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Fixed income in 2025: a balancing act featuring carry, credit and duration risk
Sandro Croce
CIO, Fixed Income
LOIM Fixed Income team
key takeaways.
In 2025, trade tariffs and fiscal policy are set to play an increasingly important role alongside monetary policy in fixed-income markets, leading to divergence in the growth and inflation trajectories of the US and Europe
Healthy carry means fixed income remains attractive, but short-term uncertainty favours a more balanced exposure to credit and duration risk, making higher quality corporate bonds particularly attractive, in our view
After the rate-hiking cycle, investors’ ‘search for yield’ has become a ‘search for carry’. We explore the liquidity benefits and return potential available by harnessing carry through credit-default swaps on high-yield indices instead of traditional bonds.
As the new year progresses, the outlook for fixed income has already shifted – and become more complex. The Q1 2025 issue of Alphorum focuses on the implications for bond investing when the dominant narrative is of diverging performance between the US and the eurozone, and the importance of capturing carry.
Portfolio positioning: adapting to a new outlook
Monetary policy has dominated the macro environment over the past two years, as central banks first fought to tame inflation and then sought to plot the way back towards normality through monetary easing. However, 2025 will see a more complex scenario in which economic policies compete for influence.
In the US, higher tariffs and other policy shifts are likely to be inflationary, creating the potential for rates to be more volatile as monetary policy is adapted to smoothen their impact. However, in a Europe already challenged by slowing growth and political turmoil, tariffs could have the opposite effect. The potential for divergence is reflected in market pricing for bottom-of-cycle rates for the US Federal Reserve (Fed), the European Central Bank (ECB) and the Swiss National Bank (SNB) versus the respective neural estimates (see Figure 1).
FIG 1. Bottom-of-current cycle rates vs neutral estimates for the Fed, ECB and SNB1
The consensus view that the US will outperform Europe creates its own risks, however. Indicators including employment levels and lending surveys suggest European countries could prove more resilient, while in the US, the Fed could struggle to calibrate monetary policy effectively in an uncertain environment, potentially causing an unexpected slowdown. A less likely scenario, but the worst for bonds, would be stagflation.
“The situation requires a shift in positioning to a more balanced exposure between duration risk and credit risk.”
Overall, we believe the environment remains broadly positive for fixed income. However, the situation requires a shift in positioning to a more balanced exposure between duration risk and credit risk. We see value in the attractive mix of the two offered by investment-grade (IG) corporate bonds. At the same time, we have shifted our overall duration bias from long to neutral in US Treasuries (with exposure to inflation-linked securities to smoothen potential noise) while standing ready to move tactically as the situation evolves.
Government bonds: diverging fortunes
In the short term, policies including higher tariffs could be supportive for US growth, although a global trade shock could force a return to restrictive monetary policy, denting consumer confidence. For the eurozone, incremental monetary policy accommodation may be the only way to offset the impact of US tariffs, supporting the argument for locking in yields. In emerging markets (EMs), meanwhile, central banks will need to balance the impact of tariffs with imported upside inflation risk from higher US policy rates and a strong dollar.
Central-bank easing is making sovereign bond yields increasingly attractive relative to cash yields, with investors benefiting from the cushion provided by positive carry and rolldown. However, despite this, and the restored diversification benefits of government bonds, the elevated uncertainty may temper investors’ enthusiasm for the segment as 2025 gets underway.
From a technical standpoint, overall net-net sovereign bond supply is likely to remain plentiful in 2025. However, there are significant uncertainties, with US Treasury issuance highly dependent on the new administration’s policy decisions, while the potential for reductions in issuance to address fiscal deficits in the eurozone is in question given political turmoil and defence spending pressures.
The risk of non-linear outcomes means we prefer to take a more cautious stance, reiterating our overweight position in inflation-linked bonds – for the attractive real yields and defensive qualities – while scaling back nominal-bonds exposure to neutral. At the same time, we have turned cautious on EM local debt, since spreads fail to compensate for poor EM currency performance.
Credit markets generally had a good 2024, with certain sectors – like real estate – generating excellent performance and rewarding our insistence on the strong fundamentals of quality real estate and our preference for hybrid bonds. With fewer opportunities for spread tightening but ample carry on offer, 2025 looks reassuringly boring for credit.
