Fixed Income: The argument for bonds is the strongest it has been in years

European high yield

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. 

US high yield

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.

European government bonds

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.

US government bonds

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.

UK government bonds

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

What’s your outlook for ETFs in 2025?

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.

What are some of the main areas of opportunities you’re seeing?

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.

Which sectors will you be keeping an eye on in 2025?

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.

What are some of the key risks, specific to ETFs?

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.