Bond outlook: rate cuts as an opportunity in 2025

Our expectations for bonds in 2025 are positive, even given the low credit spreads. Current yields are still above average (see chart below). However, we know from the past that spreads can remain low for a long time.

On the economic front, we expect robust global growth and gradually declining inflation. Global policy rates should therefore continue to fall from their current restrictive levels. This bodes well for the bond market as a whole.

Above-average current yields

Current running yields (yield to worst) and the average yield to worst over the last 10 years (in % and in local currency)

Welcome diversification

Moreover, at current yield levels, bonds offer a real alternative to the sometimes very high valuations in the equity market. The recent turnaround in the correlation between bonds and equities also argues in favour of increasing bond exposure. The correlation has returned to negative territory and can support portfolio returns in times of stress. Our current view is that inflation will gradually decline through 2025 and that the negative correlation will persist, especially in stress scenarios. Since the year 2000 for example, negative correlation has proven to be the norm (see chart below).

Against the backdrop of the inauguration of the new US president, Donald Trump, and his unorthodox policies, volatility and thus risk premiums could rise. Historically, bonds have offered good diversification properties in a multi-asset portfolio.

Negative correlation between US equities and bonds

Correlation of price changes (90-day rolling period)

Three fixed-income asset classes to watch in 2025

In this context, bond exposure can be built up across various sub-asset classes, depending on market views and risk appetite. Within the broad bond universe, we are focusing on three sub-classes that we consider attractive in the current environment:

1. Global Aggregate: Entry opportunity extended thanks to the 'Trump trade'

Fears of inflationary fiscal and trade policies in the US have pushed global yields higher in recent weeks. In our view, this "Trump trade" could make it worthwhile for CHF investors to enter the market at current levels over the medium term. This is particularly true as the asset class also looks attractive relative to the equity market.

Admittedly, the current yield on the global aggregate, hedged in CHF, may not look particularly attractive due to high hedging costs - an investment in the domestic Swiss franc market seems more sensible at first glance. However, a direct comparison of current returns after taking into account hedging costs alone is not indicative of future performance. More important is an assessment of the global interest rate cycle. With Swiss franc yields already close to zero and central banks in the US, Europe and the UK only just starting their cycle of rate cuts, yields in these currency areas are likely to fall more sharply than in the domestic market. As a result of the duration effect, we therefore expect larger positive price movements for bonds in these markets relative to the CHF bond market. Over the course of a year, this should more than offset the hedging costs.

The structural debt problems in these regions could have a somewhat dampening effect on the extent of interest rate cuts. Nevertheless, we are convinced that cyclical factors such as weak growth and high unemployment rates could overshadow the structural factor of rising debt in the medium term.

2. Global corporates: low global spreads and potential in Europe

Spreads are currently at record lows globally, although there are significant differences between sub-segments. In Europe in particular, we see potential for credit risk in the coming months, as spreads are still significantly more attractive than in the US, for example. This applies to both investment grade and high yield bonds.

Irrespective of current spread levels, however, we believe that a strategic, long-term allocation to corporate and high-yield bonds (see next section) is likely to be central to the investment success of institutional investors such as pension funds. As the traditional benchmarks for institutional investors, such as the Swiss Bond Index and the Global Aggregate Index, are dominated by highly rated issuers, investors without an allocation to higher-yielding credit classes are missing out on a potential structural yield booster, which is further enhanced by the compounding effect.

Regional differences in corporate bond spreads

Spreads in basis points (bp)

Sources: Zürcher Kantonalbank, ICE per 11.12.2024

3. Opportunities in high yield

We expect demand for high yield bonds to remain strong in the new year. Despite very low spreads, speciality bonds such as emerging market debt, contingent convertible bonds (CoCos), corporate hybrids (subordinated corporate bonds) and high-yield bonds should remain in high demand in the new year. This is because current yields for most of these asset classes are still at above-average levels, as discussed above.

In addition, corporate hybrids, CoCos and high-yield bonds could benefit from lower interest rate sensitivity thanks to their lower duration. This may also make these assets attractive to investors who expect inflation to flare up again. In the case of corporate hybrids, the fact that many of these bonds are typically issued by very solid issuers is an additional supportive factor. Our dedicated portfolio managers for this interesting asset class are monitoring the market very closely and have recently identified a number of factors that are likely to shape the asset class over the coming year.

Conclusion: Our expectations for 2025 at a glance

• We believe that bonds should be in every portfolio at current yield levels. This is because current yields look attractive and the correlation with equities has recently turned negative again.
• Higher global interest rates offer plenty of room for interest rate compression, which should disproportionately benefit global bond portfolios hedged in CHF.
• Spread levels are low. Nevertheless, a differentiated view is important and we believe that a long-term strategic allocation to spread products could pay off.
• Short-dated high-yield bond classes such as CoCos, corporate hybrids and high yield offer attractive current yields with lower interest rate risk, in our view. This should make them less sensitive if, contrary to our expectations, inflationary pressures rise. Nevertheless, they could return in line with equities.