The prevailing backdrop of higher interest rates, elevated inflation and heightened volatility has rattled bond investors’ nerves over the last few years. Nevertheless, a silver lining has emerged. This challenging environment has helped restore key defining characteristics of bonds — income and diversification.
Government bond yields sank to and hovered at record-low levels for several years following the global financial crisis. This dynamic put many bond investors in a difficult spot. They either had to accept uninspiring yields and total returns or pursue higher yields and better performance potential from lower-quality, higher-risk securities.
Now, after nearly 20 years, government bond yields are at or near their pre-financial crisis levels, as Figure 1 illustrates.
Can higher yields stabilise volatile markets in 2025?
The road back to fixed-income normalcy was treacherous, particularly in 2022, when broad bond market indices logged record double-digit losses. But we believe the bond market reset is well-advanced. While the road ahead will likely remain choppy, we think bonds are again positioned to help smooth the ride.
Tariffs, still-high interest rates and elevated fiscal deficits remain primary sources of the ongoing volatility. We expect these factors to weigh on U.S. economic growth over the next several months. We believe this slowdown will eventually trigger Federal Reserve (Fed) rate cuts, likely lowering most Treasury yields.
However, because bond yields are currently at or near multi-year highs, they have more room to rally than they have in several years. This means bonds’ price-appreciation potential is better than it was the last time the Fed cut interest rates.
Meanwhile, tariffs and trade policy remain wildcards threatening recent progress on inflation. However, if tariffs reignite inflation, we believe bonds can weather the storm. In our view, today’s yield levels could provide a potential cushion against inflation’s adverse effects on yields and prices.
How bonds are reclaiming their diversification benefits
Overall, the normalisation of bond yields has helped restore the traditional role fixed-income assets have played in asset allocation strategies. Higher yields mean bonds offer attractive income potential again — a feature that typically helps temper the risks associated with stocks, particularly in weakening economies.
We continue to find opportunities across sectors within the bond market. In our view, select securitised and corporate securities are particularly appealing from income and valuation perspectives. Given near-term uncertainties, we believe maintaining a shorter duration, higher-quality strategy remains prudent, but extending duration may make sense when rate cuts appear imminent.
U.S. Government Bonds
As the bond market awaits clarity on Fed policy and global tariff/trade negotiations, we expect most Treasury yields to remain rangebound. However, longer-maturity securities remain more vulnerable to fiscal policy challenges. We expect the yield curve to steepen once the Fed resumes its easing campaign, with shorter-maturity yields declining.
In the meantime, we are emphasising the curve’s short and intermediate areas. We believe this strategy offers attractive near-term potential from a Fed policy perspective while potentially hedging against the longer-term effects of soaring federal debt.
Outside the U.S., we believe government bonds in the U.K., Australia, Peru, Mexico and South Africa offer value due to prospects for central bank easing.
U.S. securitised assets
We still believe the securitised sector offers some of the best relative value opportunities in the fixed-income market. Specifically, the agency mortgage-backed securities (MBS) sector remains attractive, given our outlook for the yield curve to steepen. Additionally, we believe this sector offers relative value versus others due to its attractive income and higher quality.
Among credit-sensitive subsectors, we believe select commercial mortgage-backed securities (CMBS) offer value. Additionally, growth prospects for digital infrastructure may bode well for agency-backed securities (ABS) in this space. Overall, we favour sub-sectors with strong technical backdrops, solid fundamentals and structural protections.
Municipal bonds
We believe the relatively high quality and longer duration of municipal bonds should aid the asset class as the economy slows. Municipal credit fundamentals should remain stable due to reserve fund balances and conservative budgeting practices. With President Donald Trump’s tax proposals taking center stage, we will assess and monitor potential outcomes and the implications for municipal bond demand. For example, clarity around the sector’s tax-exemption status could shift the timing of new-issue supply.
Additionally, as U.S. fiscal policy takes shape, munis in the higher education, health care and state general obligation (GO) bond sectors could face mounting pressures. Overall, tight valuations keep us cautious toward spreads. We still favour higher-quality issuers and sectors and believe security selection remains crucial to performance.
U.S. and Non-U.S. Corporate Bonds
Amid tight corporate valuations and broad economic uncertainties, we are focusing on “story bonds,” or those featuring a potential positive catalyst for spread tightening. Accordingly, we are drawing on our stringent credit research to identify issuers with attractive valuations and solid fundamentals. Banks, financial companies and technology firms represent our largest investment-grade sector weightings.
Among high-yield corporates, we favour shorter-maturity, mispriced bonds with improving credits. The European economic outlook remains subdued, driving our caution toward industrial-related bonds and our preference for financial sector subordinated bonds. We still believe the European banking sector is attractive, with significant capital buffers and strong asset quality.
Money Markets
With financial markets expecting Fed easing to resume in September, we will seek to extend weighted average maturities, targeting securities maturing in January through March 2026. We expect to expand organically in government portfolios by reinvesting in government and Treasury securities.
We plan to actively swap commercial paper and CDs for Treasury bills. We also remain mindful of the approaching debt ceiling X date, when the Treasury hits its debt limit and can no longer meet its obligations. We will seek to purchase securities maturing after this date to capture excess yield potential into the fall but ahead of the Fed’s December meeting.
Emerging Markets
We remain cautious, as U.S. policy uncertainty could trigger spillover effects on global growth and commodity prices at a time when valuations are expensive. We generally favor sovereign securities in the BBB/BB ratings space.
Among higher-risk names, we believe security selection remains crucial, and we’re focusing on bonds we believe offer value due to improving credit trends, supportive catalysts and compelling valuations. We remain selective in the high-yield market, preferring bonds offering moderate correlation with global trade risks and commodities and potential positive catalysts. We expect local rates to continue rallying amid expectations that weaker global growth will create output gaps and reduce inflation pressures.
Additionally, China may end up exporting some of its excess capacity to other emerging markets (EM). We have minimal exposure to EM currencies, due to a likely slowdown in the U.S., which would dampen risk appetites and hinder EM currencies.
