Real Rates, Repriced Credit and the Case for a Short Fed Cycle

Anu: It's an interesting time to be a bond investor, with a new chair at the Fed, central bank policy paths that are diverging globally, and an AI-driven spending boom that's reshaping issuance across credit markets. In fact, we're recording this episode shortly after the Fed's September meeting, where it elected to raise interest rates for the first time since 2023, so there's a lot of fresh news to unpack.

My name is Anu Rajakumar, and today I'm joined by Ashok Bhatia, Chief Investment Officer and Global Head of Fixed Income at Neuberger. Ashok and I will be talking about expectations for bond markets, what's driving real rates, how the AI capital spending boom and hyperscaler issuance are shaping markets, and how his team is positioning duration and credit exposure heading into year-end.

Ashok, welcome back to the show.

Ashok: Hey, Anu. It's great to be back with you

Anu: All right, we're going to talk about the Fed's decision to hike rates in just a moment, but let's step back first. You've argued that this year's bond market move has really been about real yields and not inflation. Tell us why does that matter for investors right now, and how close are we to levels that could start to threaten growth?

Ashok: So I think on the real yield versus inflation debate, real briefly, ‘What is going on with inflation?’ Because I think that's an important way to start to frame this. Inflation this year—and I think this surprises people, but core inflation in the US is actually lower on the year. We started the year with 2.6 per cent core inflation. We sit here today, 2.4 per cent. Headline inflation—so that's including food and energy—that has actually increased on the year, by about 70 basis points, so that measure is running about mid-3 per cent. But core inflation, which is always what the Fed is anchored to, is actually about 20 basis points lower on the year, despite all of the attention that, correctly, inflation's been getting.

So what has the bond market really been all about this year? As you mentioned, it has been about, you know, if we decompose the bond yield into a real yield plus, you know, what you're getting paid for inflation, the 100-odd basis points of rise in some front-end intermediate yields, about 85 per cent of that is real yields. The other 15 per cent is expectations and compensation for inflation. On your question, “Why is this happening?” It's because of two things. It's one, the growth environment remains strong, good, decent—pick your adjective but this is clearly a strong economy.

I think the second thing though is the Fed's reaction function, which is really what we've all been debating in the last six months in the market pricing, and that reaction function is saying that the Fed would like to have higher yields, higher real yields, to potentially slow the economy in the future years.

Are we at a level that this is dangerous? No, not yet. Three to four per cent real yields is kind of the level that history says really starts to either bite into the economy or into the financial markets. That would really be needing a Fed funds rate somewhere north of 5 per cent to get into that type of, what I would call, a little bit of a danger zone.

And, you know, the current policy rate is now, 3 7/8, so just under 4 per cent. The bond market is not priced for us to get to 5 per cent, but that's not an unforeseeable occurrence over the coming weeks. And you know, this rise in real yields—primarily real yields, but real yields and a little bit of inflation expectations this year—it has translated into what I would call small negative returns for fixed income for the year but I don't think it's quite as bad as intuition would say. So, for example, the aggregate, the Bloomberg aggregate that we all watch, is down about 1.5 per cent for the year. And we've got things like the high yield and some of the, call it ‘spicier’ areas of emerging markets, that still have positive returns of, you know, 1 per cent to 3 per cent.

And when we think about this rise in yields, the conclusion on returns is that these are disappointing returns compared to a lot of other asset classes. But these are not really big negative numbers in returns, and that's primarily because fixed income is generating sufficient income to offset some of this rise in yields.

Anu: Makes sense. And that's really a good segue into the inflation outlook that you have. I understand your own view there diverges a little bit from consensus. Why do you expect inflation to move back towards targets sooner than the market does? And why doesn't that guarantee lower real yields?

Ashok: Yeah, It's like the Fed and everything that's going on, I feel like it's peeling a big onion. But, inflation, as we talked about, it is actually, core inflation is actually lower on the year, and we do think it is going to continue to move lower over the next, coming months and, and particularly the fourth quarter of this year.

