Will Risk Be Rewarded Again?

Uncertainty surrounding US policy under the new US administration has driven volatility higher in bond markets this month. However, one policy objective remains clear to fixed income investors: strong US growth.

Treasury bond investors have pushed the benchmark 10-year yield higher, anticipating fewer interest rate cuts from the Federal Reserve this year than previously expected. Corporate bond spreads remain historically tight as investors foresee reduced regulation and lower corporate taxes.

This divergence over the past few months has resulted in a broad range in fixed income performance for 2024. US Treasury bonds posted modest gains, averaging just 70 basis points (bps), while emerging markets and US high yield returned 6.5% and 8.2%, respectively, and distressed debt gained a remarkable 25%.¹

Can investors anticipate similar returns for taking on risk in 2025?

US: Sensitivity to Economic Data

Without a clear sense of the details of forthcoming US policies, investors have reacted strongly to economic reports, driving up market volatility. Despite this, the upward trend in yields is evident: The 10-year US Treasury yield has risen around a full percentage point since September’s low of 3.60%.²

Investors’ views on where the yield is headed vary widely, from 4% to 6%, depending on their expectations for the Fed’s interest rate path. Our US team generally agrees with the futures market’s expectation for one or two more rate cuts and therefore sees fair value for the 10-year yield at around 4.80%.

Additionally, the yield curve is expected to continue steepening. The spread between two- and 10-year yields has risen to 30–40 bps from last year’s low point of minus 50 bps in June, and our US analysts anticipate it will reach 100 bps as the curve normalizes.

US Credit: Speed Bumps Ahead?

The sentiment in US credit remains “risk-on” as strong company earnings and guidance continue to roll in. However, the optimism that has kept spreads near all-time lows since last fall’s US elections may not last.

Uncertainty over the impact of the new administration’s proposed policy changes is likely to cause periods of volatility in 2025. This should create opportunities for investors to buy high-quality credits at wider spreads, but it also warrants careful credit selection. Absolute yields of 5%–6% on investment grade credit are generally attractive to many buyers, which should limit spread widening.

In the high yield sector, demand has been exceptionally strong due to attractive yields and solid performance. In the near term, that demand could drive the average spread even tighter than the current 260 bps.³ Much will depend on the new administration’s ability to advance its deregulatory agenda and to curb government spending. Our credit analysts will closely monitor company outlooks and guidance over the second and third quarters to gauge managements’ reactions, particularly regarding capital spending and mergers and acquisitions.

New issuance for 2025 is forecast to exceed last year’s $300 billion, which should help bring supply and demand more in balance over the year. Our team therefore expects the average spread to rise around 50 bps, with greater dispersion among companies. They also anticipate the sector’s return to moderate to 5%–6% in 2025, with most gains coming from carry.

The US Dollar Conundrum

President Donald Trump’s proposed trade policies (which include tariffs), the expectation for fewer Fed rate cuts, and relative US growth outperformance should continue to provide support to the US dollar in the near term. Indeed, the currency gained 6%–12% (versus G10 currencies) in the fourth quarter, most of which came on the back of the election results. However, a strong US dollar could interfere with one of Trump’s main policy objectives: boosting US manufacturing and exports.

How the new administration will resolve this dilemma—and the potential conflict with the US dollar’s role as the global reserve currency—is uncertain. However, what is becoming increasingly clear is the dollar’s positioning and valuation appear stretched. According to our foreign exchange advisory team, long options and futures positions in the dollar are approaching, and in some cases breaching, an extreme value of two standard deviations above the mean. Comparing long-term valuations for the dollar against a basket of currencies adjusted for inflation (the Real Effective Exchange Rate or REER) shows a similar extreme in the dollar’s valuation (see chart).

To our team, these indicators are red flags and a signal to identify other currency opportunities, potentially for the second half of the year when the current momentum subsides. The Norwegian krone now tops the team’s list as the most attractive currency across a variety of factors, followed by the Danish krone and Swedish krona.

Emerging Markets: Shifting Gears Amid Uncertainty

For emerging markets, expectations for a strong US dollar, new US tariffs, and lower oil prices under the new administration are clouding the macroeconomic outlook. Our investment team believes this warrants a shift.

First, the fixed income team is adopting a more defensive stance, reducing portfolios’ duration and currency exposures. To enhance return potential, the focus is shifting from the macro picture to relative value and opportunities in frontier credits that may be insulated from global macroeconomic trends. In their view, finding alpha in sovereign and company credits with idiosyncratic stories will be crucial to returns this year, given the increasing dispersion in the asset class.

Many emerging markets currently have strong balance sheets, and as long as central banks are cautious in easing rates while the Fed slows its cutting cycle, bonds and currencies may have enough “cushion” through the first half of the year. However, US policy dynamics are likely to become more influential thereafter.

Europe: Diverging from the US

As the US pursues its pro-growth path, core European countries, particularly Germany, are struggling to grow. As a result, Treasury yields are now 205 bps higher than German bund yields—a historically high differential. Central bank policies are also diverging, with the European Central Bank expected to cut rates at least three times in 2025.

Political changes within Europe are influencing markets as well. As France’s new prime minister works to stabilize the government, uncertainty is widening the yield spread between French OATs and bunds. Meanwhile, Germany faces a highly contested national election next month.

Where can investors find some relief? Italy’s bonds performed well in 2024, and our global bond team sees room for more gain this year. In global rates, they favor Canada and New Zealand, while UK gilts remain highly volatile, driven by shifting fiscal and monetary policy expectations.

Global Convertibles: Riding the Equity Wave

Convertible bonds, which offer investors the option to convert to the issuer’s equity, are sensitive to both equity market developments and credit conditions. In the second half of last year, when the rally in US equities broadened beyond the major technology companies into mid and small cap companies, valuations on many convertible bonds increased. At the same time, convertible spreads tightened, helping support returns in the high-single digits.⁴

The sector and market cap biases of the asset class could prove advantageous in 2025. The new US administration's expected focus on enhancing growth and reducing regulations could be particularly powerful for the technology and consumer sectors. In addition, because of their concentration in mid and small caps, convertible bonds should be less vulnerable to risk coming from new tariffs and may benefit from the expected rise in mergers and acquisitions.

Seeing the Big Picture

With policy uncertainty high and volatility returning, dispersion among credits is likely to increase, and we believe bond investors will need to be more discerning in taking risk this year.

However, differentiation is good news for active investors as it creates the potential for above-market returns from careful security selection. We see other positive trends for active bond investors, indicating that the market is continuing to normalize after the global pandemic: attractive absolute yields, positive yield curves, and the return of term premiums.