Why bonds now
2025 may offer a generational opportunity in fixed income.
- 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.
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The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-back securities (agency fixed-rate pass-throughs), asset-backed securities and collateralised mortgage-backed securities (agency and non-agency).
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In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.
High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.
Lower yields - Treasury securities typically pay less interest than other securities in exchange for lower default or credit risk.
Interest rate risk - Treasuries are susceptible to fluctuations in interest rates, with the degree of volatility increasing with the amount of time until maturity. As rates rise, prices will typically decline.
Call risk - Some Treasury securities carry call provisions that allow the bonds to be retired prior to stated maturity. This typically occurs when rates fall.
Inflation risk - With relatively low yields, income produced by Treasuries may be lower than the rate of inflation. This does not apply to TIPS, which are inflation protected.
Credit or default risk - Investors need to be aware that all bonds have the risk of default. Investors should monitor current events, as well as the ratio of national debt to gross domestic product, Treasury yields, credit ratings, and the weaknesses of the dollar for signs that default risk may be rising.
Credit and default risk - While MBS backed by GNMA carry negligible risk of default, there is some default risk for MBS issued by FHLMC and FNMA and an even higher risk of default for securities not backed by any of these agencies, although pooling mortgages helps mitigate some of that risk. Investors considering mortgage-backed securities, particularly those not backed by one of these entities, should carefully examine the characteristics of the underlying mortgage pool (e.g. terms of the mortgages, underwriting standards, etc.). Credit risk of the issuer itself may also be a factor, depending on the legal structure and entity that retains ownership of the underlying mortgages.
Interest rate risk - In general, bond prices in the secondary market rise when interest rates fall and vice versa. However, because of prepayment and extension risk , the secondary market price of a mortgage-backed security, particularly a CMO, will sometimes rise less than a typical bond when interest rates decline, but may drop more when interest rates rise. Thus, there may be greater interest rate risk with these securities than with other bonds.
Prepayment risk - This is the risk that homeowners will make higher-than-required monthly mortgage payments or pay their mortgages off altogether by refinancing, a risk that increases when interest rates are falling. As these prepayments occur, the amount of principal retained in the bond declines faster than originally projected, shortening the average life of the bond by returning principal prematurely to the bondholder. Because this usually happens when interest rates are low, the reinvestment opportunities can be less attractive. Prepayment risk can be reduced when the investment pools larger numbers of mortgages, since each mortgage prepayment would have a reduced effect on the total pool. Prepayment risk is highly likely in the case of MBS and consequently cash flows can be estimated but are subject to change. Given that, the quoted yield is also an estimate. In the case of CMOs, when prepayments occur more frequently than expected, the average life of a security is shorter than originally estimated. While some CMO tranches are specifically designed to minimize the effects of variable prepayment rates, the average life is always at best, an estimate, contingent on how closely the actual prepayment speeds of the underlying mortgage loans match the assumption.
Extension risk - This is the risk that homeowners will decide not to make prepayments on their mortgages to the extent initially expected. This usually occurs when interest rates are rising, which gives homeowners little incentive to refinance their fixed-rate mortgages. This may result in a security that locks up assets for longer than anticipated and delivers a lower than expected coupon, because the amount of principal repayment is reduced. Thus, in a period of rising market interest rates, the price declines of MBS would be accentuated due to the declining coupon.
Liquidity - Depending on the issue, the secondary market for MBS are generally liquid, with active trading by dealers and investors. Characteristics and risks of a particular security, such as the presence or lack of GSE backing, may affect its liquidity relative to other mortgage-backed securities. CMOs can be less liquid than other mortgage-backed securities due to the unique characteristics of each tranche. Before purchasing a CMO, investors should possess a high level of expertise to understand the implications of tranche-specification. In addition, investors may receive more or less than the original investment upon selling a CMO.
Investments in mortgage securities are subject to prepayment risk, which can limit the potential for gain during a declining interest rate environment and increase the potential for loss in a rising interest rate environment.
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