Outlook 2025
In the aftermath of the US election, our bumper “Outlook 2025” analyses what might drive financial markets next year.
Bonds
15 November 2024
Michel Vernier, CFA, London UK, Head of Fixed Income Strategy
Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.
All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.
Bond markets have delivered solid returns in 2024, following a strong performance in 2023 (see chart). More importantly, this year saw important developments. First, with inflation back close to central banks’ 2% target in most developed countries, a global interest rate cutting cycle has begun. Second, with short-end yields declining, the yield curve has ‘uninverted’, leaving longer-dated bonds yielding more than their short-term counterparts.
The performance of various bond markets so far in 2024, compared with last year
Historically, yields have reached their peak either before, or as, policy rates peak. As such, global bond yields should have passed their cycle highs. However, we would expect some divergence to emerge as we move into 2025.
Although, inflation in both the UK and the eurozone has returned to the 2% target, the outlook for growth in both areas seems fragile, potentially increasing the downward pressure on yields.
On the other hand, the US economy continues to power ahead and the risk of recession appears remote at this stage. This combined with additional inflationary pressures stemming from fiscal policies, could lead to further upward pressure on US yields and challenge the market’s expectation that the terminal rate will be almost 4.0%. But for now, and until clarity emerges around the next president’s policies, US yields are likely to tread water.
The yield in various bond markets relative to last year’s peak and to the 20-year average
As we’ve highlighted in our macroeconomic outlook, one key question for 2025 will be around US debt sustainability. With US government debt supply surging at a time when traditional large buyers, such as the US Federal Reserve (Fed) and other central banks, have reduced their exposure, the term premium is bound to move higher.
The premium investors demand to hold longer-dated bonds has already started to increase, and it may continue to do so for two main reasons. First because, mechanically, as the market prices in more cuts for shorter-dated debt (the short end), the yield curve tends to ‘bull-steepen’. Second, as seen recently, when fixed income markets come under pressure due to shifts in supply and demand, yields tend to rise faster at the long end, compared to the short end (a so-called bear-steepening).
The bearish steepening could trigger additional volatility, as seen in 2016 or 2013, but usually does not persist for long. In this context, a neutral duration positioning seems warranted for the time being, with duration increased selectively and gradually during phases of volatility.
The last two years have been supportive for credit. This shouldn’t come as a surprise as, historically, this segment prospered during phases of economic growth and inflation moderation (see The right temperature for corporate credit?).
But credit spreads are now as tight as they’ve ever been in the last 26 years, leaving little room for further compression.
Given the richer pricing, the window for locking in yields seems to be closing quickly and a different approach may be needed.
In 2025, three investment themes stand out: diversification, carry and relative value. In terms of segments of the fixed income market that appear attractive, we would highlight the securitised credit market. This segment provides additional security through higher-quality collateral, is less exposed showing reduced exposure to rate shocks, and still provides a relatively high carry yield. The same is true of structured credit. An example would be higher-quality, AAA-rated, collateralised loan obligations (CLOs).
When it comes to corporate credit, we see select relative value opportunities within short-dated BB-rated bonds.
While the yield differential between BBB- and BB-rated indices narrowed in 2024, when adjusted for duration, the carry opportunity is clear (see chart). In fact, the latter bonds can now withstand a yield increase of 1.9% within one year (compared to 0.7% for BBB-rated debt) before they start losing money; a comfortable cushion and a carry opportunity.
That said, BBB-rated bonds can still offer value, especially as the yield curve gradually steepens. Currently, the roll-yield starts getting attractive three years out.
Comparison of the yield per unit of duration for BB-rated bonds and their BBB-rated peers since 2005
The market for ‘hard-currency’ (that is, bonds priced in US dollars) emerging market debt (EMD) has increased to $17 trillion, from $12.8 trillion in 2013, and is a segment that shouldn’t be overlooked. Admittedly, the average EMD spread is relatively low, by historical standards, when compared with US investment grade bonds.
Yet, with an average monthly correlation of 0.6 over the last 10 years against USD corporate bonds, hard-currency EMD can aid portfolio diversification. Not only that, but the wide dispersion between countries’ dynamics (see chart) further bolster diversification and allow for substantial relative-value and carry opportunities.
EMD spreads by country and in comparison with US corporate bonds
The attractiveness of EMD might become even more obvious if bond yields in developed markets continue to moderate in 2025. In fact, in the last few months of 2024, inflows into emerging market- dedicated funds picked up, as investors were increasingly tempted by the region’s yield advantage. With assets under management in this segment of the market 18% lower than in 2022, and with $6.5 trillion sitting in US money market funds, the pent- up demand could be huge.
Of course, the increased funding pressures faced by China, on the back of its troubled property market, can raise concerns over possible defaults in EMD land. After all, the country is likely to account for two-thirds of the Asian debt defaults by volume in 2025, according to JP Morgan. To make the most of their exposure to hard-currency EMD, investors need to navigate carefully through issuer selection and emphasise the timing of investments.
The low-hanging fruit may have already been taken, but for those who know where to look, fixed income markets can still offer attractive pickings in 2025. The approach to investing should be less about chasing gains, and more about minimising losses, while avoiding having over-concentrated exposure to certain segments of the bond market.
In this context, a neutral duration stance seems appropriate, and investors should be on the lookout for rate volatility, as a signal to extend duration selectively. In the credit market, securitised credit could be a useful diversification tool, while relative value and carry options abound in the BB-rated segment. Finally, EMD provides a vast pool of opportunities for investors to improve a portfolio’s risk-return profile.
In the aftermath of the US election, our bumper “Outlook 2025” analyses what might drive financial markets next year.
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