2025 was widely expected to be a good year for bonds. The US economy seemed to have found a floor, inflation looked to be contained, and interest rates had a long way to fall. The combination of high yields and capital appreciation from falling rates was, if a bit simplistic, a reason to be excited about the outlook for compelling total returns. But 2025 is looking increasingly like it will be anything but simple, writes Olivier De Larouziere.
The unfortunate certainty of uncertainty
The US economy has been weaker than expected, concerns about inflation have risen, and uncertainty over economic policy has raised volatility. Whether, or how much, the US Federal Reserve feels comfortable lowering rates in 2025 remains to be seen. In the eurozone, we expect moderate growth and the European Central Bank (ECB) to continue to lower rates, probably to around 2%.
While our views are broadly in line with the consensus, forecasting the macroeconomic environment is necessary for professional investing, but not sufficient. Not because forecasts are often wrong (consider the consensus in early 2024 for an imminent US recession), but because the path markets take to a forecast outcome can be as important as whether they get there.
In late 2024, uncertainty over the path of US domestic policy and the corresponding outlook for inflation brought a ‘term premium’ back into Treasury bond yields – a risk premium that had been largely absent for a decade. As we look into 2025, uncertainties are still rising.
For example, the Trump administration is implementing an aggressive economic agenda including
- a more protectionist approach to trade (which could put pressure on inflation and weigh on growth)
- deregulation (which could fuel economic growth)
- tighter immigration policies (which could put upward pressure on wages)
- tax cuts (which could boost corporate profitability, but weigh on the fiscal outlook).
In simpler times, bond investors would have been well advised to maintain a traditional portfolio of government and investment-grade securities. And they may well deliver in 2025, particularly if equities have cause to falter further. But given the basket of uncertainties that cloud the outlook, we believe bond investors should expect volatility to stay high and consider the benefits of diversifying portfolios.
Traditional bond allocations have value, especially now
For decades, bonds have been a staple part of a diversified portfolio because they offered yield, liquidity, capital preservation, and diversification. And however uncertain the current environment may be, it does not alter the strategic or structural value of holding bonds.
Today, government bond yields in the US and Europe are attractive even with the risks. Benchmark 10-year US yields (currently near 4.21%) aren’t far from 20-year highs, while 10-year German Bund yields are approaching 3%, near 15-year highs. Investors could realise compelling income while enjoying the diversity that these bonds can provide to a more aggressive equity portfolio.
Investment-grade corporate bonds are also likely to provide compelling income. But their generally tight spreads (yield over equivalent duration government yields) make them more sensitive to changes in sovereign bond rates. Should those remain volatile, they could significantly diminish corporate bonds’ risk-adjusted returns.
The high-yield (sub investment grade) corporate and emerging markets sectors are more attractive because their higher yields provide more of a cushion against volatility, but they are typically more sensitive to the ebbs and flows of investor sentiment, and thus geopolitical risk.
Traditional portfolios of government and corporate bonds could end 2025 with satisfactory returns should the consensus views on the world’s major economies prove correct. Indeed, if inflation slows across the developed world and geopolitical tensions and trade policy uncertainty diminishes, longer-dated bond yields could fall by enough to create total returns which would be sorely missed if one abandoned these traditional markets.
The question, in our view, is how much risk bond investors should tolerate to earn these returns.
Diversification could reduce volatility and boost yields
The global market for bonds is vast, multifaceted, and expanding. Today, there are numerous asset classes and strategies that could help reduce a traditional bond portfolio’s volatility, increase its yield, or do both.
Exposure to fixed-income asset classes such as Treasury Inflation-Protected Securities (TIPS) can offer protection against rising inflation, structured products such as asset-backed securities (ABS) can diversify corporate bond exposure, and floating-rate securities such as collateralised loans (CLOs) can help diminish the impact of interest rate volatility.
Meanwhile, greater exposure to international fixed income including emerging market sovereign or corporate bonds can help diversify credit risk while adding yield.
The development of alternative strategies that explicitly target either income or return may offer the most compelling combination of diversification and yield in uncertain times.
Income strategies aim to provide predictable income, typically between 1-2% above money market funds. These strategies generally take only moderate (or low) duration exposure and can thus be compelling alternatives to cash allocations or even investment-grade corporate bonds.
Because income funds are offered with a wide variety of specialisations, or focus or particular asset classes or regions, they can provide significant versatility when building a diverse bond portfolio. For example, an investor concerned about uncertainty in the US could substitute some of their US government bond exposure with an income strategy that exclusively targeted US bonds, while retaining exposure to longer-duration government bonds in Europe. Or vice versa.
Absolute return strategies generally take a more unconstrainted approach, allocating to global governments, corporates, and structured products to deliver a total return above a standard benchmark.
