What’s Ahead for Fixed Income in 2025?

Last year marked a pivotal year for fixed income markets, as central banks got inflation under control without triggering recession, achieving the rare “soft landing” so positive for bonds. Now, as 2025 begins, portfolio managers and market strategists from Payden & Rygel review the opportunities and risks ahead for four bond market sectors: high yield, emerging markets, global bonds and low duration securities.

Overview

Central banks are going to be able to navigate a soft landing, and in that environment, we expect strong economic conditions, robust employment, and declining inflation.

Resurgent inflation unlikely but possible. We anticipate that the ultimate Republican agenda to be less inflationary than feared by the markets. However, if Congress starts passing an inflationary agenda including tariffs, lower taxes, curbs on immigration, higher fiscal deficits, it could cause a reacceleration of inflation that would be problematic for fixed income markets.

Healthy yields on investment grade assets. We expect 2025 to be a good year for fixed income, following two strong years in 2023 and 2024. If our soft-landing forecast holds up, we believe investors will be rewarded. We expect all-in returns on investment grade assets in the 5% area.

An emphasis on high quality, liquid issues. A soft-landing environment, with strong economic conditions, robust employment, and declining inflation, should be good for credit across the board. However, less liquid and lower quality credits have outperformed recently. Spreads have narrowed to the point where you’re not getting paid to take on the risk of lower-rated or less liquid bonds. As a result, we continue to overweight quality and liquidity.

Value in regional bank debt. The new administration will likely benefit banks, easing regulations that weigh on profits. In addition, banks will benefit from a stronger economy and lower corporate taxes will benefit the smaller cap and more regional businesses. We see particular value in regional banks that operate more in a geographically concentrated area, like the Midwest, or have a focus on middle market businesses. They are trading cheap versus other banks out there and should benefit from a Trump administration and a Republican Congress and Senate.

High Yield

2024 was a strong year for high yield. The year saw an improving macroeconomic backdrop, strong corporate earnings, low volatility, and solid returns. We are constructive on the asset class going into 2025 and largely expect more of what we saw in 2024. While we concede that spreads are tight, we also believe tight spreads are warranted in this environment given:

Strong fundamentals: Earnings have grown steadily, and we expect this to continue. High yield issuer credit metrics have deteriorated slightly from the record strength that characterized the market a couple years ago, but they are still materially healthier than historical averages, which should keep defaults at bay.
Robust technicals: Persistent demand for high yield combined with muted supply should keep a ceiling on spreads (barring an unforeseen exogenous shock).
Positive macro backdrop: Our base case is for a soft landing, which is a solid set up for high yield issuers. Continued economic growth should support earnings, and interest rates should come down as inflation continues to move lower and the Federal Reserve cuts the Fed Funds Rate.
HIGH yields: Despite tight spreads, all in yields are still attractive north of 7%, and yields have been historically the best predictor of forward-looking returns. 7+% yields give the market the ability to absorb marginal price declines and avoid negative returns.

In the event of an exogenous shock or the economy does not do as well as expected, we observe that historically the high yield market has held in better than equities during selloffs, capturing only 37% of the downside for the S&P 500. Therefore, we think the probability-weighted risk/reward profile for high yield is attractive going into the new year.

With positive fundamental, technical, and macro backdrops combined with HIGH yields, we believe that high yield bonds are poised to have another strong year in 2025.

Emerging Market Debt

Emerging market (EM) countries will start 2025 on a stronger fundamental footing. On whole, EM growth has been resilient, while inflation has fallen closer to normal levels. External accounts are in a good position, with limited balance of payments pressures and rising foreign reserves. EM countries have been rewarded by rating agencies: two-thirds of EM credit rating actions in 2024 were upgrades, the most positive trend since the 2020 pandemic. EM corporates have managed their balance sheets well, with net leverage levels holding below U.S. peers. China’s slowdown has not weighed heavily on other EM countries, and we see strong growth prospects in India, Indonesia, Saudi Arabia, Brazil, and other large countries, that are picking up the slack.

Headwinds from changing U.S. economic policies. The challenge looking forward is related to policy uncertainty in the United States. For EMs, this uncertainty revolves around trade tariffs, prospects for the Federal Reserve’s easing cycle, and the effect of these variables on the path of the U.S. dollar. Overall, we see balanced risks around these issues, and we envision that there will be a mix of winners and losers. The change in the U.S. approach to global trade is not new. Due to a variety of factors – nearshoring, rising South-South trade, higher commodity prices – the negative effects of tariffs have been smoothed out. Ultimately, the pandemic and inflation shocks were much more disruptive, and those have faded.

