Bonds Commentary
Bonds: Diversification Key As Interest Rate Volatility Likely To Persist
January 2025
The 10-year Treasury yield continued to rise early in early January as trade/tariff rhetoric, U.S. government deficit and spending concerns, and additional signs of sticky inflation joined forces to put downward pressure on prices of higher quality, longer duration bonds. We believe the 10-year U.S. Treasury, specifically, is in the process of carving out a new trading range with a floor of support likely in the 4.40%/4.45% area, but with the upper end of the new range still to be determined and the topic of debate at the start of the year. At the time of this writing, the 10-year yield hovered around 4.75%, a level that provided resistance back in April of 2024 and proved to be the high for the year. But that was before immigration and trade uncertainty, as well as concerns surrounding the U.S. government’s budget deficit took center stage and entered the equation for investors, so a break above that level and potential test of the 5% level could be in the cards this time around.
After the back-up in yields over the balance of 2024 and into the new year, long-dated Treasuries now more appropriately or adequately compensate investors for taking interest rate risk. However, investors still face a dilemma regarding when and to what degree to extend portfolio duration given a lack of clarity surrounding immigration and trade policies and, in turn, inflation over the coming quarters. With the 10-year yield again running up into last year’s resistance, we would expect those seeking to lock-in these higher yields for longer to begin shifting capital farther out on the Treasury curve as yields creep higher and approach the October 2023 intra-day high yield of 5%.
In this environment, diversification across maturity buckets, segments of the fixed income market, and geographies will likely be rewarded, as attempting to call a top in yields and going all-in at that juncture is ill advised. Treasuries, both short and longer-dated issues, can play a valuable role, as can exposure to asset- and mortgage-backed securities along with investment grade and high yield corporate bonds, all of which should perform relatively well assuming the U.S. economy remains resilient. Abroad, for the first time in at least a half-decade, we are looking for opportunities to increase exposure to developed market sovereign bonds as total return can be attractive on a currency-hedged basis should the U.S. dollar remain strong in the coming year(s).
Credit Risk Still Preferable To Interest Rate Risk – For Now. Credit spreads on high yield corporate bonds widened and bonds cheapened over the back-half of December as portfolio rebalancing pulled capital out of riskier segments of the fixed income market that had outperformed over the balance of the year as a general risk-off tone took hold. However, high yield corporate bonds have fared well on both an absolute and relative basis to kick off the new year, recovering approximately half of what the Bloomberg U.S. Corporate High Yield Index lost in December as investors jumped at the chance to clip a 7.5% coupon after a pre-Christmas pullback.
The shorter duration profile of the High Yield Index has also provided a tailwind for the asset class as investors remain more comfortable taking credit risk than interest rate risk amid continued signs of sticky inflation. Undoubtedly, the upgrade cycle experienced in 2024 has increased conviction in the sub-asset class, as upgrades outpaced downgrades 2.5 to 1 over the course of the year but leaves the index weaker to start 2025. And with changes to immigration and trade policy likely in the coming months, and at least to some degree potentially additive to inflation, investors may demand higher yields to compensate them for moving into longer duration Treasuries and investment-grade corporate bonds. As investors grow more comfortable with policy shifts and the inflation outlook in the coming quarters, at some point it will likely be appropriate to extend portfolio duration to lock in higher yields farther out on the curve. However, we would be in no rush to do so as catalysts capable of forcing yields substantially lower and boosting total return for investors in higher quality bonds over the near-to-intermediate term are absent, in our view.
As of January 16, 2025
