2024 Thoughts & 2025 Fixed Income Outlook

After a challenging 2022 and a strong 2023 bounce back, 2024 has been a solid year for fixed income. In 2024, despite the Fed Funds rate being reduced by 0.75% thus far, Treasury yields have risen modestly (as we discussed in our October 21, 2024 essay, “Fed Cuts, Yet 10-year Rises”). Given the current fixed income market dynamics, we think the potential return in investment grade bonds, high yield bonds, and preferreds could potentially diverge significantly in 2025. Below we provide a framework of how we think about the potential returns in 2025 for investment grade, high yield, and preferred securities.

For intermediate investment grade corporate bonds, we project a potential return of 3-7% in 2025 with a base case of approximately 5%. The intermediate investment grade bond index (1-10 years in maturity) currently has a duration of approximately 4 years and yields approximately 5%. But we think 3-7 year Treasury rates have more downside than upside. Even so, there is an argument for rates rising based on solid economic growth, a tight labor market, sticky inflation, new tariffs, as well as potential fiscal policy changes. But all of these factors pertain primarily to 10- and 30-year Treasury yields, which could rise substantially, rather than 3-7 year Treasury yields. For those longer dated yields to fall, a material slowdown in economic growth would be required. Moreover, we do not expect 10- and 30-year Treasury yields to decline substantially because the U.S. government debt has grown significantly over the past five years, meaningful annual government deficits are forecasted to persist for the foreseeable future, and thirdly because the market is already pricing in 10- and 30-year inflation breakeven levels below 2.35% (close to the Fed’s 2% target) At the recent peak in early 2022, the 10-year inflation breakeven on Treasuries was over 3%, so the market has gained confidence in the Fed’s ability to moderate inflation closer to 2%. If that proves difficult for the Fed to accomplish, declines in long term rates will also be difficult to achieve.

Regarding investment grade credit spreads, while we recognize spreads could widen, we think the magnitude is likely limited to 0.50-1.00% based on history. (As a quick reminder, a credit spread is the additional yield or risk premium earned on a bond in excess of comparable Treasuries). Importantly, we would expect such credit spreads widening would be offset by a decline in rates providing a meaningful buffer to investment grade bond prices. (As a reminder yield = the risk-free interest rate + a credit spread.) The 3% return scenario assumes credit spreads widen by 1.0% in a weaker economy, but this gets partially offset by interest rates declining. The 7% return scenario assumes inflation moderates somewhat closer to 2% resulting in credit spreads staying near current levels and Treasury yields somewhat declining. Our base case for intermediate investment grade bonds is an approximately 5% return scenario, which assumes that interest rates and credit spreads remain relatively stable as the economy remains resilient and inflation remains modestly above 2%. Also, we have assumed investor appetite for fixed income remains robust as some investors desire to lock up 5% yields and others are concerned about equity valuations.

We see a somewhat different dynamic for the high yield bond market. After a very strong 2024 in high yield, we are more cautious now given that credit spreads are close to both 15-year and all-time lows. We forecast a potential return of 4-8% in 2025 with a base case of approximately 5.5%. Currently the Bloomberg US Corporate High Yield Bond Index has a duration of ~3.0 years and yields approximately 7%. We forecast credit spreads could easily widen 1-2% based on historical spread widening, depending upon the economic environment. Note the average high yield credit spread over the past 15 years is nearly 2% higher than current levels. Such significant credit spreads widening would likely only be partially offset by a decline in interest rates. Our 4% low return scenario assumes credit spreads widen about 1.00% from current levels and interest rates remain relatively flat, which results in that 4% return. An 8% high return scenario would require that credit spreads stay flat and interest rates decline slightly, because inflation fades closer to 2% and economic growth holds up. We don’t consider this scenario to be likely given sticky inflation, potential inflationary fiscal policy, and credit spreads at very tight levels. Our 5.5% return base case assumes credit spreads widen 0.50% and rates remain relatively stable. Given this view, we have lowered our high yield allocation in some of our strategies, as we think on a risk-adjusted basis Investment Grade looks significantly more compelling currently.

High Yield Credit Spreads over the past 15 years

With regards to preferreds, we think security selection is extremely important. The preferred market is very interesting, since each security is unique and there is a massive bifurcation between fixed rate coupons and variable/floating rate coupons. We infer the market is aggressively chasing risk in the fixed coupon preferred market. Despite these securities having very substantial interest rate risk and credit risk, some investors are chasing preferreds with yields only 0.50-0.75% higher than intermediate corporate bonds. Compared to Treasuries, many fixed coupon preferreds trade at yields of only 1-1.25% more than 30-year Treasuries. Intentionally or not, the market is priced for rates to decline and credit spreads to remain historically tight, and this bet will prove very costly if longer term rates rise and/or credit spreads widen. We have written many times that we think preferreds are the most inefficient market we play in, which occurs because of the large number of retail investors and many preferreds that trade over an exchange (like stocks rather than bonds). As a reminder, many of these securities are rated lower than the average investment grade bond and have no maturity, so if things do go wrong, there is no option to recover the par value by holding until maturity (assuming no bankruptcy). The other segment of the preferred market, the variable/floating rate coupon preferreds, have understandably performed much better over the past three years and in 2024. Notably this year, variable/floating preferreds have outperformed the overall preferred market, as well as intermediate investment grade bonds, and even high yield bonds. We have been primarily focused on variable preferreds the past few years as we saw value in many of these securities, especially those with attractive credit spreads, if they are not called. This is an example of why we prefer to manage unconstrained portfolios, as the attractiveness of each security type can vary over time.

We think 2025 will highlight the importance of being flexible and active. Since ACM runs unconstrained strategies, we are able to be more opportunistic regarding the relative value of investment grade bonds, high yield bonds, and preferreds. We continue to favor maintaining a relatively high credit quality mix because credit spreads remain tight. The market is not incentivizing us to take more risk by holding lower quality issues. While we think investment grade has the potential to perform well in 2025, we encourage investors who remain focused on high yield and preferreds to be careful and picky. There are always opportunities given the vast number of fixed income securities, but we would advise against being overly aggressive/opportunistic in the current environment.

Advisors Capital Management, LLC is an investment advisor registered with the United States Securities and Exchange Commission. Registration does not imply any degree of skill or training. All investing carries risk, including the potential for the loss of principal and past performance is no guarantee of future results. This content is for informational purposes only, can change at any time without notice, and is not investment advice or a recommendation to trade any security. Indices are not available for direct investment. We only provide services in jurisdictions where we are registered. Our disclosure brochure (ADV Part 2A) and customer relationship summary (ADV Part 3) are available at https://adviserinfo.sec.gov and upon request.