The investment outlook this year remains shrouded by uncertainty, accompanied by elevated volatility in expected returns. Markets are searching for direction, and investors are navigating an environment where conviction feels harder earned.

Volatility, of course, wears many faces. We can observe it in the lived experience of asset price return variability across securities, sectors and markets. Or we may deduce the anticipated range of returns over the next week, month or quarter from options prices. Either way, the direction, size and interdependencies (correlations) of movements in market pricing at all frequencies can provide important signals for astute investors. Volatility is not simply noise, it is information.

Right now, equity prices, cryptocurrencies, and precious metals are relatively more volatile. Yet in contrast, most bond markets remain curiously subdued. Yields remain broadly rangebound, only tentatively challenging the edges of recent ranges, reticent to enter an elusive new regime or steady state. That restraint in bond markets is notable, and perhaps more revealing than the visible turbulence elsewhere.

After hiking rates earlier this month, RBA Governor Michelle Bullock stopped short of offering explicit forward guidance, indicating that the Monetary Policy Board is heavily data dependent. This suggests further policy restriction may have limited efficacy in controlling persistently above-band inflation back to the target range. Australian government bond yields decreased markedly in response, and the market is paring back pricing for hikes and beginning to tentatively pre-empt future rate cuts next year. The tone has shifted, from further restriction to a growing debate about how long policy will need to remain restrictive at all.

More broadly, attention is turning to the Government for direction ahead of the upcoming Federal Budget. There is growing recognition that boosting labour productivity through innovation, enhanced competition and meaningful structural and tax reform remains the only sustainable path to higher national income and improved living standards for all Australians.

Meanwhile, across the Pacific in the U.S., economic activity continues to show surprising resilience. January brought unexpectedly strong employment growth, thanks in part to seasonal factors (despite large historical downward revisions). Price pressures, meanwhile appear to be cooling, although the data remains messy and influenced by lingering U.S. federal government shutdown-related disruptions. The result? Short-dated Treasury yields have drifted to multi-year lows, reflecting cautious optimism among investors.

The market has almost priced for three U.S. Federal Reserve rate cuts this year under U.S. Federal Reserve Chair nominee Kevin Warsh, although the upcoming midterm elections loom large over the U.S. macro outlook and the Trump administration's near-term policy priorities.

In Europe, inflation appears to be well controlled and the European Central Bank comfortably on hold, but recent geopolitical events have raised existential questions around the protection and advancement of national and regional interests, and defence and security strategy. While this may be the quintessential European moment to rebalance the world order away from U.S. dominance if traditional allegiances like NATO are set to be dissolved, there have been fundamental disagreements between Germany and France around policy priorities to restore competitiveness and how to fund quickly growing defence expenditures. Yields on German government bonds have also dropped materially in recent weeks.

In Japan, the Liberal Democratic Party lead by Sanae Takaichi has emerged victorious from lower house elections. Takaichi's expanded mandate and firm command over political and economic power (for instance, Japan's central bank is not independent of government) after her historic win, combined with a sense of renewed optimism across global markets that the realisation of her vision for Japan will not unduly impact interest rates and exchange rates beyond what is already envisaged, has led to a relief rally in Japanese Government Bonds after a tumultuous January.

What signal can we draw from the subdued historical measures of volatility across bond yields, especially when viewed against the domestic and global macro backdrop? There are three key takeaways.

First, periods of volatility and uncertainty (whether obvious or hidden) can bring significant opportunity to generate attractive returns for those who act thoughtfully. Second, fortune rewards the diligent and there are only downside risks to complacency. And third, and most importantly, diversification, both within and across asset classes and sectors is the primary means with which to dampen the effects of volatility and protect long-term investment outcomes.

Volatility may rattle markets, but it also sharpens our focus, driving better portfolio construction and smarter asset allocation decisions.

In 2025, with credit spreads normalising, and in some segments moving below long-term averages, a number of yield hungry credit investors responded by adding risk to meet investment objectives. These additional risks to sustain portfolio yields of 6%+ varied from increasing credit risk, interest/spread duration and/or leverage.

