Credit spreads remained largely immune to turbulence in 2024 despite concerns for a reacceleration in inflation, an unprecedented scale of global elections and volatility on economic data and changing rate cut expectations. Where to in 2025?
Read this article to understand:
- The likely paths of future interest rates in the developed world and their impact on the markets
- How much can the policies of the new administration in the US affect climate mitigation efforts and the energy transition in the US and Europe
- The outlook for investment grade corporate bonds in 2025
After a year in which credit remained relatively stable in contrast to government bond volatility, the managers of our Climate Transition Global Credit Fund – Justine Vroman (JV) and Thomas Chinery (TC) – assess what’s in store for 2025.
After a volatile year for interest rates, where do you see things going from here?
JV: Government bond markets were turbulent last year given changing rate cut expectations, in turn largely driven by GDP growth, non-farm payrolls in the US and inflation (see Figure 1).
Figure 1: Government bond yields have gone through a volatile period (per cent)
Note: Generic 10-year government bond yields.
Source: Aviva Investors, Bloomberg. Data as of December 27, 2024.
Looking ahead, we feel that the picture is likely to be different in each region in terms of monetary policy, albeit with correlation among developed market rates remaining higher. In the US, the Fed is not in a hurry to cut, and the economy remains very resilient. The election of Donald Trump is adding uncertainty across the policy spectrum, and it’s important to note that the market is less willing to accept fiscal expansion today than in 2016, considering the high debt-to-GDP ratio. In short, US rates could be more volatile.
In Europe, we believe the European Central Bank (ECB) is likely to front‑load interest rate cuts as risks to GDP growth from trade protectionism are clearly to the downside.
In the UK, the outlook is a mixed picture and we have seen volatility in rates already this year due to concerns about limited fiscal headroom, national debt levels and supply. We think the impact of the budget could also add pressure to corporate margins and economic growth and see the Bank of England (BoE) cutting rates more than the market expects into 2025, although less so than the ECB.
TC: The question for next year is around how much divergence we see. How much can the ECB ease policy if the Fed is not moving and what would be the impact? If the US becomes more isolationist, will the ECB have more room to manoeuvre and the spillover of inflation across the Atlantic become more muted? It is really hard to gauge, but from a fundamental perspective, we would expect divergence between the various central banks.
It’s been a big year for elections around the world. How has this influenced your views and expectations?
JV: What is striking this year is how credit spreads have been largely immune to macro, political and geopolitical developments. Despite rates (government bonds) themselves being much more volatile, spreads have basically been on a tightening trend. We believe falling inflation, resilient growth and central bank interest rate cuts have provided a “goldilocks” background for spreads in 2024.
We saw only two episodes when spreads widened – during the French elections in June, with the risk of an extreme party coming to power, and then in August, when a sudden rise in risk aversion was exacerbated by poor liquidity. Both episodes were relatively short-lived, and the credit markets quickly returned to their tightening trends. Even last quarter’s government bond sell‑off didn’t spook the credit markets, which continued to tighten into year end.
That tells us that there is a certain degree of complacency in the credit markets currently, especially considering the uncertain policy outlook coming from the new US administration. And that calls for some cautiousness in our positioning and is a good reason to keep some hedges in the portfolio. 2025 will see German elections and potentially more tensions in France to look out for.
Nonetheless, many of the factors that supported credit spreads this year (such as the healthy economic background, solid fundamentals and strong technicals) are likely to remain in place well into next year, which makes us relatively constructive on the asset class for 2025.
Can you tell us more about your outlook for next year?
JV: While tight valuations are uncomfortable, they are not a reason to expect an imminent inflection point as evidenced in the history of credit spreads. In previous cycles once spreads hit bottom, they had a tendency to stay rangebound for at least two to three quarters before starting to widen (see Figure 2).
Figure 2: Credit spreads tend to remain rangebound for a while once they hit bottom (basis points)
Note: Corporate bond spreads represented by BofAML euro and US investment grade credit indices.
Source: Aviva Investors, BofAML, Bloomberg. Data as of December 20 2024.
From a macroeconomic standpoint, we expect growth to remain moderate overall and the US to be more resilient still, while central banks continue easing policy at various speeds. Credit technicals should remain strong as all-in yields remain compelling (see Figure 3). In fact, if interest rate curves were to steepen on policy cuts, we could even see greater demand as investors move out of cash into longer duration products like IG. Interestingly, the large part of government yield embedded into credit spreads provides a buffer or a built-in hedge, thanks to the negative correlation between rates and spreads, which remains attractive.
Figure 3: All-in yields in IG are still at decade highs (basis points)
Note: BoAML US and euro investment grade credit indices and generic 5- and 10-year government bond yields.
Source: Aviva Investors, Bloomberg. Data as of December 27, 2024.
At the fundamentals level, the picture remains relatively healthy. We have seen a certain degree of deleveraging and earnings growth remains positive on average. Although interest coverage ratios have declined as low coupons have been refinanced at a higher yield, they remain high historically speaking.
However, while spreads are heavily constrained at current levels and offer little room for improvement, we don’t necessarily see them diverging significantly from their recent range into the first part of 2025 – translating into carry-driven excess returns. That said, we are approaching this year with relatively low conviction and are prepared to adapt our views as we get more clarity into 2025.
What are the implications of the Trump administration for the strategy?
JV: We expect increased rhetoric from a Trump administration on environmental policy. It is likely to focus on matters like stopping tailpipe emission restrictions, increasing access to federal land for resources development and expediting of federal permits and environmental reviews for construction projects.
