Investing Ideas

Why bonds now

2025 may offer a generational opportunity in fixed income.

Key Takeaways
  • A Fidelity bond manager believes the combination of relatively high current yields and lower interest rates ahead may deliver more attractive total returns for bonds in 2025.
  • That could make high-quality, low-risk investment-grade bonds an attractive alternative to cash in 2025, as well as a hedge against market volatility.
  • Bond mutual funds and exchange-traded funds (ETFs) may help investors diversify their bond exposure and target specific goals such as income or total return.

A combination of yields that are near multi-decade highs and interest rates that are expected to gradually fall through 2025 is creating an attractive opportunity for bond investors in the new year.

It’s been nearly 20 years since high-quality, low-risk investment-grade bonds could potentially deliver both attractive interest payments and more potential for capital appreciation than stocks or cash. Throw in bonds’ lower historical volatility than stocks and an increasing tendency to rise when stocks fall, and it’s easy to see why investors may want to explore this opportunity to earn reliable income, grow their portfolios, and diversify away some risk in the new year.

Michael Plage manages the Fidelity® Investment Grade Bond Fund and he believes that 2025 is likely to be a good time for skilled bond investors to take advantage of that opportunity. “The all-important starting yields are higher than they’ve been for a long time and the Federal Reserve is reducing interest rates. That’s the combination I’ve been waiting for,” he says.

The Fed factor

According to Plage, his view is that bonds will become increasingly able in 2025 to play their historical role of delivering significant income and preserving capital by rising in price when stocks fall. He believes that the Fed holds the key to the return of “normal” bond markets by both lowering interest rates and reducing the size of its balance sheet. That would mean that willing buyers and willing sellers—rather than government policies—would once again determine prices and bond markets would behave the way they have for most of history, rising when stocks fall and helping investors diversify and reduce risk in their portfolios. This dynamic is already reappearing in the US Treasury market where yields on longer-maturity bonds have been rising even as the Fed has been lowering interest rates.

Despite 2 cuts in the short-term fed funds rate and the likelihood of more to come, 10-year Treasury bonds yield more as of December 3, 2024, than they did at the beginning of the year. Instead of responding entirely to the direction of short-term interest rates which are determined by the Fed, the Treasury market now shows signs of being influenced by investors who expect a term premium, which means extra yield as compensation for owning longer-maturity bonds. Plage says this an indicator of a healthy, functioning Treasury market and expects yields will move around within a range between 3.5% and 4.5% in 2025.

Plage believes that the Fed should be able to stay on its course toward lower short-term interest rates, potentially dropping the fed funds rate as low as 3.75% by the end of 2025. "Given the size of the national debt and the need for Washington to secure the finances of Social Security and Medicare, I'm not expecting many big government ideas with big fiscal consequences so I believe the Fed will have the flexibility to potentially keep cutting rates,” he says. “With the Fed now cutting rates, the big headwind of uncertainty that previously hung over the bond market should now be a modest tailwind over the next 12 months.”

Why bother with bonds amid a bull market for stocks?

With US stocks hitting record highs, it can be easy to overlook other investment opportunities, especially ones that have delivered modest returns in recent years. To understand the opportunity in bonds in 2025, it’s important to remember where bond returns come from. A bond can deliver return to its owner from 2 sources: interest payments known as coupons whose rate is set at the time the bond is issued, and changes in the price of the bond as it trades in the market.

The interest rate of the coupon remains the same until the bond matures but the price can rise or fall throughout the trading day. Because bond prices typically rise when interest rates fall, the best way to earn a high total return from a bond or bond fund is to buy it when interest rates are high but coming down. The last time the Fed gradually cut rates over time was in 2019 and early 2020, when what was known then as the Barclay’s Aggregate Bond Index rose by nearly 15%. Of course, past performance is no guarantee of future results. But in similar periods historically, investors have been able to lock in still relatively high coupon yields and also enjoy the increase in the market value of their bonds as rates come down.

Why bonds may be better than cash in 2025

Plage believes that bonds in 2025 present a unique and appealing opportunity for investors who have been sitting in money market funds or short-term CDs to not only lock in longer-term coupon income and seek potential capital appreciation, but also to reduce risk in their portfolios. While yields on CDs and money markets rose to roughly 5% after the Fed began raising short-term interest rates in 2022, those yields are likely to continue to move lower in 2025 and to stay lower than they had been. That raises the risk that investors who need a certain level of income from their portfolios won’t get it if they stay in cash.

Investing in a bond mutual fund or ETF

Buying shares of a bond mutual fund or ETF is an easy way to add a bond position. Bond funds hold a wide range of individual bonds, which makes them an efficient way to diversify an investor's holdings even with a small investment.

An actively managed fund also gives an investor the benefits of professional research. For example, the managers can make decisions about which bonds to buy and sell based on huge volumes of information including bond prices, the credit quality of the companies and governments that issue them, how sensitive they may be to changes in interest rates, and how much interest they pay.

Not all bond funds are actively managed. Investors who seek bond exposure in a fund can also choose among exchange-traded and index funds that seek to track bond market indexes such as the Bloomberg US Aggregate Bond Index.