Why is that? One big component is housing and shelter prices. So, you know, that's about 30-odd per cent of what the US consumer spends money on. And, you know, house prices partly driven by higher mortgage rates, the growth rates there have come down from high single digits to low single digits.

We're also seeing—kind of surprisingly, but—well-behaved prices for a lot of goods markets. That inflation is not really a concern. We are seeing pockets of higher inflation in things like airfares, financial services, but things that tend to be a little bit smaller part of what the consumer spends money on.

But the short answer for why inflation, we think, continues decline over the course of the fourth quarter is, goods prices and particularly housing prices.

Anu: Okay, so inflation on a downward trajectory through the rest of the year. Let's come back to the Fed now and the September FOMC meeting, and Kevin Warsh specifically. Firstly, my question to you is did the Fed's unanimous 12-to-zero decision to hike rates surprise you at all? And then secondarily, what are your longer term takeaways from the meeting?

Ashok: So I am surprised, and I think we chatted earlier in the year, and we thought this was going to be a year where it would be close, but the Fed would get through this year without a hike because of the inflation dynamic that talked about. Was I surprised that we got a unanimous hike at this meeting?

Not after the Jackson Hole speech. Once Warsh gave that speech, and basically, there was no, dovishness in that speech, and then we were followed by a good payrolls number and an in-line inflation number. I think the Fed whether they wanted to or not, they were going to have to hike at today's meeting.

So not surprised that today was unanimous, and not surprised by the outcome. What comes next? Like, is this the start of a big hiking cycle like 2022? Is this one and done, et cetera? And I think there's a level of like, multiple layers I think of what the Fed's implicitly saying.

I think the big thing, one of the things that they seem, even though they're not saying this, is a lot of concern, that the energy price shock is going to bleed into, broader measures of inflation. So, you know, as we talked about at the top, core CPI lower on the year, headline inflation, including oil prices, higher on the year.

That's a divergence the Fed can live with for a period of time, but I think the Fed is, worried that we are going to see that sort of bleed through into, core prices. We here at Neuberger, we don't expect to see that, but I think that's clearly a risk. And then I think the second thing is the Fed is just uncomfortable with a slower pace of returning to target.

We've all heard Warsh say, you know, the Fed's missed its objective for five years. You know, one could flip that around and say, "Well, what's really another 12 months if we're headed that direction as we think?" But, you know, I think he looks at it the other side and says, "Five years is just too long, and I, want it to get there, on a faster pace," and that leads to the hiking.

So where we come out on this is I think this not likely to be a long, extended 100-basis-point hike, that the Fed will start to see that inflation starts, using Warsh's term, to come back with sufficient speed back to that objective, and, this will be a shorter, more abbreviated hiking cycle than the market currently expects.

Anu: So building on that, beyond the Fed, we're seeing central banks around the world moving at different speeds and in some cases in different directions. How are you thinking about that policy divergence globally, and what does it mean for fixed income positioning?

Ashok: Yeah, this one is, you know, I think when I look around, so, you know, the ECB has hiked, two times this year. this one is more mechanically almost rote hiking given the energy prices and, you know, particularly, natural gas prices and how it passes through in their mandate. So the ECB is, if we're in this same zip code of energy prices, the ECB will continue to hike.

Bank of England, you know, just, the week we're speaking, the Bank of England just had a hold, hawkish hold, fully, you know, the market expects them to resume their hiking cycle at the next meeting. And then we've got an upcoming Bank of Japan meeting.

Again, they're expected to hike. So I think one of the big common denominators across all these markets is the energy cycle, and for some, like the ECB, it's a really direct, connection. For somewhere like the US, it is more, a little bit of the Fed being a little bit more cautious on that pass-through and the risks associated, with it.

But I think there's more in common right now than there is divergence, and that linkage is, these very high energy prices.

