Fixed income in 2026: deficits, AI and the case for global diversification

The fixed income outlook is no longer just about rates. Instead, it sits at the intersection of AI disruption, fiscal expansion and geopolitical strain. As Sonal Desai, CIO of Franklin Templeton Fixed Income, puts it, we begin the year amid “a remarkable confluence of shifting factors.” For advisers, that means bond strategy cannot be passive or parochial.

AI, debt and market tensions

Artificial intelligence has dominated equity headlines. However, it is now shaping credit markets,, too.

“More recently, however, the sheer size of debt issuance underpinning this AI investment wave is becoming an important concern for markets,” Desai notes.

That matters for fixed income. Heavy issuance can pressure spreads and distort sector valuations. Meanwhile, uncertainty remains high. Adoption will be uneven. Some industries will win. Others will struggle.

Importantly, markets may over-react in the short term. Therefore, advisers should be cautious about chasing themes in corporate credit. Instead, focus on balance sheets, pricing power and funding resilience.

“Understanding how they will play out and interact becomes crucial to asset allocation,” says Desai.

Emerging markets step forward

At the same time, structural change is unfolding across fixed income in emerging markets.

Over the past decade, and especially post-COVID, many EM economies have run prudent fiscal and monetary policy. In contrast, several advanced economies have stretched their balance sheets. As a result, EM sovereign debt has shown resilience.

Desai sees “scope for some further spread tightening” in EM sovereigns. Fiscal discipline remains broadly intact, and reform momentum continues. However, she expects EM corporate debt to trade in a range.

For advisers, this suggests selective opportunity. Sovereign exposure may offer relative value, while corporate exposure may require tighter credit work and shorter duration positioning.

The US: strong growth, fiscal strain

Turning to the United States, Desai remains more constructive than consensus.

She notes that households are resilient, AI investment continues and productivity has improved; while fiscal stimulus may support near-term growth. Consequently, recession fears look premature.

However, the longer-term picture is more complex. The fiscal deficit is projected to hover around 6 per cent of GDP for years. Debt held by the public is nearing 100 per cent of GDP. That is the Achilles’ heel.

Persistent deficits can lift funding costs. They can also undermine confidence. Therefore, advisers should not assume US Treasuries are risk-free in real terms. Duration management across a fixed income portfolio remains critical.

Diversification beyond the dollar

The US dollar also faces structural questions. Political polarisation and a more assertive foreign policy have encouraged some countries to diversify reserves. There are limits to de-dollarisation; yet marginal shifts matter for bond flows.

Desai believes the macro backdrop favours “some diversification outside the US in sovereign, corporate and currency exposure.” Emerging markets stand out. Even so, she cautions against taking that case too far: the depth and liquidity of US markets remain unmatched.

For advisers, the message is balance. Maintain core US exposure, but broaden allocations thoughtfully across regions and currencies.

Inflation and the end of easy policy

Finally, inflation remains stubborn. Growth is solid. The labour market is stabilising. As a result, Desai suggests the Federal Reserve’s easing cycle has already ended.

That shifts the tone for fixed income. Rate cuts may not ride to the rescue. Carry and credit selection will matter more than duration beta. Furthermore, volatility could stay elevated.

In this environment, advisers should prioritise flexibility. Blend sovereign and credit exposure and manage duration actively. Above all, recognise that fixed income in 2026 is not defensive by default, it is strategic by necessity.