We believe the new macroeconomic backdrop has created many more opportunities to generate returns across the fixed income landscape as we head into 2025.
The monetary policy backdrop provided by central banks, which is expected to continue in the year ahead, is positive for the asset class from a total return perspective.
Our experts share their views across a broad range of teams and asset classes.
Over the last couple of years, bonds have been anything but boring. The low-income environment that the world lived through in the aftermath of the global financial crisis has been completely turned on its head.
First a pandemic, then supply chain disruption, and then the outbreak of war in Europe. Each of these factors contributed to the highest level of inflation experienced in a generation, and a cycle of aggressive interest rate hikes from almost all major central banks.
Against this backdrop, fixed income has defied its staid reputation by experiencing almost unprecedented volatility, and now presents rare opportunities. Put simply, the “income” in “fixed income” is back.
As we approach 2025, we believe the case for the asset class is stronger than it has been in years. Moving forward into this new environment, we share insights and analysis from our experts on what this means across a range of fixed income asset classes.
Lewis Aubrey-Johnson, Head of Fixed Income Products
In summary, investment grade credit spreads are now near or at their all-time tights but could remain there for some time to come. On an all-in yield basis however, the asset class is still trading at levels not seen since the Global Financial Crisis (GFC).
Global investment grade credit in aggregate offers 90 basis points (bps) of spread. Excluding the Covid period, the range over the last 10 years has been 90-200 bps. Whilst there are some small differences between regions (US dollar and sterling credit spreads are at their tights, whereas euro credit is not quite at its tights), the key point is that spreads are unlikely to narrow any further in 2025. Returns will be driven by 1. the income or ‘carry’ on the asset class and 2. interest rate effects as Central Banks are still expected to ease monetary policy.
The reasons for this tight pricing are twofold: fundamentals and technicals. First, the macro environment is currently supportive for risk taking. Economies are broadly stable, corporate earnings have been healthy on the whole, and the risk of recession seems low. Inflation and interest rates are coming down. Stock markets have risen sharply again this year.
Second, the demand for bonds is very strong indeed. It has been a very significant year for supply but far from pushing credit spreads of existing bonds wider, the supply of new bonds has been digested very well in an environment of spread tightening. Demand for most new issues is significantly ahead of supply and there is precious little new issue premium.
So long as large western economies do not start to lose momentum, for the time being, returns from the asset class are likely to be yield and duration-based rather than influenced by big changes in credit spread. Investment grade credit has the advantage over government bonds of the extra carry, plus a shorter duration profile which can be beneficial as interest rate volatility has been on the rise recently.
US economic data paint a picture of an economy that is only slowing very gradually. GDP growth this year will likely remain above 2.5%. With interest rates already being cut, the chances of recession appear very low. In Europe, growth is more tepid and indeed slowing. Fiscal restraint, slowing investment and challenges in the auto sector all weigh on the region. But with interest rates already coming down and ECB lending surveys showing some loan growth, there appears sufficient stimulus to ward off a recession even there.
We have gradually reduced credit risk all year. High yield issuers, subordinated bank securities and cyclical issuers have all been trimmed. With risk premia compressed, we think this is a good time to be adding higher quality borrowers that should be less immune from an increase in market volatility. This includes senior bank securities (particularly in Europe), consumer staples issuers or high-quality real estate operators. We have also been taking selective positions in emerging market sovereign and government-related issuers where spreads are relatively generous for the credit quality.
The Auto sector in 2025 as is facing perhaps the greatest challenges. Established car manufacturers are grappling with the twin risks of the shift to electric vehicles and the rise of Chinese competitors with a significant cost advantage. The starting point of the current pressures for these companies was a strong one, following a strong cyclical post-Covid recovery. But sales have fallen sharply and European and US auto companies have significant cost bases that will likely need to be cut. For the time being, the market considers this an equity story. In other words, that whilst profitability will suffer, the balance sheets are too strong to warrant a serious reappraisal of the credit risk. However, these challenges are more than simply cyclical and we shall be watching the sector closely.