While mostly still at manageable levels, increased debt funding of credit securities is nonetheless a throwback to the heady pre-GFC era where synthetic and physical leverage was more commonplace. Indeed, we are now also hearing of less sustainable practices once again creeping into the credit investment lexicon.

From our discussions in the marketplace towards the tail-end of 2025, the use of leverage is principally occurring through the use of repurchase agreements (repo) of eligible collateral up to an eye watering 15-times for AAA rated securities, as well as via placement of senior secured leverage to enhance portfolio yields in both private and public credit portfolios.

New levered investment products that have recently entered the market offer a floating rate running yield from a portfolio likely comprised of major bank T2 hybrids (T2s) and investment grade (IG) corporate bonds. Products such as these typically seek to enhance yield by deploying 3-3.5-times leverage.

Leverage enhances yields and amplifies performance (both positively and negatively) from changes in spreads and any impairments/defaults. Working off current pricing, an IG portfolio yielding ~5.0-5.5% p.a. with ~3-times leverage moves what is an already enhanced yield into a yield in the 7%+ range (refer Chart 1).

Chart 1: YCM estimate: Levered IG portfolio yields

Source: Yarra Capital Management Feb 2026.

The use of leverage to enhance returns can work very effectively in environments of stable or contracting credit spreads. It is a double-edged sword, however, with the combination of widening credit spreads and leverage usually resulting in significant drawdowns.

For instance, working off an estimated credit spread duration of ~5 years, a widening spread environment would quickly overwhelm underlying yields, with a ~100bp spread expansion on 3-times leverage generating a negative total return in the range of 10-15% from what is an underlying low risk IG credit portfolio (refer Chart 2).

Chart 2: YCM estimate: Levered total returns and widening credit spreads

Source: Yarra Capital Management Feb 2026.

Given fixed income investors generally have a low tolerance for negative returns over a 12-month period, the use of significant leverage to enhance returns could be somewhat of a dubious exercise, especially when you consider today's starting point. As evidenced by major bank T2s, credit spreads have performed over the last 2-3 years and now sit around their long term averages across most segments of Australian credit and significantly below the previous peak in 2022 (refer Chart 3).

Chart 3: Major Bank Tier 2 5-year FRNs (credit spreads and yields)

Source: Yarra Capital Management Feb 2026.

At current spread levels, the probability of a +/-100bp move is weighted to the positive and in the current macroeconomic environment is entirely possible over the near to medium term. In such an event, which can occur two to three times each decade, the prospect of equity like drawdowns from levered credit funds should give credit investors pause for thought.

Put more simply, credit investors in these levered structures should be thinking hard about whether they are comfortable taking what is effectively equity drawdown risk for a miserly 1-2% in additional yield. We would suggest that this represents incredibly poor compensation for the risk assumed at this point in the cycle.

In contrast to levered credit funds, both the Yarra Enhanced and Higher Income Funds are still providing attractive 6-7% yields with precisely zero leverage. Moreover, while it is true that a 100bps widening in credit spreads would lead to value diminution for both these funds, high unlevered yields combined with active management should protect against negative returns over any 12-month period. We do not believe the same can be said of levered credit funds running a similar mix of underlying credit assets.

In the five years since the Glasgow-based COP26, sustainable investment initially surged. Expectations were high, pledges were ambitious, and many believed capital markets could play a decisive role in addressing climate change and broader environmental and social challenges. But more recently, geopolitical shocks, legal scrutiny and market realities have tempered that optimism. 

In its place, a more durable approach is emerging, which we describe as grounded sustainability. It's a framework for incorporating sustainability factors into investment decisions, where those factors are financially material and aligned with client mandates. It's evidence-led and recognises inherent trade-offs. Importantly, it's clear about the limits of what investors and companies can achieve within the constraints of public policy. 

Mandates and market realities 

Over the past five years, conflicts, the global energy crisis, and the resurgence of populist politics have created a more fragmented, unpredictable and idiosyncratic environment. For example, coal use rose during the energy crisis, even as renewable deployment consistently exceeded expectations. This highlights the growing regional and thematic divergence. With this complex backdrop, sustainable investment must balance long-term systemic goals with the constraints imposed by mandates, markets and regulation. Ambition alone isn't enough. It must be combined with pragmatism. Importantly, it must also align with clients' financial objectives and constraints, otherwise commitments risk becoming empty promises - or worse, reputational liabilities.

