With a new US president poised to take office, central banks diverging and ongoing political uncertainty, how are the key fixed income asset classes positioned for the year ahead?
Read this article to understand:
- The factors supporting investment grade and liquidity
- Opportunities in high yield and emerging markets
- The potential impact of tariffs on sovereigns
Happy New Year, and welcome back to Bond Voyage! As we step into 2025, it’s a great time to assess how asset classes are positioned, the risks they face, and the opportunities they present. We will check in later in the year to see if our predictions are lasting longer than our new year’s resolutions.
Investment grade (IG) is supported by various factors, emerging markets (EM) offer attractive returns, sovereigns have potential for capital appreciation, high yield (HY) presents opportunities through M&A, and liquidity should provide reliable income.
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Investment grade: Starting from a strong base
Expectations at the beginning of 2024 were for seven interest rate cuts in the US. By the time the US Federal Reserve (Fed) started lowering rates in September, expectations had been revised to just 1.5 cuts. This led to heightened rate volatility, setting the macro tone for much of the year. Despite this, spreads remained largely immune, staying on a tightening trend. Falling inflation, resilient growth, and interest rate cuts created a “Goldilocks” environment, with only brief episodes of widening in June and August. Even the late December government bond sell-off didn’t spook markets, which continued to tighten into year-end.
Companies with highly leveraged balance sheets will need to refinance more debt at higher levels
Looking ahead to 2025, US rates are expected to stay higher for longer, meaning companies with highly leveraged balance sheets will need to refinance more debt at higher levels. In contrast, euro market issuers have seen their funding costs decrease significantly. We might see more M&A and deregulation in the US, impacting fundamentals, but we’re starting the year from a strong position.
Policy divergence is a key question for 2025. If the US becomes more isolationist, will the spillover of inflation across the Atlantic be muted, giving the European Central Bank (ECB) more room for manoeuvre? It’s hard to gauge, but we expect divergence between central banks. While tight valuations are uncomfortable, we don’t anticipate an imminent inflection point. Many factors that supported spreads in 2024 are likely to persist into 2025, making us relatively constructive on the asset class.
High yield: M&A will create opportunities and risks
Although the election calendar is lighter than in 2024, we still expect heightened political risk at the start of 2025. In Q1 alone there will be the German federal election, President Trump’s inauguration, subsequent tariff news, and France’s new government budget.
In the US, robust economic activity is expected to support earnings, credit metrics, and lower default rates. However, further fundamental tailwinds from easing financial conditions are less likely, given that inflation remains above target and the Fed’s cautious approach. In Europe, fundamentals are weaker, particularly for high-yield industrial companies facing softer demand and potential US trade tariffs.
Moody’s forecasts a decline in the global default rate to 2.7 per cent by November 2025, down from around five per cent today. Interestingly, the US high-yield default forecast (2.8 per cent) is lower than Europe’s (3.0 per cent), which would be a first in 13 years.
Index spreads, around 300 basis points (bps) remain tight, with higher-quality bonds particularly rich. Supportive fundamentals, especially in the US, are likely to anchor spreads at these levels. Sensitivity to rate volatility could trigger further widening, but all-in yields of over seven per cent are considered adequate compensation if the economic cycle remains steady.
The high-yield market expanded slightly in 2024, growing by three per cent after contracting by 17 per cent in 2022/23. Historically, a shrinking universe has been a positive technical factor.
We expect a resumption of refinancing activities and increased M&A proceeds
We expect a resumption of refinancing activities and increased M&A proceeds, with significant transactions like the leveraged buy-out of Walgreens Boots Alliance already flagged. M&A will likely be a source of both alpha and risk, depending on leverage, transaction structuring, covenants, and bond trading levels.
Given our “higher for longer” view, we favour maintaining a high level of carry, overweighting higher-quality single-B names and underweighting CCCs. We prefer US spread risk and European rate risk, despite the ECB’s less reliable performance.
Liquidity: Benign conditions
We expect broadly favourable conditions for liquidity investors in 2025. Most major economies are growing, inflation is stable or slowly falling towards target, and unemployment levels are relatively low, making credit conditions generally benign.
Banks can fail, as we saw in 2023, so a rigorous and repeatable credit process is critical
For banks, the mainstay of liquidity fund allocations, these conditions are positive. Rating agencies do not expect material downgrades over the next one to two years, and default rates are widely forecast to remain low in 2025. However, banks can fail, as we saw in 2023, so a rigorous and repeatable credit process is critical.
