2025 Fixed Income Outlook: Centrist Portfolio Positioning Amid Hyper-Bullish Sentiment

• Our base case has been that we are entering a rare non-recessionary rate-cutting cycle that should support credit performance in 2025, particularly for leveraged finance assets. The US election’s red-sweep outcome will add to pro-growth policies and further support risk assets from a fundamental perspective, while introducing potential headwinds outside the US amid more restrictive trade policies.

• The stimulative fiscal policies will add to near-term inflationary pressures, resulting in a less accommodative Fed and yield curves remaining at recently elevated levels – with the “kinked” curve persisting through 2025. By contrast, the weaker economic outlook for Europe will allow the ECB to cut rates at a steady pace. The net outcome should bolster a stronger US dollar.

• Offsetting positive fundamentals are extremely tight valuations, which fully reflect hyper-bullish sentiment. We thus see a benefit in being “centrist” and balanced in portfolio risk positioning, moving closer to neutral to the benchmark while still targeting security selection to take advantage of divergent prospects among issuers.

• High yield bond defaults have already peaked in the current cycle and are expected to decline, while leveraged loan defaults, including liability management exercises (LMEs), should remain near historical averages. CLOs are enjoying strong demand given high all-in yields and are increasingly dominant buyers of loans, which supports loan demand and technicals.

• In investment grade credit and rates, we expect any short-term weakness to create buying opportunities. We remain bullish on MBS valuations relative to IG credit. We view EM debt as a source of diversification but do not think valuations are especially cheap. China, EM (particularly Mexico), and even Europe could be dragged into trade policy challenges under the coming “America first” regime, but resulting selloffs are more likely to be buying opportunities for adjacent regional credit assets, such as broader Asia investment grade or high yield bonds, as well as broader EM IG credit relative to developed market IG.

The US election outcome has removed a key source of uncertainty for financial markets, and while credit was perhaps less vulnerable to either result than other asset classes, we believe an era of “watchful neutrality” may be settling in for 2025 – yet with a slight leaning toward risk and an emphasis on greater diversification.

Our baseline view has been that we are entering a rare non-recessionary rate-cutting cycle that should support fixed income performance over the next 12 months, with the Federal Reserve joining other developed market central banks, including the European Central Bank and the Bank of England, to solidify global policy easing.

We believe leveraged finance assets are likely to benefit the most from this environment. Normally when a rate-cut cycle begins, default rates are rising (see chart). This time, however, things look much different: Rate cuts are coming at a time when economic growth, while slowing, remains firm, unemployment is relatively low, and a soft landing (or no landing) is highly likely and may have already occurred – a broadly supportive economic picture, particularly given the health of public corporate credit fundamentals entering this easing cycle.

Signs Point to a Rare Non-Recessionary Rate-Cut Cycle

Source: BofA Global Research (defaults) and NBER (recession periods) as of 30 September 2024.

That said, we have seen benefits from being more centrist and balanced in our credit allocations of late, and we maintain our tendency to move closer to neutral beta positioning relative to the benchmark while maintaining security-level differentials. Within this framework, we seek opportunities to create dry powder without sacrificing yield: For instance, taking positions in high-quality CLOs, such as AA CLO tranches, can provide yield comparable to BB rated high yield bonds. We view such “yield-equivalent dry powder” as a critical element in fixed income positioning in 2025.

We believe credit markets remain favorable despite tight valuations, and we expect yield and carry to be the dominant drivers of returns over the next 12 months. Despite our slight bias toward risk, we remain highly selective across industries and issuers given persistent market uncertainties, including ongoing US budget issues, the expected introduction of new trade tariffs, conflicts in the Middle East, and the ongoing war between Russia and Ukraine.

Notwithstanding these risks, a soft landing is still our base case, and we expect credit market performance to hold firm overall in 2025.

Our 2025 fixed income asset class outlooks

Leveraged finance enjoys supportive fundamentals and solid technicals. Bond and loan scenarios have been converging, leaving them about equally attractive heading into 2025, with loans providing better carry but bond prices approaching par. Given the resilient macro backdrop, we continue to expect a modest decrease in high yield bond defaults, while defaults for leveraged loans, including liability management exercises (LMEs), should remain near historical averages. We believe LMEs will remain a market focus, having accounted for most recent defaults – and, importantly, signaling defaults to the market six months or more in advance, which has crowded investors into BB/B assets. CLOs are much more dominant buyers of leveraged loans than in the past, which supports loan demand and lends them greater technical resilience. New-issue ‘CCC’ capital structures will be financed by the burgeoning large cap private credit market rather than public markets, thereby limiting the formation of the highest-risk credits into the syndicated market. From a geographic standpoint, Asia’s high yield market continues to offer an attractive spread advantage despite some compression.

CLOs continue to see strong demand given high all-in yields. Despite falling US interest rates, we believe the tradeoff between fixed and floating benchmark rates is fairly valued overall, and that floating-rate assets such as CLOs that offer an attractive risk-adjusted spread will remain in high demand. We continue to favor positioning higher in the capital stack overall and taking advantage of new-issue yield premiums to secondary spreads.

Volatility in investment grade credit – if it emerges – would create buying opportunities. While stronger-than-expected US economic data since the initial Fed rate cut have reined in expectations for future cuts, the reverse has been true for Europe, where the outlook appears more downbeat. Nevertheless, we expect any short-term weakness to provide buying opportunities in both investment grade credit and rates, with fundamentals likely to remain relatively solid notwithstanding some margin weakness. The technical picture is also supportive of tight valuations due to strong global demand for US dollar-denominated investment grade credit, and a high level of coupon payments to expected supply will provide investors with ample liquidity to absorb primary issuance. While there is some concern that yield curves could continue to rise in the year ahead, we would favor adding incrementally to duration should they spike above current levels, with the 10-year around 4.5% and the two- to five-year in the 4.3% area. We also view adding to European yield exposures as prudent, given the growing confidence that growth and inflation will not accelerate in the eurozone in 2025.

In securitized products, MBS remains attractive. We continue to be constructive on mortgage-backed securities (MBS) valuations relative to investment grade credit. Within commercial mortgage-back securities (CMBS), recent spreads have reflected expectations that lower rates will support property refinancings, though that would do little to address ongoing occupancy challenges.

Look to emerging market assets for diversity. The EM fundamental and technical picture remains solid heading into 2025. While EM corporate spreads have tightened on an absolute basis, this segment remains relatively attractive on a risk-adjusted basis compared to both EM sovereigns and US investment grade and high yield bonds, but we could see some added volatility as new trade tariffs emerge next year. Broad-based negative market reactions to EM corporates will create opportunities to add exposure, particularly to issuers that are domestically focused, such as utilities, renewables, and telecoms, among others. Within EM sovereigns, local currency returns still look the most attractive, with the likelihood of further Fed rate cuts and supportive data boding well for future inflows. Investors are increasingly interested in frontier countries’ local debt, which is viewed as less correlated to the global macro picture. In hard currency, we maintain our preference for IG.

Watchful neutrality in 2025

Though we have broadly adopted more neutral positioning relative to the benchmark heading into 2025, we are focused on greater diversification within that stance and maintain a slight leaning toward risk. We continue to expect short-term fluctuations in pricing, but believe fixed income fundamentals remain solid.

Against this backdrop, we would expect any bouts of volatility to represent opportunities to selectively add risk at more attractive valuations. No fixed income segment can be painted with a broad brush, however, and careful credit selection remains paramount at a time when issuers continue to present idiosyncratic risks and opportunities.