Over the past three years, even though US energy has significantly outperformed US credit, we managed to outperform our index. To help achieve this, we offset our structural underweight in energy by using a combination of corporate hybrids, consumer cyclicals and BBs. Going into 2025, with spreads heavily compressed across the universe, the risk of a strong outperformance of energy is somewhat reduced, but we will need to choose how we offset our underweight carefully. For instance, within cyclicals we are cautious on European autos. They face a perfect storm at the moment between overcapacity, fierce competition from lower cost Chinese electric vehicles (EVs), potential US tariffs, still-higher energy costs and excess employment, which is difficult to reduce due to unions and political pressure.
On a more positive note, we don’t necessarily expect the Trump administration to fully repeal the financial incentives in the Inflation Reduction Act (IRA). This is essentially because of the job creations, reshoring and economic growth coming from investments in solar, onshore wind, advanced manufacturing, carbon capture and storage that have emerged. These are largely concentrated in Republican states, so we would not expect a full repeal of the IRA. Also, the dynamic for green innovation in the US is solid and does not solely rely on incentives. This all means that the environment will be supportive for many solution providers in our strategy that largely benefit from green capex.
Finally, while the Trump administration might withdraw from the Paris Agreement or repeal some regulations such as the SEC climate‑related disclosures, we note that a majority of US companies in investment grade (IG) operate on a global scale and are subject to EU and Californian regulations. It may be that existing laggards will lag further but good operators are likely to stay on the right path and look through the change of administration.
How do you think the current geopolitical risks will play out with some of the utility companies and might this type of scenario lead to more green issuance?
JV: In terms of energy mix, overall, we are moving from coal and oil producers towards renewables and gas as a transition fuel. The conflict between Russia and Ukraine means the shift from coal to gas has been delayed, particularly in Europe where some coal power plants have been brought back onstream – for example with Enel on the request of the Italian government.
Fears about the possible loss of residual gas supplies from Russia resurfaced in November 2024 as the Russian energy giant Gazprom cut off gas flows to the Austrian energy firm OMV, and the cold weather accelerated withdrawals from European gas storage sites. With the tight supply-demand balance in European gas, we expect continued upwards pressure on energy prices in the region over winter, which will support utilities’ earnings – a positive factor, considering the large capex pipelines they face. Further, the war with Ukraine has undeniably highlighted the need for greater energy independence in Europe. We have seen a rapid build-out of renewables and energy grids over the past couple of years, largely supported by global incentives such as REPowerEU in Europe and the Inflation Reduction Act of 2022 (IRA) in the US.
While a second Trump presidency might slow down some new projects in the US, we continue to expect huge renewable investments across the sector. And, despite the fact that some capex plans were recently trimmed by a number of utilities, record levels of capacity are still under construction. We note that supply chains and input costs pressures have stabilised, and financing cost should ease into 2025 as central banks cut rates further.
We continue to expect European utilities to lead the way in terms of green investments and issuances; with the likes of Iberdrola and Enel’s respective net capex plans of €36 billion and €26 billion over 2024-26 (this is split approximately as 50 per cent in grids and 30 per cent in renewables.)
Over the past few years, the “greenium” has reduced from around 15 basis points to about two basis points. What has driven this change?1
TC: We always viewed the greenium as a liquidity premium and it is shrinking mainly because of two factors. First, there has been a raft of issuance (and in larger volumes), significantly improving liquidity in these markets, taking the volume of labelled bonds from low double digit $ billions in issuance to over $200 billion across markets on a yearly basis.
But more specifically, some issuer curves now include well over 50 per cent of labelled bonds. Good examples would be European electric companies and the electric generators, who have issued a variety of labelled bonds in different formats such as sustainability‑linked bonds (SLBs) or other green bonds. This then means that there is now no rationale for a difference between vanilla bonds and green bonds on their curve. What we are seeing is a normalisation of labelled bonds.
The industry is more mature, the quality of oversight is much better and with hardly any difference, buyers can now choose whichever bond they find more attractive from a valuation perspective as well as for sustainability reasons. Hence, demand has increased. On the supply side, and from an issuer perspective, while the discount is gone and the burden of proof is increased, many companies still prefer to issue labelled bonds to benefit from the broader messaging of their underlying ethos.
ESG appetite seems to have fallen of late. Now that Asia seems to be interested in net zero, could the tide be turning?
JV: Fund flows into IG, both in euro and US dollar, have been impressive last year and while the competition from passive funds keeps on rising, active IG funds grew even more (see Figure 4). Additionally, other buyers like pension funds and insurers have increased their allocation to IG, which is translating into the strong technical support for the asset class that we discussed earlier.
Figure 4: Remarkable inflows into active IG strategies (US$ billion)
Source: Aviva Investors, Morningstar. Data as of November 2024.
However, it is true that ESG funds have not experienced the same level of demand and the competition from Paris‑aligned type of ETFs has been fierce.
We have spent the last three years building a track record that shows investors do not have to give up performance to deliver positive climate outcomes, and that broad climate risk integration can improve risk‑adjusted performance versus traditional strategies.2
We have also been educating investors about the limitations of Paris‑aligned Benchmark ETFs, essentially decarbonising portfolios on paper, but not contributing to the solution.3 While we fear the tick-box approach of some investors, we are encouraged by our recent business trips to the Asia‑Pacific region. In Australia in particular, our discussions with institutional investors were probably the most advanced in terms of climate risk integration into fixed income portfolios. There is a clear focus on not purely responding to regulatory requirements, or limiting investments to negative screening, but using climate risk integration to protect clients’ capital in the medium term. And, to do that in a smart way that does not exclude sectors that will be the most impactful in terms of world decarbonisation.
In that sense, we stay optimistic about a pragmatic active ESG approach such as ours, for which performance remains front and centre, and which has the ability to deliver positive real-world outcomes through active engagements, complementing a smart asset allocation process.4
