An opportune time for bonds

Editor's note: This story appeared in the February 10 InvestmentNews magazine.

This year is shaping up to be a good time to be a bond investor – and it is almost unquestionably great for active fixed-income managers.

Largely, worries about volatility and continuing inflation have been pushing up fixed-income fund sales, and rates are much better than they were five or 10 years ago. Last year, even amid outstanding stock-market performance, bond mutual funds and ETFs were in high demand – taxable bond funds outsold the next-fastest-selling category, US equity funds, by nearly three-to-one. Taxable bond funds raked in $482 billion in 2024, more than double what they sold in 2023, largely driven by a resurgence in actively managed funds – a category that bled nearly $400 billion in 2022, data from Morningstar show.

“High quality fixed income is now outyielding cash – plus, you get some of that downside protection,” said Greg Wilensky, head of US fixed income at Janus Henderson.

Going into 2025, the economy is strong, and inflation has returned to historically normal rates. But there is so much uncertainty with the new Republican administration, given the president’s objectives for taxes, tariffs, and immigration, that fixed income as a category may look increasingly appealing to investors.

Inflation in question

While any president has little power over the rate of inflation compared with that of the Federal Reserve, some of the administration’s policies are expected to at least put upward pressure on prices.

“Inflation could be around for a while,” said Paul Olmsted, senior manager research analyst for fixed income at Morningstar Research Services. “That will mean higher yields for longer. The theme that I would think is coming into 2025 … [is] yields are high across the board.”

Unless Congress approves massive cuts in spending, an extension of the Tax Cuts and Jobs Act provisions – or an expansion of tax cuts – stands to increase the national deficit, which is inflationary, observers said. And tariffs, which have been proposed to cover the costs of tax cuts, can simply increase the prices of goods. Further, the expansive deportations of immigrants that appear to already be underway will take away workers in the US and cause a supply shortage.

“Reducing labor supply would be inflationary from a wage perspective, but these folks are also consuming,” Wilensky said. Effects could be seen in food and housing, where immigrant labor is critical to production. However, the net effect in housing could be a reduction in inflation because of the outsize role of a drop in demand, Wilensky said.

Separately, the White House late last month abruptly halted federal aid, including disbursements for Medicaid, and how that ultimately plays out – likely in the courts – could affect spending and the deficit.

For 2025, the market seems to be pricing in two cuts by the Fed.

“That’s not much. It’s certainly far fewer than what we thought it would be coming into the year. Short rates will stay high. Inflationary pressure will also keep long-term rates relatively high,” Olmsted said. Additionally, fundamentals are largely strong on the corporate side, both high-yield and bank-owned, he noted. On the consumer credit side, despite some deterioration in asset-backed securities, bond managers have been conservative in what they’ve been buying, he said. It helps that housing prices have stabilized, he noted.

Opportunities ahead

“We’re now at a point where there are fewer than two cuts priced in for 2025. We now think the market has swung back to the point where we are comfortable having more interest rate risk in our portfolio,” Wilensky said. “[Expecting] two cuts is being too conservative at this point. There is room for rates to rally more…. If we’re wrong, we still have a soft landing as our base case.”

And there are some indications that inflation could remain low this year, at least based on Consumer Price Index data, State Street chief investment strategist Michael Arone wrote in a recent paper. Part of that is due to figures from the first quarter of 2024, when inflation was higher than expected, falling off of the year-over-year data quickly, Arone wrote. Additionally, owners’ equivalent rent, a major piece of the CPI data, has started cooling, he said.

“Inflation could come in lower than expected in 2025, giving the Fed greater wiggle room to cut rates more than anticipated. At 4.25 to 4.5 percent, the target range for the federal funds rate remains sizably above the Fed’s preferred measure of inflation, providing it ample room to cut rates further,” he wrote. “If the Fed’s end game is to have a real policy rate about 100 basis points above inflation, it could easily cut rates three times and by 75 bps in 2025.”

And amid uncertainty at home and abroad politically and economically, there is a higher-than-normal chance of amplified volatility, Wilensky said.

“We actually like that,” he said, noting that markets will overreact to data points, ranging from information from the Fed to social media. “That creates good opportunities for active fixed-income managers.”

Maintaining some liquidity may be wise for some investors, allowing them to take advantage of opportunities as they arise, he said. With assets in money market funds sitting at nearly $7 trillion, there is a lot of money on the sidelines, he said.

Even as spreads are tight by historical standards and valuations are unattractive, fundamentals and technical are very positive, he said.

“Most investors are not buying spreads. They’re buying yields,” he said.

Janus Henderson has prioritized higher-quality securitized bonds, and that focus on higher credit quality has now extended to corporates, with yields being higher than with Treasuries, he said. Having shorter average maturity can also be beneficial if spreads widen, with it being easier to roll into new paper, he said.

A promising path for fixed-income investors, regardless, is to stay invested and diversified and avoid attempting to outsmart the market, Olmsted said.

“Anytime you own one type of security, you do have some concentration risk,” he said. “Stay diversified, and certainly you improve your chances of [weathering] anything bad happening out there.”