Donald Trump is likely to make a lot of headlines in 2025, but for credit markets the new US administration is no big deal. Many IG companies are global businesses with a footprint in the US, where tariffs are likely to make their products more competitive against cheaper imports. Meanwhile, high-yield (HY) companies tend to be smaller and more focused on their domestic markets, making international tariffs largely irrelevant.
One sector looking quite challenged is automotive, with lower-than-expected electric vehicle uptake affecting production volumes. We would characterise this as ‘nearly’ an opportunity – component manufacturers are most likely to suffer, with potential second-round effects for raw material suppliers, but none are likely to be compelling trades. Similarly, while we foresee an increase in M&A among BBB and BB issuers, we are not interested in buying weak companies on the basis of takeover rumours – although we may sell bonds we hold to crystallise profits if they rally based on M&A stories.
With little scope for further price recovery and the evolving environment all about carry, bond investors may be tempted to go down in credit quality seeking better returns. We see some value in crossover and the higher end of HY, based on thorough fundamental analysis of individual names. However, the search for extra carry at greater risk lower down the ratings spectrum is potentially something of a fool’s errand, in our view.
Can an ambitious, verified emissions-reduction target be taken at face value? In our experience, not always. Analysing the substance behind such claims is integral to our TargetNetZero investment-grade (TNZ IG) credit strategies, which focus on companies making real emissions reductions in hard-to-abate sector like steel and shipping.
For example, ‘SteelCo’ (a real firm that we anonymise here), looks to be setting out well on its decarbonisation journey. The Science Based Targets initiative (SBTi) has independently validated its 1.5°C aligned targets, which include a 50% reduction in absolute scope 1 and 2 greenhouse gas (GHG) emissions by 2030 and 14% reductions in scope 3 emissions from business travel and waste generated in operations. The firm also pledges for 80% of its suppliers of purchased goods and services and upstream transportation and distribution by emissions to have science-based targets by 2025. However, we would like to understand its rationale, the capex required and the balance sheet implications. To date, SteelCo has been unwilling to engage.
Like SteelCo, ‘ShippingCo’ faces major challenges to decarbonise, but it is taking clearer action to secure success. The company has just appointed an expert on alternative fuels to its board who will head a committee overseeing its decarbonisation strategy, and has announced a capex programme aligned with reducing its emissions by 30% by 2030. It is also formally assessing the potential to improve on its goals and aims to set a science-based target by the second quarter of 2025. Significantly, ShippingCo is open to holistic conversations with us regarding approaches to decarbonisation among its peer group, as well as developments beyond the sector and across the value chain.
Systematic research: capturing HY carry through CDS
The rapid hiking cycle of 2022 has changed the dominant investment thesis for fixed income from the ‘search for yield’ to the ‘search for carry’.2 Usually, corporate HY bond indices are the go-to option to capture carry. But other options may be more effective.
Over the last 20 years, the massive growth of the corporate-bond market, combined with a collapse in primary dealer inventories, has made liquidity conditions extremely challenging. This has kept bid-ask spreads for HY corporate-bond indices elevated despite innovations in broader market trading capabilities. By comparison, credit-default swap (CDS) indices across both EUR- and USD-denominated markets offer bid-ask spreads 10 times lower on average (see Figure 2A), as well as trading volumes comparable to that of the entire corporate bond index combined (see Figure 2B).
FIG 2. Corporate bond market liquidity conditions and costs3
The laws of finance require a premium to compensate investors for holding illiquid assets. Yet selling protection on HY CDS indices actually significantly outperforms the excess returns of a long HY corporate bond index in the long run across both euro and USD-denominated markets, in absolute terms and on a risk-adjusted basis, our analysis finds.
While part of this outperformance is due to index composition, the difference between the performance of the CDS index and a CDS index-matched bond portfolio indicates a basis effect. One component of basis is the spread difference between CDS and bond indices, with CDS outperforming when CDS spreads are higher, as is currently the case.
Based on our analysis, in the current environment we believe accessing HY markets through CDS indices is a compelling option for allocators, offering both enhanced liquidity and higher realised risk-adjusted returns.
To read the full report, please use the download button provided.
1 Source: Federal Reserve Bank of New York, ECB, SNB, Bloomberg, Lombard Odier. As of January 2025. For illustrative purposes only. 2 We define carry as the excess yield over risk-free cash rates. 3 Source: LOIM; Bloomberg; FINRA TRACE at 31 December 2024. We use trading volumes from FINRA TRACE for bonds and Depository Trust and Clearing Corporation for derivatives. Past performance is not a guarantee of future results. For illustrative purposes only.
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