Whilst the macroeconomic backdrop is currently supportive, economies are slowing, albeit at a gentle pace. However, just as economies have appeared resilient to previous rate hikes, if and when a slowdown takes root, there is always the possibility that it requires more policy loosening than expected. Indeed, oftentimes slowdowns do not progress in a linear fashion and there may reach a point at which the economy deteriorates at a more rapid pace. Whilst not sufficient to threaten the creditworthiness of investment grade borrowers, it may be enough to stymie risk appetite and force a re-pricing of credit risk in general.
There is also the possibility that the Trump administration could initiate a round of higher tariffs that could disrupt the global economy. The US fiscal situation is unlikely to improve, either from lower taxes or increased spending – this is likely to put pressure on longer term Treasury yields but may support US spreads as an offset, given a pro-growth/fiscal stimulus tilt.
In addition to the economic risks, geopolitical tensions also have the potential to undermine market confidence. Today, there is conflict in Eastern Europe and the Middle East and rising tensions elsewhere.
Thomas Moore, Co-Head of Invesco Fixed Income Europe
The outlook for European high yield is shaped by the macroeconomic environment, the general financial health of borrowers and market pricing.
The economic environment in Europe is subdued without being especially worrisome. Growth is close to flat, business investment has been relatively weak, employment growth is slowing, and a number of European countries have fiscal deficits they need to contend with. Furthermore, the challenges facing European auto manufacturers are likely to persist and perhaps intensify next year if tariffs are placed on US imports. Nonetheless, inflation and interest rates are coming down boosting real incomes and spending power. There are also tentative signs of a cyclical upswing judging from recent PMI surveys and recovering credit growth. These factors should contribute to a small improvement in growth in the region next year to a little over 1%, according to consensus forecasts.
Whilst there will almost always be a small number of borrowers running into difficulty in any one-year, average credit quality is relatively solid, and this is reflected in the default rate that’s projected to decline through the coming year. Moreover, despite the very strong investor demand for bonds, we have not seen a slew of more highly levered companies attempt to issue debt. For example, only 1% of high yield bonds issued in Europe this year have been rated CCC.
Rather than macro or credit quality, the greatest challenge to the asset class today is market pricing. On a spread basis, BBs are back below 250bps which is as tight as they have been since 2007. B-rated spreads are 380bps which although is not an all-time tight, is not far away. Only CCC spreads are wide but this is a modest component of the overall market and driven by the difficulties faced by a small number of borrowers. However, viewed from a yield perspective, the pricing looks a little less extreme. BB-rated bonds still offer 5% on average and Bs 6.5%. Not cheap, but certainly investible and especially so in the context of strong demand for bonds and interest rate cuts. As yields have fallen, we have gradually shifted towards better quality issuers and kept cash and other liquid securities in case of any unforeseen market volatility.
Overall, whilst cognisant of the risks, we are sanguine about the prospects for the market next year with returns likely to be driven by the carry.
Niklas Nordenfelt, Head of High Yield
We are constructive HY credit in 2025. Fundamentals are strong with healthy balance sheets, upgrades exceeding downgrades, and a declining default rate. Moderation across many fronts (growth, inflation, and monetary policy) is an ideal backdrop for high-yield credit. A Fed biased towards more aggressive rate cuts, if necessary, provides a better floor for risk. Demand for high yield has been strong in 2024 and we expect that to continue given the attractive all-in yields and our soft-landing base-case scenario for the economy.
We see opportunities in the energy sector, specifically midstream. Companies are paying down debt, engaging in credit-friendly transactions and volumes will likely remain supportive of midstream issuers. We see more dispersion, which leads to opportunities, building within the retail sector amid consumer concerns and shifts in spending patterns. Finally, the build-out of AI data centers should benefit the utility sector, communications issuers with fiber assets, and issuers engaged in cooling and connectivity components.