Anu: It's a good line, more in common than divergences. Let's shift over to credit for a moment. Hyperscaler and AI-related bond issuance has really dominated the investment grade calendar this year. Do you see signs that credit quality or spread risk is shifting with the increasing supply? And from the demand perspective, is this wave of hyperscaler bonds starting to crowd out other issuers?

Ashok: Yeah, so on the hyperscalers, I think when we spoke earlier in the year, we were talking about how we weren't really very excited about this area. We had very low, if any, holdings. And then, sort of in the summer, I think we chatted and, we sort of made the point that we're seeing a lot of value emerging with some of the widening and pressure.

That's where we're still at today. Hyperscalers is an area of the IG credit market. We think you're getting paid for the risk. We think it's on the cheaper side right now, and our holdings in general, we've been adding across portfolios. And, I'd make two points on this.

These issuers are, you know, the hyperscalers—we can define them as the Amazons, the Metas, the Microsofts, the Alphabets; you could put Oracle in that category as well. There's a lot of debt that's being issued, but I think point one is the earnings are showing that they are getting a return on this capital investment.

I think there is a little bit of, you know, the market says, well some of this is just forward earnings or very circular finance. You know, there's some truth to that, but, when you even peel that back, these are profitable investments and the companies are earning a return on this capital.

So I think that's one thing that's helped. And then the second is the core businesses for these companies remain strong. And so although debt levels are going up, there is just not a threat on the credit quality side. companies like Nvidia, Microsoft, these are A to AA type of companies and it's really hard to see that changing.

Anu: As we start to wrap up here, I do want to turn to positioning. Where are you seeing the opportunities in relative value at the moment, and how are you positioning on duration, curve exposure, credit risk across portfolios today, and what are some signals you're most closely watching as we head to year-end?

Ashok: I think into year-end, some of the things that have really worked in the bond market will continue to work. So one of those is the non-investment grade, the high yield market. That includes cash high yield, it includes loans, it includes CLOs. So just a lot of still-strong credit in the double B, double B plus space where one can earn 300 basis point types of spreads for what we think are, for the ratings and for the risk, really attractive types of credit for a lot of portfolios.

If I look at the high yield market in the US, it's up about 2 per cent this year, plus or minus, and I think that's an area that can build on those gains into year-end. Second has been, emerging markets, particularly some of the lower rated riskier parts of emerging markets.

That's one area I think you can still should have some positions too, although we've started to do some reductions in that area, and that really opens up a bit of a source of capital to rotate into some more of these, say, hyperscaler risk at these levels.

So for credit, I think it's going to be a little bit more of the same. Credit spreads remain tight, but can still generate, in this kind of fixed income environment, some decent returns. I do think we will see a lot more interest in floating-rate types of instruments—so that could be asset-backed, CMBS, all kinds of public and private debt that has a floating-rate structure—given the changing risks around the Fed.

So I wouldn't, wouldn't be surprised if that area of the credit markets is supported. And then on interest rates, we've really just been concentrating on the front and intermediate rates. Obviously those rates have backed up and increased. It's kind of surprising to a lot of people, those maturities—at least some of the shortest maturities—they still are generating positive total returns, and that is because of the income levels despite this rise in interest rates.

So I think at these levels, you might be investing in a short-maturity Treasury that has a current yield today of, you know, a little bit under 4 per cent. But when you look at what's really priced into the market, we are pricing a decent hiking cycle. So I think, clients and investors, and we are, we're staying the course on portfolios, taking duration risk in these front and intermediate rates, and effectively saying, the income levels are compensating you for the duration risk and the risk that this turns into a little bit of a broader hiking cycle.

Anu: You know, we've spoken a lot about US fixed income, and you did highlight EMD as well. What about other areas outside of the US when it comes to credit exposures?

Ashok: Yeah, similar to the US, credit spreads in the European region, they also remain towards the low end of ranges. I do think there's opportunity there: positions in banks, financials—from the senior to a little bit more subordinated in the capital structure—we found a lot of interesting things to do there. I think within Europe, you get a little bit more of a mix of exposures to global manufacturing, global conglomerates, and these tend to be higher-quality issuers, but from an investment-grade perspective, interesting things to do there.

