Fixed Income: Rates Return to Normalcy

With negative and zero interest rates now well in the rearview mirror, investors are witnessing what we would consider a “normal” U.S. interest rate setting. For many market participants, this environment is a relatively new experience, and some adjustments in their portfolio decision-making process may be in order, in our opinion. Indeed, even with the Fed cutting rates, overall yield levels will likely remain elevated compared to the years leading up to and including the COVID-19 pandemic. Against this backdrop, we believe the bond portfolio decision-making process could benefit from taking an active/passive barbell approach from a solution standpoint.

In our opinion, UST yields returning to 1%, or even 2%, is very unlikely barring any unforeseen developments. To provide some perspective, through the years 1988–2007, UST yields posted an average of 5.15%, only to plummet to 1.52% during the 2010–2021 period. As of this writing, the reading has rebounded to nearly 4.50%. While this level still does not reach the aforementioned high-water mark, it is certainly a lot closer to the pre-financial crisis/great recession average yield than where it was from the financial crisis through COVID.

With the Fed’s monetary policy being highly data dependent, the money and bond markets, by extension, will also remain highly data dependent, keeping the volatility quotient elevated, accordingly. Since reaching their peak yield levels in October 2023, UST 2- and 10-Year yields have experienced two massive rallies, only to see their respective rates reverse course in a notable fashion because the underpinnings were never validated. Looking ahead to 2025, based on our macro and Fed-related base cases, we expect the UST 10-Year yield to straddle the 4.50% threshold (perhaps skewed to the upside) and the yield curve to steepen in the process.

“With negative and zero interest rates now well in the rearview mirror, investors are witnessing what we would consider a “normal” U.S. interest rate setting.”

Fixed Income: Asset Allocation

All the attributes we look for in bonds are back: an income stream in excess of inflation, inflation expectations that are relatively stable and a yield curve that is at least subtly upward sloping. In the current environment, bonds can offer investors an attractive level of income with a reasonable level of volatility and diversification benefits, meaning they are likely to zig when equities zag. A return to normalcy.

Our base case scenario—incremental Fed easing, a resilient economy and reasonably anchored inflation expectations—points to a year in which income will likely play a starring role in driving bond performance. Securing diversified sources of income remains a key consideration for investors in 2025.

Corporate debt will continue do its part, but with credit spreads for both U.S. investment-grade and high-yield corporate debt grinding to 20-year historical tights this year, expectations need to be managed. Spread preservation as opposed to spread tightening appears to be supported by the demand for income and resilient corporate fundamentals.

Agency mortgage-backed securities (MBS) and securitized debt are better positioned to lead income sectors this year. With more attractive valuation levels, MBS and securitized debt offer opportunity for spread compression, as well as providing attractive levels of income. Elevated volatility and ongoing anxiety over demand from banks and the Fed (regulatory and QT respectively) served as headwinds for MBS in recent years. Burgeoning bank demand for MBS has diminished concerns over Fed QT and together with expectations for limited mortgage production, we see a much better demand backdrop entering 2025. The continued strength in consumer and corporate fundamentals also lends support to the more credit sensitive sectors of the securitized market. Non-agency MBS and collateralized loan obligations (CLOs) stand out as attractive sectors given these dynamics, while select opportunities in the commercial MBS sector are starting to emerge.