Key risks we are watching include a stronger-than-expected economy leading to higher treasury yields which would further challenge housing, construction, and companies with excessive debt, whereas an economic downturn would likely challenge valuations.
Hemant Baijal, Head of Multi-Sector Portfolio Management, Global Debt
We see a favourable backdrop for emerging market local debt, as continued monetary easing by the US Federal Reserve enables further easing by emerging market central banks, in turn boosting their domestic growth. Nominal and real interest rates have remained elevated in emerging markets, while disinflation has generally continued – offering attractive interest rate differentials versus developed markets.
In addition, diverging growth and inflation dynamics across individual countries offer compelling total return opportunities. We remain focused on countries with higher nominal growth, such as India and Malaysia, which have experienced significant economic growth due to higher export activity and resilient domestic spending. The biggest opportunity we see is in the normalisation of yield curves globally.
While key risks include volatility around US policy uncertainty and potential currency impacts, this is amidst a positive external environment of loosening monetary policy globally, the prospect of additional stimulus from China, and lower oil prices. Overall, we see a promising opportunity set ripe for generating alpha.
Gareth Isaac, Head of Multi-Sector, Fixed Income
We are broadly positive on the European bond market in 2025, as we see some attractive opportunities, but there is likely to be dispersion between the performance of individual countries.
On interest rates we expect the European Central Bank (ECB) to lower interest rates below market expectations and potentially well below 2% depending on the scale of the trade tariffs imposed by the new administration. A lower interest rate environment should be positive for bond valuations in the region, but there are several headwinds to negotiate in 2025. Although the ECB has begun to lower rates in the region, they are still in restrictive territory and, in our view, still far too high to support growth in the region. We feel the ECB are at risk of making a policy error by maintaining rates too high for too long.
We are due to have elections in Germany in the first quarter, where there are risks that a divided result could lead to another unstable government coalition. Whilst in France, where the budget deficit is predicated to reach 6% by the end of 2025, we expect a new parliamentary election where another defeat for President Macron could unnerve investors in the French Government bond market.
James Ong, Senior Portfolio Manager, Fixed Income
Our outlook for interest rates suggests that US Government bonds are expected to yield returns comparable to T-bills, albeit with higher volatility. This indicates that while the potential for gains exists, we should be prepared for more significant fluctuations in bond prices. A steeper yield curve presents the most promising opportunity over the long term.
It is essential to closely monitor the evolution of fiscal, regulatory, and immigration policies, as these factors will significantly influence the economic landscape and, consequently, interest rates. Changes in fiscal policy could impact government spending and borrowing, regulatory shifts could affect productivity and investor confidence, and immigration policy could influence labor markets and economic growth.
A key risk we need to manage in this environment is the potential inflationary impact of potentially expansionary fiscal policy in an already tight labor market. Increased government spending could drive inflation higher which could drive volatility in interest rates. By staying vigilant and responsive to these developments, we can better navigate the complexities of the interest rate environment and make informed decisions to optimize our portfolios.
Gareth Isaac, Head of Multi-Sector, Fixed Income
We are positive on the outlook for UK Government bonds in 2025 due to attractive valuations and an expectation that The Bank of England will lower interest rates further than the market currently predicts. UK Government bonds have been under pressure recently due to rising yields in the US and uncertainty surrounding the UK Budget but with only two rate cuts now priced into 2025 and the budget behind us we expect gilts to perform well, especially on a relative value basis versus the US.
Longer dated gilts also offer attractive valuation with 30-year gilts offering a yield near 5%. That said, there are also uncertainties surrounding the impact of the National Insurance rise announced in the Budget with many hospitality and service sector companies warning that the additional costs would be passed on to consumers. If inflation remains elevated for longer than the Bank of England anticipate they may delay lowering rates until they see evidence that the inflationary impulse arising from the budget measures is manageable. Additionally, yields may remain higher for longer following the chancellor’s plan, delivered at the Budget, to significantly raise the issuance of government bonds over the coming years to fund spending, the scale of which was a not anticipated by the market.
