How will fixed income perform in 2025?

Having peaked and troughed throughout 2024, the US 10-year yield is not far from where it began the year. But importantly, yields continue to cover inflation in many instances, offering positive “real” yields.

However, a Trump presidency may bring about renewed inflation and more US fiscal deterioration, which may pose considerable risks to longer-dated bonds.

• Invest with ii: Buy Bonds | Tax Rules for Bonds & Gilts| General Investing with ii

Morningstar favours short- to intermediate-term government bonds, which still offer income while mitigating duration/default risk. In Europe and Japan, bond yields are not offering much headroom above inflation[1].

In contrast to government bonds, both investment grade and high-yield corporate debt offer unusually low returns for the additional risk, or put differently, an asymmetric risk profile; limited upside owing to historically tight spreads, coupled with significant downside risk should the economy experience a hard landing.

Headline yields in emerging-markets bonds remain at enticing levels - in the high single-digit range. While emerging market bonds carry more risk than other parts of the bond market, there is a substantial yield cushion in place, in both nominal and real terms. Local currency bonds are preferred over hard currency, even accounting for the added risk. Morningstar’s view remains that many emerging market sovereigns, (with notable exceptions), have improved their fundamental strength compared to history and their currencies also look undervalued overall1.

• The biggest bond bets the pros are making
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

The Super 60 strategy investing in this asset class is M&G Emerging Markets Bond. The managers allocate the fund’s assets between the three main emerging market debt (EMD) sub-asset classes of hard currency sovereign, local currency sovereign and hard currency corporate bonds. They note that the performance of the asset class has been better than expected over the past decade despite the series of challenges faced, which includes a China slowdown, commodity weakness and strong US dollar.

Two of the primary reasons for this resilience being that the “carry” (or income) on offer provides a significant buffer to any spread widening over risk-free treasuries, and that the composition of the asset class is highly diversified geographically; where no one country exceeds more than 10% of the index, mitigating volatility[2].

The general consensus is that inflation will continue to fall in emerging markets (apart from Brazil) as their central banks moved quicker than developed markets in their hiking cycles. Furthermore, history shows that a US Fed cutting cycle serves as a strong tailwind for riskier market segments like EMD[3].

Like Morningstar, M&G are more bullish on the outlook for local-currency sovereigns with a 45% allocation within the strategy, the highest level in a decade. Within hard-currency sovereigns, which typically comprises the largest portion of the fund, they deem investment-grade rated spreads as very expensive but sub-investment grade sovereigns as very attractive. But with the caveat that fundamental analysis is paramount here[3]. With a portfolio yield of 8.2%, the fund provides a high buffer for any spread widening relative to history.

Also included on the Super 60 is the Jupiter Strategic Bond fund, a flexible bond strategy that can take advantage of a wide opportunity set, including emerging market debt, but mainly consisting of high-yield bonds, investment-grade bonds, and government bonds.

• Watch our Jupiter Strategic Bond video: outlook on inflation, interest rates and yields in 2025
• Watch our Jupiter Strategic Bond video: a 7% yield from global bonds

While a recession is not Morningstar’s base-case scenario for the year ahead, we wrote last year that Jupiter’s base case was for a slowing economy and rate cuts in 2024 and therefore the fund had significant exposure to government bonds; particularly short-dated US Treasury futures. This was barrelled with an income-generating bucket of high-yield bonds.

Despite the first half of 2024 seeing a modest re-acceleration of inflation data in the US and volatility in yields, which hampered fund performance, this thesis remains intact for 2025 and positioning is broadly similar. The managers cite softer data indicators such as the speed of increase in US unemployment, a weaker US consumer and lags in service inflation, which still leaves very meaningful room for disinflation and calls for further rate cuts[4].

Over half the portfolio is still in high-yield corporates, which the managers, like Morningstar, admit looks expensive. Notwithstanding this, they believe the asset class offers a diversifier and source of carry if a more benign environment for growth were to unfold.

Importantly though, this is currently the lowest-risk fund, on a spread duration basis, that they have ever run, eclipsing the lows reached in 2019. The checklist of features currently includes bonds with short-dated maturities, low duration, high probability of being called, defensive either (by sector or specific trades) or secured bonds with high-quality collateral against it. The fund uses Certificates of Deposits to reduce their net exposure to high yield[5].

Overall, despite the different composition of these strategies, EMD and high-quality government bonds remain good options to hold for diversifying equity risk, and Morningstar advocate investors, especially those focused on income, to prepare their portfolios for different outcomes via robust portfolio construction.

Andrew Jayne is associate director of manager selection at Morningstar Wealth.

Sources

[1] Morningstar 2025 Outlook Report, November 2024

[2] M&G Bond Vigilantes Forum, Emerging Market Debt – Time to step in?, November 2024

[3] M&G Bond Vigilantes, The Fed’s easing era, September 2024

[4] Jupiter Insights, Positioning bond investments for steep rate cuts, October 2024

[5] Jupiter Strategic Bond Fund, Latest Quarterly Webcast, October 2024