Fixed Income Outlook 2025 Favorable Environment for Sovereigns

Against a favorable backdrop of central bank rate cuts and easing inflation, the relatively generous government bond yields on offer provide additional support for fixed income investors. The US dollar’s progress will have a key bearing on emerging markets debt prospects.

We retain our favorable outlook for fixed income assets as we move into 2025. Slowing economic output and tame inflation will allow central banks to cut policy rates further, and while the pace and scale may be even more uncertain under a Trump administration, the direction appears clear. That uncertainty may offer investors tactical opportunities to build or expand their duration positioning through the easing cycle.

Sovereign Bonds

We expect government bonds across most advanced economies to provide attractive returns as central banks can worry somewhat less about inflation and more fully align policy rates with weakening domestic demand and international activity. Short-term interest rate markets have priced in a soft landing with policy rates expected to fall towards 3.75% in the US and below 2.0% in the euro area. As rate cuts materialize, yield curves will be pulled lower, led by the short end in the classic bull steepening trade. Duration exposure is important, however: history shows us that rewards are typically much greater further out the curve as the cutting cycle begins (Figure 1). The journey will not be smooth, however, with the Treasury market fluctuating with policy pricing in federal funds futures and the evolving fiscal and trade policies of the incoming Trump administration. The direction of travel is clear though, and this opens the door for investors to get to their desired duration positioning at relatively attractive prices. One notable exception among the advanced economies is Japan, particularly for short-dated government debt given the different policy imperatives and direction.

The longer-term demographics also support our bullish stance on bonds. Muted labour force and productivity growth place a soft cap on trend growth across many advanced economies and thereby provide a medium- to long-term anchor on sovereign yields.

We believe a soft landing can provide returns in the mid-single digit range as investors capture relatively generous yields and a generally favorable roll effect. This varies by country in line with current absolute yield levels: in that respect, US Treasuries look comparatively more attractive versus core eurozone bonds, where the starting position is very different and thus offer more moderate returns. A harder landing would amplify returns — potentially into double-digit territory.

Substantial fiscal deficits and debt levels remain a distinct, and so far unaddressed, challenge. While the US captures most of the attention especially considering the election result, aging populations make this just as pressing an issue in Europe and Asia. This represents the most obvious risk to an otherwise encouraging outlook.

Investment Grade Credit

With investment grade (IG) spreads close to historic lows, there is little prospect of further spread compression from here (Figure 2). Average credit fundamentals are still solid, but it seems reasonable to expect some deterioration in balance sheet strength and interest coverage as the credit cycle progresses. Indeed, there are already signs of this: although leverage among US non-financials has declined from its pandemic-era high it has risen once again from recent lows. Meanwhile, profit margins at those non-financials have recently reached an all-time high — unless that trend continues, it seems unlikely that interest coverage for this segment can improve and may weaken further.

High Yield Debt

We see high yield debt in a broadly similar position to its IG counterpart. With spreads at their tightest levels since 2007, returns will be driven more by declining underlying yields rather than further significant spread compression. Having previously faced legitimate concerns around an approaching maturity wall in the face of relatively high prevailing yields, many issuers have taken advantage of lower yields and tight spreads since then to refinance, thereby improving the technical outlook. This opportunistic refinancing has been more of a US dollar market phenomenon so far. That said, the fall in yields and tighter spreads are more widespread and those improved refinancing conditions could yet provide the same opportunity for euro (and other) issuers.

Emerging Market Debt

Although hard currency emerging market (EM) debt spreads have narrowed, most credit events have been priced in and a positive outlook for US Treasuries means that this debt segment has scope to add value for investors. Additionally, the turn in the US rate cycle should — in time — weaken another support for the external value of the dollar, which in turn would bolster sentiment towards emerging market assets.

That same US rate cycle dynamic can also support an easing in domestic policy rates across emerging markets, with positive implications for local currency (LC) EM debt as well. This will be nuanced, however — individual LC issuers currently face very different inflation pressures and domestic conditions, so we cannot assume that all the regions will be able to deliver a similar level of policy accommodation in the coming quarters. For example, China — a local currency heavyweight — has the resources to boost domestic demand, but the efficacy of current and potential future support is unclear.

As noted above, the evolving policy stance of the incoming Trump administration may have a bearing on US Treasury yields and the US dollar, with implications for both EM debt segments. Depending on how targeted they are, protectionist US trade policies could have significant consequences for sentiment towards individual countries.

The Bottom Line

We see a generally favorable environment for advanced economy sovereign debt. As fiscal, trade and monetary policies evolve, we expect to see swings in sentiment and bouts of volatility — potentially creating opportunities for investors to manage or extend duration. Credit investors faced with limited scope for further spread compression and a maturing credit cycle can also expect dispersion and volatility — a fruitful regime for an active approach to credit.