Paul Syms, Head of EMEA ETF Fixed Income & Commodity Product Management
It’s likely that there will be continued strong growth in fixed income ETFs in 2025. With $68bn, 2023 was a record year for net new assets in European-domiciled fixed income ETFs and this year looks like it could beat that record. As of mid-October, fixed income ETFs have already seen $56bn of net inflows which has taken total assets under management for European-domiciled fixed income ETFs to almost $0.5tn and there are many reasons to expect this trend to continue.
Fixed income ETF usage has broadened over the last few years. Having initially been a vehicle used by wealth managers, in recent years we’ve seen increased usage by asset managers and, more recently by asset owners such as pensions and insurance as they recognise the many benefits of gaining bond market exposure via an ETF.
We are also at a stage in the economic cycle which is likely to be supportive for fixed income as an asset class and is likely to see it have a higher weight in multi asset portfolios. Having acted aggressively to combat inflation, central banks are now easing monetary policy to support economic growth which should provide a positive environment for fixed income.
Fixed income ETF flows this year have primarily been focused on very short-dated exposures. Of the $56bn of net new assets, almost 40% has gone into cash management or sub-1 year government bond ETFs. It appears that, with short-dated yields at attractive levels and uncertainty about the rate outlook earlier in the year, investors didn’t see the need to increase interest rate risk. However, as central banks cuts rates, yields and therefore expected returns on cash will decline. At the same time, yield curves will likely steepen, making it more attractive to invest further along the yield curve. With record levels of cash in money market funds, it’s likely that 2025 will be a year in which investors will start switching longer to lock in the current levels of yields that are available.
Indeed, ETFs could benefit as a tool that many investors deploy to do so. Investors often use ETFs as a liquidity sleeve within their portfolio to enable them to quickly implement changes to their tactical asset allocation, particularly given the targeted exposures available which allow for precise views on duration or credit to be expressed. This was the case, in early August, when the Yen carry trade unwind caused some market volatility and credit spreads to widen, large inflows were seen into USD-denominated investment grade credit ETFs to take advantage of the more attractive valuations on offer.
As mentioned above, 2025 could be a year in which investors look to lock in yields available further along the yield curve as curves steepen and cash returns decline. However, the sectors in which they choose to deploy those allocations will depend on valuations and the economic outlook. Credit spreads are trading at relatively tight levels which is likely to favour allocating to higher quality fixed income. However, with the wall of cash that’s waiting to be invested, any cheapening in credit valuations is likely to be used as a buying opportunity as it was in early August.
One interesting way of locking in yields is via fixed maturity ETFs. The normalisation of central bank policy, which has driven yields to the best levels since the GFC, has led to several fixed maturity ETFs being launched over the last 18 months. These combine the characteristics of individual bonds in the fact they have a final maturity with the diversification, liquidity and low-cost benefits of an ETF. They may provide an interesting solution for investors interested in locking in current yield levels or matching a series of liabilities. Over $4bn has been invested in fixed maturity ETFs so far this year which is very strong performance from a relatively new asset class.
The risks with ETFs generally relate to the underlying assets, just as is the case with most mutual funds. As such, the risks experienced by ETFs are more about what is happening to specific asset classes. However, ETFs may benefit from the additional liquidity that come from both the index design and particularly the ability for them to trade in the secondary market.
We expect the global economic cycle to move from a slowdown to a contraction, as this disinflationary backdrop will likely be accompanied by stagnating growth, given both monetary and fiscal headwinds. This scenario will likely favour fixed income, especially higher quality and duration-sensitive assets like investment grade corporates.
Given that yields are the highest they have been since the global financial crisis, we believe we face a once in a generation opportunity to lock in attractive levels of income. Though recession risks will likely rise, we believe that investment grade corporates remain well placed to navigate this backdrop from a fundamental perspective, and spreads are above historical averages. We see the technical picture as supportive as well, as investors rotate out of growth-sensitive investments and into defensive investments.