A similar dynamic is playing out in collaborative industry groups like the Net Zero Asset Managers (NZAM) initiative. Initially, in the post-COP26 momentum, there was strong pressure to sign up to firm-wide climate targets. But as geopolitical and market realities set in, many asset managers found themselves unable to deliver on those commitments across all mandates. This wasn't a failure of ambition, but a mismatch between system-level objectives and mandate-level authority. The practical lesson is that real-world outcomes must align with the client promise. To be clear, where clients want outcome-led objectives, this should be reflected in mandates.

Climate law gets real: from global duties to corporate liability

Legal frameworks are catching up with climate ambition. The International Court of Justice's (ICJ) recent advisory opinion [1] clarifies that states have a legal duty to prevent environmental harm, including to the climate system. It also clarifies that a lack of regulation doesn't absolve other actors - whether companies, asset managers or investors - from managing foreseeable risks. This shifts climate accountability from voluntary action to legal risk.

However, it also raises a hard question: what happens when governments fail to act, or act too slowly? Can companies and investors be expected to fill the gap? In theory, both public and private actors share responsibility. But in practice, companies and investors operate within legal and commercial boundaries. In particular, asset managers' decisions are shaped by what clients ask for, legal responsibilities to act in clients' best interests, and market competition. Expecting companies or investors to sacrifice value by absorbing costs not required by law is difficult to justify - particularly in hard-to-abate sectors like steel or aviation. This challenge is heightened where government incentives can often support conflicting goals across energy security, affordability, and economic growth.

Policy as a catalyst 

This is where effective policy matters. Recent European initiatives to align climate objectives with industrial competitiveness and energy security reflect growing recognition that markets alone cannot deliver the transition at scale. Together, they signal a shift from fragmented initiatives to coordinated, state-backed action, while offering companies and investors the long-term policy clarity that has been missing. This is why we are calling for greater long-term policy certainty, which retains strategic intent while limiting unnecessary complexity.

This is the essence of grounded sustainability: integrating environmental and social factors when they are material to value, and doing so with clarity, discipline, and alignment to mandates.

What does this mean for investors?

Sustainability concerns need not be sidelined in financially focused mandates. Forward-looking considerations of material environmental and social risks are fully consistent with long-term value creation. What cannot be justified is pursuing sustainability outcomes that are disconnected from financial objectives, unless explicitly agreed with clients. This is the essence of grounded sustainability: integrating environmental and social factors when they are material to value, and doing so with clarity, discipline, and alignment to mandates.  Policy is the missing link. Without it, companies struggle to act without breaching fiduciary duties or losing market share. With it, sustainability themes become investable, scalable, and defensible.

Looking forward 

We expect that the rise of climate risks - coupled with increasing energy and mineral demands to facilitate technology advances and the energy transition - will mean that sustainability themes will remain at the heart of many geopolitical tensions. This will apply whether they are presented as energy transition, resilience or strategic government objectives (such as economic competitiveness or national security). Overall, we expect the policy landscape to remain uneven, with less support than previously. But where outcomes align with strategic government objectives, policy support will surely follow.

Final thoughts...

A recalibration is needed to find an equilibrium, where sustainability is seen as a fundamental tool for making better investment decisions, rather than being wrapped up in unrealistic expectations. The sector needs to evolve from idealism to pragmatism, grounded in legal clarity, mandate alignment and financial materiality. Despite the potentially gloomy outlook, we've seen record investment in the energy transition - twice as much as in fossil fuels. So it's not about abandoning sustainability themes. Rather, it's about doing it deliberately and within real-world constraints. 

February Edition

In this instance, the direction change is Australia's late 2025 bond selloff, culminating in a 25bp hike from the RBA this week and with the prospect of more hikes through 2026. Looking forward, current market pricing for 2026 shows a widening gap between the RBA cash rate and the FED funds rate, with the pricing of rate hikes in Australia in stark contrast to the US where easing appears virtually certain (refer Chart 1).