It is not a world where there is a big spread divergence between, say, the US or the UK or continental Europe, but it's more I think about some pockets of value in those areas. We've also been finding some things to do in the financial sector for some of the Middle East issuers. In emerging markets, you know, I think one thing that has occurred in EM this year is you've had some pretty strong outperformance from some of the lower-rated, call them more speculative, types of names, countries that have maybe come out of restructuring programs that have done really well.

But it has left still a lot of opportunities in what we'd call core BB, BB+ type of hard currency exposure as well. So that's still an area I think that's attractive for global capital

Anu: now you did mention speculative non-investment grade data center financing as an area that you're a little bit wary of and just being cautious on to some degree. Any other areas that you are really paying attention to, whether that's geopolitical shocks or tail risk or specific areas, that you feel like there may be some risk?

Ashok: So I think a couple quick things I'd say. One is, this area's been under some pressure for a while, but things related to housing and housing products and things really tied into the housing construction cycle, that's an area that I think you still want to be very careful on.

These can tend to be more levered companies and, every day that interest rates rise, and we're already seeing, as we talked about on the inflation front, softness in the housing market, there's some headwinds there for companies. I think the second thing we're spending a lot of time on is, and I think we won't really know until post-election, is whether there is political backlash to AI and data centers and things like that.

Our suspicion is that there's so much capital in motion, it's going to be very hard, in a divided government, it’s highly likely we'll have divided government after November. It's hard to see that changing, but I think that should be a little bit up on the radar screen.

And then lastly is the energy price issue. I think similar to when the war started, this has really been about the front month crude prices really moving higher and diesel prices. The structure of the market is still pretty relaxed that this will end, and 12 months from now energy prices will be substantially lower.

And you know, look, anything that changes that, the energy importing countries, a lot in the emerging markets, I think there's risk kind of brewing. You can see risk brewing there if oil remains high for a lot longer.

Anu: Ashok, thank you for all of those comments. As you well know, as a veteran of this podcast, I can't let you go without one quick bonus question. Fixed income is all about steady, reliable payouts, but I'd like to know what's the most reliable habit or ritual in your personal life that you would never give up?

Ashok: I'm probably the most ritualized around my morning coffee routine. So I make a pot of coffee. I make 10 cups every morning. I take the majority of it. I leave some for my wife, and then my mom, who lives with us, comes over and has a cup of coffee, after I've gone for work. So 10 cups, and it all gets drank, drunk, every morning.

Anu: Consumed.

Ashok: Consumed, yes.

Anu: Coffee's very important to most of our lives, so thank you very much for sharing that. Thank you for all those comments today, Ashok. We covered a lot of topics here. We spoke about performance for fixed income markets so far in 2026, and the inflation outlook across both core and headline inflation.

We discussed the Fed decision to hike, and your view that this is unlikely to be an extended hiking cycle. We talked about the global central banks and how they actually do have a little bit more in common than divergences. And we also touched on hyperscaler- and AI-related bond issuance, where you said that you felt that we are getting paid for taking the risk here, and these are still profitable investments with low threats to credit quality.

You talked a little bit about what you found attractive right now in fixed income markets, highlighting non-investment-grade high yield emerging market debt, which has been quite attractive this year, as well as front and intermediate rates. And you also noted some areas where your team is being a little bit more cautious: speculative non-investment grade data center financing, and interest-rate-sensitive areas like housing and construction. And other broader areas of potential risk: first of all, the political backlash that we may be seeing in AI, particularly as the midterms come along, and finally also in energy prices, where your expectation is a downward trend, but again, there is risk in elevated energy prices.

Thank you so much again for all those thoughts, and I know we'll have you back on the show soon. So thank you once again, Ashok.

Ashok: Thanks, Anu.

Anu: And to our listeners, if you've enjoyed what you've heard today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts, or you can visit our website at nb.com/disruptiveforces, where you can find previous episodes as well as more information about our firm and offerings.