We see opportunities from a regional, sector and capital structure perspective, given the dispersion and differentiation within the market. As a result, we favour financials. We’re keeping a close eye on subordinated, callable debt issued by European banks; high-quality, longer-term credit in consumer non-cyclical sectors; and sterling-denominated credit from globally diversified corporates.
Furthermore, given a “higher for longer” rates backdrop and weakening growth, we favour being underweight consumer discretionary sectors, real estate investment trusts, and US regional banks.
We believe now is a good time to hold high-quality fixed income assets, as we come to the end of a period dominated by inflation risk and monetary tightening. We think the repercussions of higher interest rates will put pressure on growth, and there is already some evidence of this in labour market and money supply data.
The path of rates and inflation is uncertain, but we think the Bank of England (BoE) is finished with its interest rate hiking cycle and that inflation will continue to moderate. We favour holding duration at this point in the rates cycle. We think the level of yield is attractive and anticipate potential price upside if rate expectations soften.
We have as much duration in our portfolios today as at any time since 2007. Most of the yield we’re earning is from underlying rates. This increases our comfort with high-quality credit, where the balance of return to risk seems good. Because weaker growth will likely be felt most in riskier credit, we favour reducing exposure across higher credit risk markets.
Growth and inflation data are softening in the eurozone, and we think the European Central Bank (ECB) is at the end of its hiking programme. Regardless of the exact path of rates from here, this period has seen the greatest tightening in a long time. We think we are in the right phase of the cycle to hold duration and we have increased our exposure substantially.
We also favour increasing portfolio credit quality and have added core investment grade and senior bank paper. Where we are holding more credit risk, we prefer subordination risk in stronger balance sheets, holding corporate hybrids and subordinated financials.
There are good bonds to buy in the high-quality end of the market, in our view, where strong names are offering some attractive coupons. There are also some good bonds to buy in sectors that have been marked down due to their greater sensitivity to higher interest rates and slower growth.
Following the first pause in the hiking cycle from the European Central Bank in late October, both the Fed and the BoE left rates unchanged for the second consecutive meeting in early November.
The Fed also appeared to be more dovish in their recent meeting, highlighting that job gains have moderated, and tighter financial and credit conditions are likely to weigh on economic activity.
Therefore, without a further inflation shock, it appears that interest rates have now peaked for this cycle, which will provide a supportive backdrop for fixed income heading into 2024. However, interest rate futures and ETF flows are showing a divergence of opinion about the outlook.
Markets are currently discounting a gentle easing cycle next year, implying that central banks have managed to bring inflation under control without choking off growth. Meanwhile, flows into fixed income ETFs have recently been dominated by US Treasuries and, more specifically, long-dated Treasuries, as investors increase interest rate risk.
This potentially indicates concern about the economic outlook and suggests investors could be anticipating sharper rate cuts than are currently expected.
Whether markets or investors are correct, ETFs provide a range of targeted exposures to suit your outlook.
We know investors are living through an unprecedented period of market disruption and volatility. From active to passive, from mainstream to innovative, we have the expertise, the strategies and the flexibility needed to match your objectives as markets evolve.
To explore the fixed income capabilities on offer in your local region, please click the below links which will redirect you to your local country website.
Gold had a remarkable month, gaining 9.3% after breaking through US$3,000 and ending March at US$3,124. Economic and geopolitical uncertainty drove the gold price higher ahead of the trade tariffs scheduled to be announced on 2 April. Discover insights into the key macro events and what we think you should be keeping your eyes on in the near term.
We assess what President Trump’s “Liberation Day” tariffs might mean for US and global markets, European and UK equities, and more.
The 2025 equities outlook is improving. Balance sheets look healthy, and many stocks are attractively valued, though geopolitical risks remain. Find out more.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Data as at 18 November 2024.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Views and opinions are based on current market conditions and are subject to change.
EMEA4020280
