Key takeaways
• Markets are increasingly taking their cues from governments, with fiscal spending and policies becoming key drivers of growth and inflation.
• The US Federal Reserve may take a measured approach to lowering interest rates, with elevated rates potentially translating into opportunities.
• Risk premiums have tightened and bond investors may benefit from moving up in quality.
• Demand for bonds could remain strong, with high starting yields offering attractive return potential and increased protection against equity market volatility.
As we navigate a new era of fiscal dominance, the bond market is poised for a very different 2025 compared to years past.
For a long time, fixed income investors have viewed central banks as a primary driver of markets — whether it was the ultra-low rates of the 2010s aimed at boosting economic growth and combating persistently low inflation, crisis interventions to stabilise markets and the economy during the Covid-19 pandemic, or subsequent moves to raise interest rates in response to soaring inflation. Overall, central bank actions and their forward-looking guidance have been front and centre as a leading indicator for economic growth, inflation and ultimately markets.
I believe 2025 will be different. Instead of being a principal driver of markets, I see the US Federal Reserve (Fed) taking a back seat and responding to events after they occur. Investors will likely hear the Fed maintain a refrain of ‘data dependence’ and ‘economic uncertainty’ and a ‘meeting-by-meeting’ approach. With US economic growth expected to remain above 2% and inflation back within range of the Fed’s 2% target, the Bank can afford to take a more patient approach.
As the Fed’s stance becomes less influential, markets will instead be taking their cues from the other dominant macro force: governments. Fiscal spending and policies — on everything from trade and immigration to taxes and regulation — are all highly important to the future path of growth and inflation. With US policies in flux, I believe market volatility will remain elevated, leading to both higher risk and greater opportunity for investors and active managers that can successfully navigate this period of fiscal dominance.
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Against this backdrop, here are five themes that I anticipate will drive bond portfolios in 2025:
1. The macro backdrop may be favourable, with healthy growth and contained inflation
As President Donald Trump takes office and starts to enact policy changes, I anticipate that US growth may be stronger than previously expected. I see the economy benefiting from a more business-friendly climate defined by potential deregulation and tax cuts. I also anticipate that inflation may be stickier than previously estimated, with tariffs and immigration policies potentially affecting the pace of price increases.
Still, I am not overly concerned about a sustained spike in inflation. I see a variety of factors that may help offset the impact of potentially inflationary fiscal policies, including a decline in shelter inflation being gradually reflected in the consumer price index (CPI), the deflationary effect of a strong US dollar, and the prior Trump administration’s track record of enacting tariffs without igniting inflation.
2. Elevated interest rates and rate volatility may offer opportunities
With US economic growth at or above 2%, inflation stubbornly above target, and financial asset prices at or near record levels, I believe it will be hard for the Fed to argue that monetary policy is currently restrictive. I expect the Fed will take a measured approach to further reducing interest rates in 2025, with perhaps only one to two 25-basis-point cuts, as it takes its time to assess the impact of fiscal policy on the outlook for growth and inflation. In this environment, I anticipate the 10-year Treasury yield will remain range-bound, potentially trading between 4% and 5%. It is also my view that rate volatility, which has been elevated over the past few years, will remain so in the near term.
In this environment, yield curve and duration positioning may present opportunities to play both offense and defence. Risks to taking duration exposure appear better balanced and could be appealing over the medium term, while swings in interest rates higher and lower may offer opportunities to lean against potential market overreactions.
While yield curves have finally begun normalising from their deeply inverted levels of 2024, I believe this process still has room to run. Yield curves remain relatively flat against the backdrop of a more normalised growth and inflation environment. Moreover, there is the potential for additional steepening if the new administration’s policies prove more inflationary than expected or if government deficits and Treasury supply remain high. Positioning for a steeper yield curve may also have the benefit of providing a measure of downside protection to core bond portfolios in case economic growth expectations fall or an unexpected shock surprises the market.
3. Higher-quality bonds offer better value
Spread compression has been sweeping in its depth and breadth. The differential between higher and lower-quality opportunities has narrowed, with compensation for risk falling to historically low levels. This dynamic has played out across markets, from structured products to investment-grade (BBB/Baa and above) corporates to high yield, as well as within each market, such as between higher and lower rated corporate credit.
Paltry incremental spreads are not adequately compensating bond investors for increased risk. Spreads on the Bloomberg US Corporate Investment Grade Index fell to record lows in late 2024 and reached 80bps as at 31 December 2024. These tight spreads suggest an unfavourable asymmetry, as a relatively small shock has the potential to wipe out incremental returns. For example, a widening of just 10 to 12bps in investment grade spreads could potentially generate enough of a price drop, based on the index’s average duration of about seven years, to wipe out a year’s worth of excess carry on those holdings.
