Factors that will drive fixed income yields
27 JAN, 2025
By Jose Luis Palmer from RankiaPro Europe
Fixed income is emerging as an attractive option for investors in 2025, with the outlook promising interesting opportunities in an environment of subdued inflation and possible interest rate adjustments by central banks.
Drivers for fixed income in 2025
Alessandro Tentori, CIO Europe at AXA Investment Managers highlights that in 2025, two factors will drive fixed income performance: duration management on the one hand, and management inclined to take credit risk on the other.
Monetary policy and interest rates
Expectations for 2025 suggest a stabilisation of interest rates, with projections placing rates in the US between 3.75% and 4%, while in Europe they could converge towards 2%. This scenario of stable or falling rates could particularly benefit longer duration bonds, increasing their valuation.
Market prices have become more pessimistic about the outlook for rate cuts. Rates in the US and the UK are expected to remain between 4.0% and 4.25% as far as the eye can see. That is fine for bonds if there is no reason for the market to price higher rates. The inflation outlook is key to this. In both the US and the UK, December inflation data came in better than expected, leading oversold bond markets to rally.
Chris Iggo, CIO Core Investments AXA IM
Alessandro Tentori, CIO Europe at AXA Investment Managers, offers a crucial perspective on the impact of monetary policy on bonds:
The term ‘bonds’ defines a wide range of financial instruments that do not always generate uniform returns for investors. Looking ahead to 2025, it is not only the effect of duration, credit and currency risk that needs to be taken into account, but also the path of monetary policy. The latter proved to be a key factor in the construction of bond portfolios, particularly during the Quantitative Easing period. It could again prove to be a crucial factor for performance also in the near future, in a scenario of divergence between the ECB and the Federal Reserve. In our estimates for 2025, we foresee only a 25 basis point cut by Powell and company, while the ECB might have to reduce the cost of money by another 125 basis points.
Alessandro Tentori, CIO Europe at AXA Investment Managers
This divergence in monetary policies between the Fed and the ECB could create unique opportunities for fixed income investors.
Duration and risk management
Strategic duration management in bonds will be key to maximising returns and minimising risks in a changing rate environment. Investors will need to carefully balance interest rate risk and reinvestment risk:
- Longer durations: offer greater exposure to market price movements, but lock in returns over an extended period.
- Short durations: Offer less exposure to price fluctuations, but higher reinvestment risk.
Opportunities and challenges
With this outlook for fixed income in 2025, several challenges and opportunities arise, which will make the correct analysis and selection of fixed income instruments a differential factor to weather a volatile outlook.
Middle parts of the yield curve
There is a favourable risk-return trade-off in the middle parts of the yield curve, which could represent an attractive opportunity for investors.
Increased government bond issuance
Higher government bond issuance is expected, especially in the US, which could raise risk premia at longer maturities.
Geopolitical and inflationary uncertainties
Factors such as international tensions or more resilient inflation than expected could create additional challenges for the bond market.
Conclusion
The year 2025 looks like a period of opportunity for fixed income, with attractive yields and the potential for bonds to regain their pivotal role as portfolio diversifiers. However, investors will need to keep a close eye on monetary policy developments and carefully manage the duration of their investments to make the most of opportunities in this dynamic environment.