Chart 1: Cash Rate Futures - US and Australia (%)

Source: Bloomberg, Yarra Capital Management Feb 2026.

While the year ahead can pan out differently since actual movements in interest rates in some instances can bear little resemblance to the futures market at any point in time, pricing is always eventually reflected in security valuations across Australian credit and thus impacts investment decisions.

For us, higher bond yields in the closing months of 2025 enabled a rebuild of strategic duration at ~1.7 years across both our Enhanced Income and Higher Income strategies. While market timing is never perfect, this duration positioning - where we have a skew to the front end - should help limit any drawdowns from risk offs in 2026. This period reminds us of April 2025, where both strategies generated positive performance despite credit spreads moving materially wider. We believe a similar scenario can play out in 2026 (refer Chart 2).

Chart 2: Australian 3-year Interest Rates and ANZ 2033/38 T2 Credit Spreads

Source: Bloomberg, Yarra Capital Management Feb 2026.

Another key theme through 2025 was the 6%+ "mania" which appears to be back with gusto. A pool of investors attracted to higher outright yields, especially longer dated major bank T2s, appear to be forgoing adequate credit spread compensation and happily accepting higher spread and interest rate duration risk to achieve their 6%+ yield objectives.

Our analysis of the ANZ T2 credit curve illustrates the poor credit spread compensation that is currently on offer for the longer dated 2035 (call) and 2045 (bullet) maturities (refer Chart 3).

Chart 3: ANZ T2 $A Securities Credit Spreads and Government Bond 10-year Yields

Source: Yarra Capital Management Feb 2026.

Unsurprisingly, the significant contraction in the credit spreads on longer dated T2s is closely correlated with the rise in government bond yields and ANZ's T2 credit curve, as with the other major banks, is unattractively flat. We have taken this opportunity to rotate out of these longer-dated T2s given the inadequate spread compensation, preferring instead to be invested in shorter dated T2s such as the 2030s which are paying comparable credit spreads but with much less risk.

While we are rotating out of longer-dated T2s, we remain comfortable investing in longer dated securities provided the credit spread compensation is commensurate to the risk assumed. In early February, we invested in the 5 and 10-year BBB rated Aroundtown bonds. While these securities are more off Broadway than the major bank T2s, the 10-year securities priced at an attractive 200bps credit spread and a yield of 6.72%. This deal provided ~70bps additional compensation for two notches lower credit quality (i.e. approximately double the normal compensation over A- rated major bank T2s).

Global equity markets kicked off the new year in volatile fashion, driven by geopolitical concerns over Greenland, Venezuela and Iran. This provided a boost to Resources, which drove the ASX All Ordinaries Accumulation Index up +1.6% for the month. This represented a slight outperformance vs the S&P 500, which rose +1.4%. However, the NASDAQ underperformed most global benchmarks (+0.9%), as fears over disruption caused by Artificial Intelligence (AI) weighed upon the Tech sector. Outside of the US, the FTSE 100 and Euro Stoxx 50 continued their strong run, rising +2.9% and +2.7%, respectively.

The ASX experienced a particularly volatile month, which was more pronounced in the small-cap segment of the market. Energy and Gold were the strongest performing sectors, whilst Technology was the weakest performer, impacted by concerns about AI disruption. During the month, the ASX Small Ordinaries Accumulation Index rose +6.0% at its peak, before falling over -3% in the final week of the month, to finish +2.7% higher. In addition to the factors noted above, we believe the small-cap segment was disproportionately impacted by two events, being (1) stronger-than-expected Australian inflation data, which supported the RBA's subsequent February 2026 rate increase, and (2) a sharp reversal in commodity prices following the appointment of Kevin Warsh as the new Governor of the US Federal Reserve. Regarding monetary policy in Australia, the market expects 1- 2 more RBA rate hikes over the next 12 months.

In bond markets, the US 10-year bond yield rose +7 basis points (bp) to 4.24%, whilst its Australian counterpart rose +7bp to 4.81%. The Australian dollar had a strong month, rising +4.4% to US$0.70, implying an increase of 2.9 cents.