With inflation cooling and the US Federal Reserve transitioning from rate hikes to a cycle of rate cuts, bonds are poised to perform well in 2025.
We believe success in the coming year will depend on how well portfolios are positioned to take advantage of lower rates while protecting against potential economic and credit volatility. In our view, the key theme in 2025 will be how investors successfully navigate greater dispersion across bond sectors.
Soft landing supports bond performance – but will it last?
So far, the Fed appears to have engineered a “soft landing”, with lower inflation accompanied by a gradual slowdown in growth. But it is important to remember that, historically, that’s how most hard landings begin. The challenge facing bond investors in 2025 will be whether the current economic deceleration continues smoothly or whether it evolves into a more severe downturn. The labour market will likely be a key factor. Should weakness in job creation persist, the economic outlook could deteriorate further.
We think inflation will continue to decline towards the Fed’s 2% target, and that the Fed will ultimately lower rates to below the neutral rate of 3% by the end of 2025. This expectation is based on our view that there is more softness ahead in the labour market and consumer demand.
However, two key factors could prompt the Fed to adjust its approach:
- Sticky or rebounding inflation If inflation reemerges – particularly in core services – the Fed may need to pause its cutting cycle and stabilise rates in the 3%-4% range.
- A significant demand shock A demand shock, especially coupled with labour market weakness, could cause the Fed to cut rates more aggressively, pushing them well below the neutral level, as seen in traditional rate-cutting cycles.
Regardless of which path unfolds, the Fed’s roadmap for 2025 remains flexible, with incremental rate cuts expected to reflect evolving economic conditions.
Opportunities in a rate-cutting environment
Given our base case, we believe the rate-cutting cycle should create a favorable environment for high-quality bonds in the US, particularly mortgage-backed securities and municipal bonds. These sectors, which are already starting from attractive yield levels, are well-positioned to deliver strong price returns as rates decline. We are taking a slightly more defensive stance on corporate credit, given the current level of risk premiums.
In the event of a harder landing, bond markets may experience increased volatility. High-quality and longer maturity fixed income securities are likely to benefit in such a scenario, as investors seek save haven assets during periods of economic stress.
Globally, as the Fed aligns with other central banks that have already begun easing monetary policy – the European Central Bank and the Bank of England among them – asynchronous opportunities in European and Asian credit markets may also arise. Diverging economic conditions across regions may create valuable entry points for global investors.
Navigating credit dispersion with active selection
As we assess valuations, it appears the market is not yet fully pricing in the potential for significant credit weakness across the globe. Therefore, we think a cautious approach to credit is warranted.
In addition, we expect credit dispersion will increase in 2025. While high-quality bonds are likely to perform well, certain industries are expected to experience elevated default rates – potentially in excess of 10% in certain sectors over the next two years, while others may remain closer to 1%. This divergence stems from the differing balance sheet health across industries, with highly leveraged companies – particularly in the high yield space – facing greater challenges. As economic volatility potentially rises, these weaker companies are more vulnerable to credit deterioration. This disparity creates an environment where active credit selection – our core strength at Columbia Threadneedle Investments – becomes essential for avoiding pitfalls and capturing the most attractive opportunities.
Bottom line: bonds positioned for success in 2025
Fixed income investors are entering 2025 with a strong foundation. With yields at attractive levels and the Fed in a supportive, rate-cutting cycle, bonds are well-positioned to generate healthy returns. Importantly, with the so-called “Fed put” – the belief that the Federal Reserve will intervene to support the economy during periods of stress – bonds are regaining their critical role as portfolio diversifiers. This implicit backstop should give investors confidence that even if economic conditions deteriorate, fixed income markets will remain supported.
Encouragingly, a significant macroeconomic shift is not required for bonds to perform well. Starting yields are currently above their 20-year average in most sectors. The tailwind from falling interest rates will only further boost total returns.
