Bond time

Something for everyone 

Bonds are my favourite asset class. There are bonds for high return – like the CCC-rated US high yield segment which delivered an 18% total return in 2024. There are bonds for long-term value, such as the UK government bond (gilt) maturing in 2046 which could eventually double in price. There are bond strategies that, today, look more attractive than cash, such as short-duration credit. I also like the fact bonds are important. Bond market moves are driven by growth, inflation, policy, and geopolitical events. The first week or so of 2025 saw a continued rise in government (and other) bond yields to multi-year highs. Total returns are negative so far this year. It might not sit well with readers when I say that, with yields this high, it is a good time to invest in fixed income.

Macro

The current bond bear market started in September, around the time the Federal Reserve (Fed) cut its overnight rate from 5.50% to 5.0%. That was a bold move, signalling that the Fed was confident it had got inflation under control. The market has increasingly seen the move differently and the two subsequent rate cuts have reinforced fears that inflation is still a risk. Including September data, the US consumer price index has increased by an average of 0.28% - too high to be consistent with the Fed’s inflation target or a return to the pre-2021 trend. Growth data has been robust as well. Since the Fed’s first move, the average increase in the non-farm payroll has been 170,000 per month – reflecting annualised employment growth of around 1.4%. Finally, since that rate cut, Donald Trump was elected US President. His policies are seen to be pro-growth and inflationary.

The Fed has eased monetary policy by 100 basis points (bp). Treasury yields increased by 120bp to their recent high. There are some who think the Fed has eased too much too soon, considering where the economy is and where US government economic policy is heading. Thankfully, the market corrected some of its overshoot in the wake of December’s better-than-expected inflation data. Yields are still up compared to 31 December, 2024. Bonds remain attractive.

Valuation 

The 10-year US Treasury yield reached 4.80% on 14 January - its highest level since October 2023 and, before that, July 2007. The bond yield moved above the Fed Funds Rate in December for the first time since late 2022 and the gap has widened in recent weeks. Real 10-year yields – derived from the Treasury Inflation Protected Securities market – have oscillated around 2.0% for the last two years. That is double the rate they averaged during the 2010 to 2022 period. The rise in yields, in my view, has created a better opportunity to invest in bonds. Taking the history of the Bloomberg Aggregate US Government Bond Index since 1985, yields at current levels have been associated with a high probability of a positive subsequent 12-month total return (there have been 219 months when the yield has been at 4.60% or above, and in 203 of those occasions the following 12-month total return has been positive).

Sentiment and Technicals 

It is not just the US bond market that has sold off. Global bonds are higher compared to their lows of the last six months. The UK has been the worst performer with concerns about the fiscal outlook and whether it can attract enough foreign capital to finance its twin deficits. The pound has fallen too. A weaker pound adds to inflationary concerns and the Bank of England appears frozen regarding the bank rate. The market only expects two rate cuts this year, despite evidence that the UK economy is stalling (from a very low speed, GDP has been flat since the end of the first quarter of 2024). AXA IM expects four rate cuts in 2025.

The adjustments to growth, inflation and policy rate expectations and fears that governments cannot control their fiscal paths have conspired to generate a lot of bond bearishness. The recent increase in energy prices risks bolstering inflation in the near term and the pressure on government spending is not going to disappear (public services, the energy transition, security etc.). And of course, as yields go up, future government borrowing costs rise as new debt comes with higher coupons. However, there is a bond maturing in the UK in March that was issued with a 5% coupon, so with a decent tailwind it might end up being cheaper to refinance that particular security – although this would be the exception.

I have highlighted the cheapening of government bonds relative to swaps and corporate credit. This continues. Markets believe government credit risks are rising relative to firms. Companies are issuing debt – over $80bn in investment grade bonds have been sold in the primary market in the US already this year. Banks that underwrite new corporate bond issues often hedge their books by selling government paper. And if Trump moves to deregulate banks in the US, they will have less need to hold government securities. There is plenty out there for bond bears.

Year of the bond 3.0? 

For the last two years I have been guilty of touting the “year of the bond” narrative. That has been partly rewarded by performance, although volatility in the rates markets has remained high. The ICE/Bank of America Global Aggregate bond index did deliver positive total returns in 2023 and 2024. But returns have been mixed. Credit outperformed government bonds while short duration outperformed longer maturity bonds. The one-to-three year bucket of the global aggregate delivered 3.8% total return in 2024; the seven to 10-year bucket just 0.9% and the over 10-year part of the market lost 3%. In Europe, investment grade credit and euro high yield markets have had two good years while short duration sterling investment grade has also performed well. Short-dated, lower credit quality performed much better than long-duration high quality government bonds.

It is good that bond yields are high at the start of the year. This raises the probability of decent returns across the asset class. Carry alone will be a major contributor. Income return in bonds is stable – US investment grade credit income return was 3.2% per year in 2021 and 2022. It was 4.5% in each of the last two years. For US high yield, income return has been close to 7%. If underlying rates have moved up enough, income returns will dominate the total.

Rates outlook 

Market pricing has become more pessimistic on the outlook for lower rates. US and UK rates are priced to remain between 4.0% and 4.25% for as far as the eye can see. That is fine for bonds if there aren’t reasons for the market to price in higher rates. The outlook for inflation is key to that. In both the US and UK, the December inflation data was better than expected, leading oversold bond markets to rally. Core inflation stood at 3.2% in both the US and the UK in December. It needs to be lower than this to get the central banks moving lower again but the December data is a short-term positive. Energy and Trump risks are the key threats to inflation in the short term.

Credit outlook 

Credit spread tightening was last year’s story. It allowed credit to outperform rates in investment grade and high yield markets. The reasons why rates have increased and there is not much central bank easing priced in – a strong economy – should also mean stability in credit spreads going forward. There is certainly strong demand for credit. Unless there is a surge in merger and acquisition-related corporate borrowing, or earnings growth slows to threaten the ability of companies to meet their coupon payments, credit markets should be a source of secure income for bond investors in 2025.

Higher rates good for bond investors 

We do live in a higher rates environment compared to the decade or so after 2010. I repeat, this is good for investors looking for income from bonds. Duration can be managed and hedged, but income returns are stable, and the power of compounding should not be overlooked. For all the market commentary around bond markets, liquidity is good, demand is strong and losing money through default is still a very rare event. It feels that there is limited scope for global investors to add more to their US equity holdings, especially as performance is likely to remain quite concentrated and the growth part of the market is expensive. Bonds provide attractive diversification. Hopefully, diversification can be successful in meeting the challenges of the stream of policy comments that will no doubt start flowing once Trump takes office on Monday.

Weird season 

Liverpool FC won the so-called “COVID-19” League in 2021. Manchester City has won the league every other season since 2018. Manchester United has not won it since 2013, Arsenal since 2004 and Nottingham Forest since 1978. A Manchester team has been outside of the top two positions in only five out of the last 20 years. It is looking like this season will be the sixth time. Liverpool will probably match Manchester United’s 20^th title, but the romantics will want Forest to win the league (Arsenal have been serial runners-up, Chelsea’s campaign has fallen apart). United are starting to look better under Ruben Amorim - unbeaten in 2025 – although ambitions are limited now to a top-10 finish and another FA Cup win!

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 16 January 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.