Given a positive economic backdrop, some investors may be tempted to reach for yield and take on more risk. But leaning into lower-quality debt at current valuations may eat up investors’ risk budgets by adding risk while potentially adding little to no incremental return.
In my view, this compression in valuations is creating a rare opportunity for bond investors to move up in quality without sacrificing yield, and potentially even providing an increase in yield. Shifting to higher-quality bonds can mean moving up the ratings spectrum, such as from BBB-rated to A-rated corporate bonds, or upgrading quality across other dimensions.
For example, high-quality securitised bonds, as the name conveys, are secured in nature compared to the unsecured profile of a typical corporate bond. Parts of the structured credit and agency mortgage-backed security (MBS) market reflect AAA-rated bonds with minimal credit risk and strong liquidity. They have nominal yields and spreads that rival or exceed those of many lower-rated corporate bonds, offering attractive return potential for investors while they wait for a more compelling entry point in corporate credit.
Higher-quality investment-grade bonds may deliver results similar to their lowerquality peers while providing much greater downside protection potential. Drawing on my observations from market cycles across my career, I fully expect dispersion across credit quality to increase again in the coming years and reward a more defensive posture.
Instead of playing offense, I will increasingly use security selection to play defence in portfolios. High-quality issuers in industries ranging from pharmaceuticals to utilities and top-tier financials can be attractive in a risk-off environment given their more defensive profile. And security selection within both securitised credit and the large variety of agency MBS coupons offer compelling opportunities with very attractive yields and minimal credit risk.
4. Correlations are likely to revert to historical norms
The Fed’s aggressive rate-hiking campaign, aimed at taming inflation, upended the traditional relationship between stocks and bonds. When US CPI peaked at 9.1% in 2022, it was the first year in decades that bonds fell alongside stocks. High inflation forced the central bank into a policy of sacrificing future growth to fight inflation. In this environment, rather than using rate cuts to offset weaker capitalgroup.com 6 growth, the Fed actively pursued slower growth by hiking interest rates. This led to negative results for both asset classes.
Inflation has since dropped significantly, with US CPI reaching 2.7% in November. With inflation much closer to the Fed’s target, the Bank is no longer trying to engineer slower growth and is instead looking to maintain the current level of growth with stable inflation. This pivot is incredibly important to bond investors because it is the key factor that may allow the stock/bond correlation to revert to historical norms. In response to the next growth shock that negatively impacts equity valuations, the Fed now has the ability to cut interest rates to bolster economic growth, leading yields to fall and bond prices to rise. Highquality bonds may once again provide diversification to equities and other risk assets in potentially adverse market environments.
Importantly, the potential diversification benefit for bond investors is higher than it has been in decades. Given the current high level of the federal funds rate, the Fed can meaningfully cut rates if needed to support growth, potentially pushing bond returns into double-digit territory in the event of a negative economic surprise.
Multi-asset portfolios that incorporate high-quality bonds may achieve superior risk-adjusted returns, with the trade-off that bonds should enhance returns if the equity market wobbles and dampen returns if equities continue to reach new highs.
5. Technical factors may be supportive of fixed income
Following a strong year for inflows to bond funds in 2024, I believe structural allocations to fixed income will continue to grow. With yields on the Bloomberg US Aggregate Index of about 5%, investors can capture significantly more income potential versus the index’s 10-year average of about 2.9%. Higher starting yields have historically meant higher forward returns. And bond investors could also receive the potential for double-digit returns if growth expectations falter. This combination of higher return potential with compelling downside protection potential could lead to higher fixed income allocations in 2025.
In addition, with equity and many other asset classes at or near record-high valuations, investors may increasingly seek to preserve their significant gains and compound them through elevated bond yields. Even rebalancing back to investors’ neutral equity/bond allocation — as portfolios are likely skewed toward stocks given the strength of recent equity market gains — would likely lead to significant fixed income demand, further supporting demand for the asset class.
The bottom line for bond investors
With healthy US economic growth, high starting yields and inflation more in check, bonds are poised to deliver positive returns in 2025.
The current landscape offers a chance to construct a high-quality, high-yielding portfolio that may provide attractive return potential and a measure of downside protection across various scenarios. If 10-year Treasury yields remain rangebound at 4% to 5%, carry will be an important component of total return and price appreciation less so. However, the Fed now has ample room to cut rates in the case of a negative economic shock, leading to a very attractive risk/reward profile for high-quality fixed income. Amid an era of fiscal dominance, I see greater opportunities in store for investors and active managers who can successfully navigate this new landscape. Demand for fixed income is expected to remain very strong in 2025, with bonds once again poised to diversify portfolios while generating meaningful total returns.
