Q1 Bond Market Outlook for ETF Investors
With the Federal Reserve (Fed) already cutting rates by 100 basis points and the market predicting additional cuts, how can you reposition portfolios as cash’s yield and return potential decline?
Is Now the Time to Exit Cash?
Not since the late 1970s has cash outperformed nominal core bonds like it has in three out of the past four years — including 2024.1 So it’s no surprise money market mutual fund assets have reached a record $6.7 trillion.2
But with the Federal Reserve (Fed) already cutting rates by 100 basis points and the market predicting additional cuts, the return on that stockpile of cash is about to dwindle. That’s because cash’s return comes from the coupon only, and the US 3-Month Treasury Bill yield (a proxy for cash) has already declined alongside the fedfunds rate.
In response, investors should consider rotating out of cash-like vehicles, with their declining yield and return potential, and invest that capital in:
- Active short-term and core ETFs where managers have wider remits to pursue increased yield and total return
- Targeted maturity bands and tenors to customize portfolios for cash flow management
- High income sectors where credit trends support selectively adding risk to seek higher yields
Will Cash Lose Its Crown in 2025?
The Fed’s aggressive rate increases in 2022 sent cash returns soaring and led to duration-induced losses for core aggregate bonds. With cash as king for the first time in 40 years, the rolling three-year excess returns for core bonds resembled the dark days of the late 1970s/early 1980s (Figure 1).
Figure 1: Rolling Three-year US Core Aggregate Bond Excess Return to Cash
What stemmed these losses back then? The Fed’s rapid rate cuts brought the fedfunds rate down from 18% to single digits in just two years.3 But we’re not likely to see cuts of that magnitude this time around. In fact, central bank rates in the US are only expected to fall from 4.5% to a 3.875% implied rate by year end 2025.4
Abroad, however, the European Central Bank is projected to cut four times and the Bank of England twice in 2025.5 Of course, global easing can increase downward pressure on money market yields, since money markets hold more than just T-bills. Therefore, the return on that $6.7 trillion pile of capital likely will be lower in 2025 than it was over the past few years, creating a lower bar for bonds to jump over given their higher carry (5% yield to start 2025).6
But a lower return profile from cash and cash-like instruments doesn’t mean the rolling three-year trend will immediately change its trajectory. Core aggregate bonds could face losses if the curve steepens. Yet, it would take rates on the long end rising by over 80 basis points for duration effects to cancel out the current yield on core bonds.7
That’s because following a post-election rise in rates, core aggregate bonds started 2025 with yields close to 5% and duration around six years — a fairly balanced yield-per-unit-of-duration ratio of 0.81 (92nd percentile over the past 10 years) that makes it difficult for duration-induced losses to wipe out all the income.8
Still, core bond yields are expected to decline over the next year. Consensus is for the curve to stay upward-sloping, but for the US 10-year yield to fall to the low end of 4% (Figure 2). That means core aggregate bond returns could come in above that of the current yield (5%), as duration effects would be additive. And that increases the chance that core bonds finally beat cash to become a source of return for balanced portfolios.
Consider Core and Credit Strategies
Moving out cash means taking some risk — either by extending duration, taking on credit risks, or both.
If the consensus surrounding lower rates for both short- and long-term rates is correct, having some duration in the portfolio above that of cash has potential to add to total returns.
Current earnings and economic growth trends,9 as well as issuance technicals and low default rates,10 support taking on credit risk, even though both investment-grade and high yield credit spreads are 46% and 42% below their long-term averages.11
Notably, our research shows starting index spread levels have a weak relationship with subsequent returns.12 So, while these low spread levels don’t forecast poor returns on the horizon, investors should expect the majority of credit sectors’ returns to come from the income stream and not price movements, like they did in 2024 when income drove 82% of high yield’s return.13
With the yield on high yield indexes sitting around 7.3% to start 2025,14 if the majority of the return comes from income and credit fundamental risks don’t suggest pressing price drawdown concerns, that income-generated return screens as attractive. And active management may be able to add value beyond that.
Active managers have the ability to discern absolute and relative value credit opportunities despite tight spreads. There is also less difference between credit rating bands than usual (Figure 3). As a result, active managers’ credit selection techniques across ratings, sectors, and issuers have the potential to enhance returns above that of broad core and credit indexes.
Selling Cash to Buy Risk
Investors moving out of cash can consider short-term strategies to target maturity credit, core-plus, and high income sectors, adding variables of risk and income at each step. And selectively using active management offers the ability to target enhanced opportunities from both traditional and non-traditional bond sectors. These solutions include:
Short-term Active Core Strategies
Moving slightly up the curve from ultra-short money market exposures into the 1-3 year duration bands still provides stability. Like ultra-short T-Bills, 1-3 year US Treasurys have a negative correlation to equities and credit.15
An actively managed short-duration strategy may be able to enhance income and total return potential, given that the wider opportunity set can include securitized credits. A yield for a portfolio of 1-3 year US Treasurys can be enhanced by adding under 3-year duration investment-grade credit, high yield credit, emerging market debt, and mortgage-backed securities, while retaining a low rate risk profile.
Implementation Idea
STOT
Target Maturity Strategies
Rather than outsourcing duration management to an active manager, investors can selectively position in a maturity bucket to control their own duration profiles. Either a specific maturity band exposure (i.e., 1-3 year corporate bonds with a yield of 4.8% and a duration 1.9 years as show above) or a blend of single target maturity strategies to create a custom ladder can be utilized.
For example, an equal-weighted blend of 2026, 2027, and 2028 target maturity corporate bonds results in a weighted average yield of approximately 4.84% and a duration of 2.1 years.16 Under this scenario, once the 2026 proceeds are returned at the end of the year, they can be rolled over into a 2029 exposure to maintain the customized cash replacement strategy. Proceeds also can be allocated elsewhere based on market conditions.
Core-plus Active Strategies
Moving from cash to core strategies with intermediate duration profiles will increase portfolio volatility but also has the potential to increase income and return, provided core bonds course correct their excess return trends in this new global central bank easing paradigm.
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. That flexibility will be even more attractive if consensus rate forecasts turn out to be different than expected — or don’t take a linear path during the year.
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 income and diversification benefits, supporting tactical positioning along the yield and credit curve to seek out relative value mispricings and alpha opportunities.
Implementation Idea
TOTL
High Income Strategies
While adding risk, rotating out of cash and into below investment-grade can be a lower volatility approach than buying equities to re-risk a portfolio by buying into a rally supported by strong US economic tailwinds.
High yield bonds carry a historical 0.45 beta to equities, while senior loans have a 0.26 beta.17 And while both high yield and loans will expose the portfolio to credit risks, senior loans will have less rate risk due to their floating-rate structure — resulting in realized volatility of just 1.5% versus high yield’s 3.6% and the more rate sensitive Agg’s 5.6% over the past year.
But this reduction in volatility doesn’t constrain senior loans' potential to generate income. As they are still below investment-grade, senior loan yields are above 8%.18 And if risks do emerge or spreads tighten further, active strategies’ prudent risk management and sector and security selection may help position a credit portfolio toward high income opportunities.