Fixed income to benefit from broader economic trends

By Julien Houdain, Head of Global Unconstrained Fixed Income, and Lisa Hornby, Head of US Fixed Income, at Schroders

The changes implemented by the incoming US administration will clearly have a major impact on markets, but it is also important to note that fiscal plans in Europe, UK, and China will play a big part in shaping the overall economic cycle and the strategies of central banks. These factors will likely create a favorable environment for fixed income, which stands to benefit from both broader economic trends and the high starting point in yields. 

Fixed income now earns its place in portfolios not only for its attractive income potential but also due to its scope for capital appreciation and its ability to serve as a diversifying asset relative to more cyclical segments of the market.

US : valuations in bonds have improved

First, let’s pause and take a look at the US economy going into this year’s Presidential election. Growth was strong, inflation was improving (i.e. falling), and the labour market was close to balanced. The economy was back to equilibrium, and the much-discussed soft landing, a scenario where economic growth slows but does not contract and inflation pressures ease, was being delivered. The key question for 2025 is: can that momentum be maintained?

There’s a high level of uncertainty about policy as we approach 2025. The key issues on the US political agenda, including stricter immigration controls, more relaxed fiscal policy, fewer regulations on businesses, and tariffs on international goods, suggest a growing risk.

These factors may halt any improvement in the core inflation figures and could cause the US Federal Reserve (Fed) to cease easing monetary policy earlier than expected. In other words, we see a no-landing risk rising, a scenario in which inflation remains sticky and interest rates may be required to be kept higher for longer, though it’s not our base case.

The likely impact of Trump’s administration on economic growth is less clear cut. Firstly, as mentioned, growth was already very good. Even though it has the potential to get better, it is worth remembering that we’re starting from a high base already. Measures such as reducing regulation and enhancing fiscal impact can foster growth. These measures include making smarter investments in key areas like infrastructure, education, and healthcare to stimulate economic growth, create jobs, and ensure that public funds yield the best possible benefits for citizens. However, stricter immigration policies resulting in fewer available workers or significant disturbances to global trade due to higher tariffs could harm growth instead. The pace, scale and sequencing of these different policies will play a critical role in steering the direction of the markets.

Though the potential growth and inflationary impetus of policies of the US government have led us to increase our no-landing risks, valuations in bonds have improved to offer more cushion against these. We’re likely to start the year with 10-year US Treasury nominal yields above 4%, and real yields (net of inflation) above 2%, an attractive level of income we haven’t seen since the 2008 financial crisis.

Moreover, with policy rates also coming down, the negative carry (where the yield on the bond is below the funding cost of owning that bond position), that has been such a headwind to bond ownership over the past few years has disappeared for all but the shortest maturities.

Furthermore, at lower inflation levels, the diversification benefit of bonds increases, providing a more efficient hedge against weakness in cyclical assets. Bonds also look cheap versus alternative assets, with current yields higher than that of the expected earnings yield on the S&P500.

With these dynamics, bonds can serve a dual purpose in a portfolio: they can provide a source of income and build resilience in a diversified portfolio.

Industrial cycles weakness in China and Europe

In other parts of the world, the worsening trade environment will amplify existing weakness in the industrial cycles in both China and Europe. We believe more policy support is needed to offset this, particularly if we see further signs of slowdown within the service sector. The less fiscal policy does, the more monetary support will be needed.

Thus far the policy response has been muted in both regions, but the upcoming German general election could be a change for a significant reassessment of the role of fiscal policy in Europe. It remains to be seen which path will be chosen.

At the same time, the UK has seen its fair share of change when it comes to government policy. We believe market valuations largely reflect the impact on inflation with rate cut bets being scaled back significantly recently. This repricing makes gilts attractive, despite the macro landscape remaining volatile.

This disparity in fiscal paths creates relative value opportunities in bonds, currencies and asset allocation. Being flexible and active in how we manage these investments will be key in seizing the excess returns these opportunities afford.

Cautious on credit, but finding value in securitized assets

A starting point of reasonable valuations, strong growth and central bank easing has made a happy cocktail in 2024 for cyclical assets, such as corporate bonds. Returns have been good, especially in higher-yielding areas.

In 2024, we’ve seen credit spreads—essentially the difference in yield between safe investments and those with higher risk—narrowing. Many segments of the market, including US investment grade and high yield corporates, now trade at narrower spreads than at any time since the pandemic. This trend suggests that investors are becoming more confident and willing to invest in higher-risk assets. This rally in spreads has been driven by a combination of robust economic growth, strong fixed income demand and expectations for the continuation of a supportive macroeconomic backdrop.

We expect credit fundamentals to remain robust in 2025. This, combined with elevated all-in yields and steeper yield curves (yields curve steepens when the difference between long-term and short-term interest rates is widening) should continue to attract inflows into credit.

Across the various industry sectors, we prefer banks as their valuations, in our view, have been more compelling than industrials, capital positions remain strong and steeper yield curves should improve bank net interest margins. 

Better opportunities exist in securitized assets such as agency mortgage-backed securities. Agency mortgage-backed securities are issued by government-sponsored enterprises and are backed by a pool of mortgages. Lastly, we favour embedding a degree of liquidity. With valuations in most credit sectors at the tighter end of history and policy uncertainty quite high, it is very likely that periods of volatility will provide a good opportunity to deploy capital at less expensive levels. We are embedding that liquidity in various ways, such as through short-dated, high-quality asset backed securities, short-dated corporates, and US Treasury securities.

Further reading

• Outlook 2025 for global and emerging market fixed income, by Julien Houdain (Head of Global Unconstrained Fixed Income), Lisa Hornby (Head of US Multi-Sector Fixed Income) and Abdallah Guezour (Head of Emerging Market Debt and Commodities) at Schroders.
• Schroders’ Outlook 2025 website : with in-depth articles about the outlook for equities, fixed income and private markets.