Bonds well positioned to play a stronger role in investor portfolios

The Reserve Bank has cut rates three times this year and, while the recent inflation data was firmer than expected, we think it is premature to think the RBA easing cycle is done.

Growth is expected to remain subdued, as the economy navigates a bumpy transition from public-led to private-led expansion – the latter typically generating fewer jobs. Recent softness in the labour market is therefore likely to continue into 2026, requiring additional policy support from the RBA.

In this environment, 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. They provide attractive yields, potential capital gains, and diversification benefits that are increasingly hard to ignore.

A global easing cycle is under way

Australia is not alone in its pivot towards lower interest rates. Central banks across developed markets – including the US Federal Reserve, the Bank of England and the Reserve Bank of New Zealand – are easing policy in response to slowing growth and inflation returning to target. This synchronised global easing cycle is reshaping the opportunity set for income-seeking investors.

Traditional reliance on savings accounts and term deposits for income and diversification is becoming less compelling. With cash rates falling, real returns on cash are likely to remain low. Bonds, by contrast, offer a way to lock in higher yields today and benefit from capital appreciation as rates decline further.

High starting yields and steep yield curves

Starting yields are one of the strongest predictors of future bond returns. Today, yields remain elevated across many parts of the global bond market, providing a solid foundation for returns over the next three to five years. This is especially true for core strategies that combine high-quality government and corporate bonds with active management.

The shape of the yield curve adds another layer of opportunity. While short-term rates have been falling, long-term rates have risen, resulting in a steepening of global curves. This creates potential for capital gains through roll-down strategies – where bonds appreciate as they move closer to maturity. The five to seven-year part of the curve is particularly attractive, offering a favourable balance between yield and duration risk.

Volatility as an opportunity

Market volatility is often seen as a risk, but in fixed income it can be a source of opportunity – especially for active managers. Global trade uncertainty and fiscal policy divergences are allowing skilled managers to generate returns above the benchmark.

Australia’s relatively low government debt and stronger fiscal dynamics – especially compared to other developed markets – combined with sustained global demand for Australian dollar-denominated bonds, present a compelling case for owning Australian duration. These kinds of macro divergences, whether in fiscal positioning or policy outlooks, create fertile ground for rotating across geographies and sectors to capture relative value. In this environment, where dispersion is high and uncertainty persists, active management is not just advantageous – it’s essential.

Diversification benefits are back

One concern that has lingered in recent years is the potential for positive correlations between equities and bonds – particularly during periods of high inflation. But with inflation now close to central bank targets, correlations have dropped. This is good news for portfolio construction.

Correlations don’t need to be negative to be effective – just low. And right now, they are. With long-term inflation expectations well anchored, we expect that to persist. This means bonds can once again serve as a reliable diversifier, helping to smooth portfolio returns and reduce overall risk.

The global bond market, valued at nearly $US150 trillion ($230 trillion), offers a vast array of options for diversification. From developed market government bonds to emerging market debt, from short-duration strategies to longer-term core allocations, investors have more tools than ever to build resilient portfolios.

Preparing for what’s next

The message for investors is clear: prepare portfolios for lower cash rates. With the growth outlook sluggish, unemployment edging higher and inflation close to central bank targets, the case for tight monetary policy is behind us. As central banks continue to cut rates, the case for bonds becomes even stronger – supported by what is arguably the most attractive set-up for fixed income in more than a decade.

Whether through short-term active fixed-income funds or longer-duration core strategies, the current environment offers a wealth of opportunities. The positive returns we’ve seen from bonds over the past couple of years are not a one-off – they reflect compelling valuations and a favourable environment for active managers.

For Australian investors, this is a moment to rethink fixed income. Bonds are no longer just the ballast in a portfolio – they’re a source of income, capital gains and diversification. In a world of falling rates and rising uncertainty, they can play a larger, more strategic role in portfolios heading into 2026. And with the growth in exchange-listed active bond ETFs, the asset class has never been more accessible to individual investors.

This article first appeared in The Australian as Bonds well-positioned to play a stronger role in investor portfolios

Adam Bowe is head of Australia portfolio management at PIMCO.