believes a lot is already priced into treasury market yields. Patrick Brenner, chief investment officer on the multi-asset team at Schroders (which manages the Schroder Global Multi-Asset Cautious Portfolio), agrees: “We’re less positive on US Treasuries, given ambitious market expectations at the short end and crowded investor positioning at the long end of the curve. This stance helps to diversify our broader pro-risk positioning, alongside equities and gold, both of which remain sensitive to liquidity conditions.”

However, that is not the case for gilt yields, which still look relatively high. “Inflation has been sticky, but as we struggle for any economic growth, inflation is likely to cool down,” says Ariel. He argues that while tariffs make the inflation picture in the US tricky to analyse, inflationary pressures are coming down in Europe and the UK. Key European industries such as chemicals and autos could be hurt by Chinese exports and create a deflationary effect. This should be good for government bonds.

Emerging market debt

After a stellar year, emerging market debt is still favoured by many strategic bond managers. Dickie Hodges, manager of the Nomura Global Dynamic Bond fund, says: “Lower US rates will lead investors to seek yield where they can find it, in turn supporting higher-yielding areas of the credit markets. It should also prove positive for emerging markets, which will benefit from continued downward pressure on the US dollar. It is for these reasons that we continue to have elevated allocations to both high coupon, high yield emerging markets such as South Africa and Mexico, and subordinated European bank debt.”

He also has an allocation to a number of emerging market countries likely to benefit from convergence towards the European Union and the Eurozone. “Chief among these is Romania. Romania is already a member of the EU and is on a medium-term path towards joining the Eurozone.”

Bond markets still appear to offer plenty for investors to get their teeth into – particularly high yields and diversification. There are risks, particularly in the credit markets, and the level of government debt is an ongoing source of fragility, but nothing that a good active manager can’t navigate.