On yields, most major central banks are in a rate-cutting mode, but there is no indication of rates falling back to the ultra-low levels of the 2010s. This means liquidity funds are likely to continue providing a good level of income. With inflation falling and below central bank base rates, yields should be positive in real terms for the foreseeable future.
“Step-out” strategies such as standard money market funds and ultra-short bond funds could be useful tools in 2025, helping investors achieve higher overall blended yields while maintaining good levels of liquidity.
The biggest unknown for the year is regulation. We expect announcements in Europe in 2025, but the timing, specifics, and implementation period remain uncertain. Key points to watch include:
- “Delinking”: The European Commission may remove the link between weekly liquid assets and the potential imposition of liquidity fees and gates, which can have unintended consequences. This is a positive development.
- Increased liquidity requirements: While current levels are deemed adequate, there is pressure to demand more. This should make liquidity funds safer but could reduce their yield.
Stay tuned for more updates.
Emerging market debt: Attractive return prospects
The outlook for EM hard-currency bonds in 2025 appears promising, mirroring the performance seen in 2024. This is supported by high all-in yields, a favourable global risk environment, and ongoing improvements in high-yield credit metrics. Attractive valuations for IG relative to US credit could continue to support crossover demand for EM debt.
With President-elect Trump taking office, attention will be on the potential negative effects of high US rates and a stronger dollar
With President-elect Trump taking office, attention will be on the potential negative effects of high US rates and a stronger dollar. High-yield EM bonds are relatively well-positioned to withstand higher rates, with debt to GDP having stabilised, provided market access remains intact. However, elevated borrowing costs and weaker growth could lead to more dispersion among low-investment-grade countries, where debt to GDP continues to increase (see Figure 1).
Figure 1: General government debt to GDP (per cent)
Source: Aviva Investors, IMF, Macrobond. Data as of December 31, 2024.
Countries such as Ghana and Sri Lanka, with new governments committed to IMF programmes, could see their macro-linked bonds priced more aggressively, providing potential upside. The macroeconomic backdrop remains uncertain, so we will continually assess risk and reward, seeking opportunities where compensation for risk is adequate.
The growing corporate bond universe will continue to offer opportunities to maximise returns. Continued scrutiny needs to be applied to issuer resilience, particularly in HY and cyclical sectors, while recognising the increased return potential within the HY universe. The fundamental argument for the asset class remains, and default risks seem muted.
Even as inflation has largely normalised in emerging markets, there is still a monetary policy premium to unlock
Even as inflation has largely normalised in emerging markets, there is still a monetary policy premium to unlock. Some EMs are well advanced in their easing cycles, but in many others, real ex-ante policy rates remain high. This, combined with lower commodity price pressures and slowing domestic demand, should continue to push inflation down towards targets. This should allow for interest rates to move lower, in some cases even below neutral rates, to offset growth concerns.
Given the many policy permutations to come, EM currencies are likely to be driven by a myriad of factors rather than an overarching directionality. This provides opportunities to augment hedged returns. We see resilience in countries like India, Indonesia, Turkey, and Egypt and expect that high real rates in Mexico, Colombia, and Brazil will deliver outsized returns. Even lower-yielding countries in Asia and CEE should fare well given the policy space to offset weaker growth outcomes.
Return prospects look attractive across the entire EMD asset class, and we continue to assess the full universe for opportunities that offer the potential to deliver outsized returns.
Sovereigns: Scope for capital appreciation
The past year has seen easier global monetary policy, with most major central banks lowering policy rates. We expect this theme to continue in 2025, albeit more gradually, with the focus shifting to how much further policy rates need to fall to be neutral or slightly accommodative. We expect most developed market central banks to conclude their easing cycles by the end of 2025, though the pace of cuts and terminal rates will differ across countries.
The distribution of policy outcomes has widened, mainly due to the new US administration’s proposed policies
The distribution of policy outcomes has widened, mainly due to the new US administration’s proposed policies. Tax cuts and deregulation could provide a short-term boost to economic growth. Tariffs have the potential to raise inflation but could also adversely impact growth, especially if other countries respond with their own measures.
Overall, we remain constructive on short-dated government bonds, which still provide attractive income. Bond yields are now more attractive relative to cash rates. Policy rates falling and curves steepening bring back positive carry for the asset class for the first time in several years. With policy expectations pared back in the second half of 2024, particularly in the US, we think the risk/rewards favour more easing than currently priced. Therefore, we see scope for capital appreciation alongside the positive income and carry backdrop.
While progress on inflation falling to target has slowed, we still think the lower inflation backdrop and more sensitivity to activity data support the gradual return of the negative equity/bond correlation, which supports the defensive nature of global sovereign allocations.