Structural forces that will continue to benefit EM debt investors are: 1) stronger long-run growth prospects, and 2) the broadening out of the investment opportunity set. Today’s EM debt investors can select from sovereign, corporate or local market opportunities in about 90 different countries, across all geographies and sectors.

Say, for example, that U.S. trade policy unfolds in a way that causes slower global growth. In response, investors can allocate to countries with lower trade openness, shift to more defensive corporate sectors, or take advantage of falling interest rates (while hedging out currency risks). A reacceleration of inflation would pose a greater challenge, but we imagine the incoming U.S. administration is aware of the political problems that come with rising prices. A slower Fed cutting cycle – which has been priced in as of late 2024 – is still a cycle suggestive of a soft landing.

Emerging market monetary policy will provide support. One of the most important support factors for EM countries has been the credibility of their central banks. Following proactive hiking cycles in 2021-2023, EM central banks were able to start cutting rates in 2024, but they have taken a cautious approach, keeping policy rates well above inflation. Thus, as we enter 2025, EM central banks are in a good position to either stay on old, or ease gradually, with room to cut more aggressively if needed. This posture will help EM economies navigate choppier waters, should they emerge.

A stronger US dollar. The U.S. dollar may remain favored to start 2025, and investors will likely tread cautiously in EM currencies in the short-term. Ultimately, a stronger dollar promotes greater U.S. imports – the very situation the incoming U.S. administration is trying to avoid. Considering this, the current high valuation of the US dollar, and the prudent monetary policy being run by EM central banks, we think prospects for EM currencies are balanced to constructive in the medium term.

Favorable valuations create opportunities. Finally, the EM debt outlook is supported by favorable valuations. JP Morgan’s main hard currency EM sovereign debt index yields nearly 8%, sitting at the 84th percentile of the past 20 years. The asset class shows value compared to other fixed income sectors, like US credit. The EM corporate debt market has an investment-grade average credit quality, with credit spreads above developed-market peers, particularly when adjusted for leverage. At Payden, we believe there are excellent opportunities for investors to generate income and gain diversification across the EM debt landscape.

Low Duration Securities

Changing market conditions. Assets in money market funds reached an all-time high of $7 trillion this past month. Now that rates are moving lower, money market yields may not be as attractive to many investors and assets may gradually leave money funds.

Institutional Outflows. While we've reached these new highs, prime institutional funds are the only category with net outflows this year, down by over half of the assets under management and expected to continue to shrink. This is directly a result of the SEC's latest round of reforms.

The low duration opportunity. For investors seeking an alternative to money market funds, a low duration strategy can make sense. Low duration funds are different from money market funds in two ways:

Longer maturities: Low duration strategies invest in bonds with maturities as long as five years, compared to the 397-day maturity limit on money market funds. This gives investors the flexibility to lock in longer term yields when short-term rates are declining.

Investment flexibility: Low duration strategies can invest across the fixed income universe – from Treasury bills to corporates to structured bond credit. This investment diversification can generate greater returns while maintaining liquidity.

Two low duration strategies. Investors can tailor the risk and return characteristics of their cash holdings to their needs by investing in either or both of two types of funds:

Enhanced cash: These funds are only slightly riskier than money market funds. They have short durations, generally less than 0.75 of a year, and low spread durations, typically under 1.25 years. Volatility is low and liquidity is exceptional.

Low duration: These funds typically have a one- to three-year benchmark duration and spread duration of somewhere between one and three years. They are a bit more volatile than enhanced cash strategies but less risky than long, intermediate or core bond strategies.

ABOUT PAYDEN & RYGEL

With $164 billion under management, Payden & Rygel is one of the largest privately-owned global investment advisers focused on the active management of fixed income and equity portfolios. Payden & Rygel provides a full range of investment strategies and solutions to investors around the globe, including Central Banks, Pension Funds, Insurance Companies, Private Banks, and Foundations. Independent and privately-owned, Payden is headquartered in Los Angeles and has offices in Boston, London, and Milan.

This material is intended solely for institutional investors and is not intended for retail investors or general distribution. This material may not be reproduced or distributed without Payden & Rygel’s written permission. This presentation is for illustrative purposes only and does not constitute investment advice or an offer to sell or buy any security. The statements and opinions herein are current as of the date of this document and are subject to change without notice. Past performance is no guarantee of future results.

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