In principle, such an approach allows them to find more, and more efficient, opportunities to generate returns than traditional bond benchmarks or funds actively managed relative to these benchmarks. Absolute return funds are usually offered with a short or long duration target, making them suitable alternatives to cash or cash-plus allocations as well as longer duration exposures, such as government or corporate bonds.
Expecting the unexpected: Building more robust portfolios
Most years contain a surprise. Often it has a relatively minor impact on a diversified portfolio of stocks and bonds, but sometimes – as in the case of the onset of the Covid pandemic – surprises can have massive effects on even a well-diversified portfolio.
2025 is unlikely to have a surprise of that magnitude, but there are several non-consensus scenarios that are at least plausible in the coming year. Below, we consider some of them and propose diversification strategies that could help improve risk-adjusted returns should that scenario unfold.
1: Growth slows more than expected; inflation, interest rates fall
This scenario supports maintaining allocations to longer-dated government bonds which should see lower yields as economic growth, inflation, and policy rates decline. Depending on the causes of slower growth, volatility could well remain high. Diversifying into income and absolute return strategies could thus suit investors eager for yield, but less tolerant of volatility.
This scenario could also significantly lower the yield available on cash instruments, potentially impacting a wide range of investors. Since the pandemic, investment in US dollar cash (money-market) instruments has roughly doubled, to around $6 trillion. In an increasingly uncertain environment, the stability and security of cash investments has remained attractive. But if inflation remains contained, falling policy rates (particularly in the eurozone) will steadily erode the usefulness of cash as a yield-generating instruments.
The following portfolio could suit investors who currently hold traditional long-duration bond exposures and large allocations to cash. It diversifies some domestic government bond exposure into inflation-linked bonds and global bonds to help reduce interest rate volatility while still maintaining duration exposure, and diversifies money market exposure into short-duration corporate and government bonds to boost both yield and return.
- Global government and inflation-linked bond funds for exposure to falling yields while increasing diversity to reduce volatility
- Corporate bond funds to boost income
- Short duration government bond funds to generate income and return should interest rates fall.
2. Inflation rises by more than the market expects
Whether due to faster-than-expected economic growth, expanding trade tariffs, or external shocks, it is not unreasonable to think the largest risk to a bond portfolio is higher inflation.
In this scenario, bond investors are likely to face a tough year. But shifting some nominal government bond exposure to inflation-linked securities and shorter-duration assets could help.
More exposure to absolute return strategies could also help protect returns while exposure to asset classes such as emerging market local-currency bonds or private credit could help reduce volatility given their broadly lower sensitivity to changes in US Treasury yields.
Finally, structured products, especially instruments with floating-rate coupons, could provide attractive yields and help lower a portfolio’s overall volatility.
3: Geopolitical risk rises, weighing on sentiment
Geopolitical risk could rise further. The new US administration has challenged many long-held assumptions about the role of America on the global stage, raising uncertainty around a variety of active and potential conflicts.
Should concern about geopolitical stability continue to climb, concern about economic stability will likely follow. This should benefit traditional government bonds, while weighing on credit asset classes such as corporate bonds, the emerging markets, and private credit.
But volatility creates opportunities for active investors which could particularly suits absolute return strategies. Also, structured products, which generally have investment-grade credit risk and are more insulated from interest rate volatility, could provide stability and yield.
4: Consensus forecasts prove right, but volatility remains high
In this scenario, none of the above risks fully emerge. Instead, the year unfolds with concern over higher inflation, geopolitical risks, a slowdown in growth, or even a surge in growth.
In this environment – which may be the most likely scenario in 2025 – a traditional bond portfolio will likely deliver underwhelming risk-adjusted returns. Adding strategies that could improve the diversity within the portfolio (such as absolute return, private credit, and structured products) could help lower its volatility, while adding sources of additional income (such as income funds or private credit) could help raise its returns. Either should help improve risk-adjusted returns.
This global portfolio strategy could outperform a traditional bond portfolio’s risk-adjusted returns in such a scenario, given its aims to balance income and diversity to help generate compelling, and more stable, total returns.
- Global government and inflation-linked bond funds to diversify interest-rate exposure
- High-yield corporate bonds, structured products, and emerging market bonds to boost income and diversify returns
- Absolute returns funds to provide diversity and boost total return.
Highlighting the benefits of diversification
In each of these scenarios, we proposed actions to diversify portfolios and improve risk-adjusted returns for that specific scenario. But all our sample portfolios share a common theme: Reducing risk through diversification does not have to come at the expense of significantly lower expected returns.
All of today’s concerns may turn out to be temporary and 2025 may yet prove to be a simple year for bond investors. But if it is not, investors are likely to appreciate any effort made to improve the diversity of their portfolios. Considering the certainty of uncertainty, they may well continue to benefit in the years ahead.
