Although uncertainty over monetary policy and fiscal policy is fueling bond market volatility, the new Trump administration’s pro-business policies may boost credit’s favorable outlook. Taking an active approach to core bond exposures can help you balance rate risks while pursuing credit opportunities that seek high income.
Monetary policy has been the primary driver of interest rate trends and volatility for the past three years. But in 2025, given the inflationary potential of some of the new Trump administration’s proposed policies, fiscal policy likely will become an equal variable in the volatility equation.
While this change may complicate the Federal Reserve (Fed) guiding inflation closer to its 2% target, it supports the tailwinds for credit. The new administration’s pro-business policies may accelerate a corporate growth cycle that’s already underpinned by strong fundamentals and a healthy consumer. Credit selection may help decipher winners and losers in this new policy regime, considering that today’s tight credit spreads are in the bottom 2nd percentile over the past 30 years.1
With this favorable credit outlook set against a backdrop of policy-related rate volatility creating challenges for broad core bond exposures, consider adding:
Following the Fed’s jumbo rate cut in September, positive growth surprises and slowing disinflation reduced expectations from eight cuts by May 2025 to just four.2 And although the market had priced in almost two cuts by the January meeting, the Trump administration’s pro-growth and potentially inflationary policies have dropped traders’ forecast to less than one (Figure 1).
After the election, planned fiscal policy changes and revised Fed policy expectations were met with a surge in bond yields and elevated uncertainty. Long-term Treasurys had a four standard deviation jump in volatility that sent their trailing 10-day volatility into the 95th percentile.3
Clarity on the Trump administration’s new fiscal policies could take months. And Powell reiterated at the November meeting that the Fed’s policy decisions depend on incoming economic data, and that the Fed won’t speculate on fiscal or trade policy.4
This waiting game will likely exacerbate already high rate volatility — underscoring how duration management will be a key alpha driver in 2025.
Five factors underpin the current case for credit:
These credit tailwinds have led to tight credit spreads. Both high yield and investment-grade corporate bonds spreads are approximately 40% below their historical averages and plotting in the lowest decile over the past 30 years.13
Yet, our research reveals mixed relationships between the starting spread level and the subsequent 12-month returns.14 Returns have a correlated pattern only when spreads are at extreme wide ranges. This is a time when there is absolute market dislocation, and high yield betas are rewarded as the market course corrects and mean reverts.
But today, with credit trends favorable but spreads tight, utilizing rating, sector, and security selection techniques may add additional value versus owning only the betas of the below investment-grade market. Even with credit spreads tight, mispricings exist — and being able to actively make those relative value decisions can add to returns.
Elevated rate risks alongside conducive credit trends support using credit-related strategies with the potential to limit rate-induced price swings.
Active strategies’ flexibility to manage rate risks while pursuing opportunities in a broader universe may be the most beneficial approach in the core. Especially considering active strategies have the potential to lower or extend duration relative to the benchmark and implement curve steepener or flattener trades to seek alpha.
The ability to combine traditional (e.g., investment-grade corporates, and US Treasurys) and non-traditional bond sectors (e.g., CLOs, securitized credits) can add diversification benefits, supporting tactical positioning along the yield and credit curve to seek out relative value mispricings and alpha opportunities.
Expanding a strategy’s opportunity set into those non-traditional areas can also help with income generation. Active core strategies seek three objectives: higher income, less risk, and improved returns relative to basic bond benchmarks. And already, on a return basis, active managers with flexible remits have added value heading into 2025 (Figure 2).
Due to their floating rate coupons, senior loans have minimal interest rate risk — resulting in realized volatility of just 1.8%, versus the Agg’s 7.6% over the past year.15
Since senior loans are below-investment-grade rated securities, this reduction in rate risk doesn’t constrain their potential to generate income. Yields are above 8%, leading to a yield-per-unit-of-volatility more than seven times that of core bonds and four times that of fixed rate high yield.16
And active strategies’ prudent risk management and sector and security selection may help navigate a credit market with healthy fundamentals and supportive technicals, but rich valuations.
Even though they are floating rate exposures, Fed rate cuts have historically not had the same one-to-one impact on senior loans yields (Figure 3) as they have had on investment-grade floating rate notes. In fact, there is just a 51% correlation and 0.62 beta between senior loan yield movements and the fed funds rate. And given the reduced rate cut expectations, the potential for elevated income generation from loans remains high.
High-quality investment-grade corporate bonds with maturities between 1 and 10 years, leading to a weighted duration of four years, allow investors to take on some duration risk, but with a better balance toward income.
The segment’s 5.06% yield is greater than core bonds’ 4.85% and on par with broad corporates’ 5.25%.17 Sitting in the short-plus belly of the curve cuts out the long-term tail of corporate bond exposures that offer little yield pickup (30 basis points) while adding eight years of duration relative to the 1-10 year space.18
As a result, the 1-10 year part of the corporate curve helps strike a better balance between yield, duration, and potential rate volatility relative to other broad corporate bond and Treasury sectors. This is illustrated by the segment yield-per-unit-of-duration being greater than one, while those other areas, including core aggregate bonds, are well below one and not in balance.19
This means if rates rise, the more aligned coupon with duration (5% yield versus 4 years of duration) can help offset those duration-induced price losses. Meanwhile, if rates fall, having some duration can lead to price appreciation.
In either scenario, duration controlled exposure is balanced. And looking ahead, that balance will be crucial in tempering the impact of monetary and fiscal policy on portfolios.
Taking an active approach to core bond exposures can help you balance rate risks while pursuing credit opportunities that seek high income.