Finding income in high yield bonds, bank loans, and emerging markets

Despite the U.S. Federal Reserve starting its monetary easing cycle in September, yields could move higher if the central bank does not cut as deeply as markets expect. High yield bonds and bank loans remain the two fixed income sectors with the most potential to generate meaningful income in 2025, while emerging market bonds also present solid income opportunities.

Expect modestly wider credit spreads

We anticipate continued volatility in the wake of the U.S. presidential election, leading credit spreads¹ to widen from the unusually narrow levels experienced through most of 2024. As a result, all‑in yields in sectors with credit risk would remain attractive even if high‑quality government bond yields decrease as the Fed and other global central banks cut rates.

However, I do not foresee a global recession in the next 12 months, so the spread widening should be relatively modest as rate cuts and lower energy prices continue to support the consumer and economic growth. Credit spreads could tighten again in 2025 as the uncertainty clears and investors become confident in the economy’s health.

Bank loans and high yield bonds are best positioned for income

The non‑investment‑grade sectors—high yield bonds and bank loans—are best positioned to generate income in 2025, in our view. With their floating coupons, we expect loans to perform better than high yield bonds if the Fed easing cycle is shallower than expected and yields increase. Loans are higher in the capital structure than bonds, making them more stable (although they are also less liquid). The bank loan sector also has less exposure to volatile energy prices than non‑investment‑grade bonds.

“...high yield bonds and bank loans...are best positioned to generate income in 2025, in our view.”

High yield bonds should also produce attractive income, but thorough credit analysis and selection is even more critical. If short‑term interest rates decrease, creating steeper yield curves, non‑investment‑grade bonds could actually generate more income than floating rate loans.

Corporate bonds with the lowest credit ratings in the investment‑grade universe (BBB on the S&P Global Ratings scale) could also produce healthy incomes as a result of their high credit spreads relative to other investment‑grade issues.

Emerging market bonds to benefit from favorable growth

Casting a wider net, emerging market corporate and sovereign bonds should benefit from a favorable growth environment in developing countries, where many central banks are well into their rate‑cutting cycle. Emerging markets are well positioned to generate higher growth than developed European markets, for example. The credit quality of emerging market corporate bonds has steadily moved higher over the past several years.

Global growth could surprise on the upside. In this scenario, markets would likely price in rate hikes to battle inflation, resulting in a steeper yield curve as intermediate‑ and longer‑term yields move higher. The risk of an inflation resurgence is high enough to consider including a small allocation to inflation‑adjusted bonds such as Treasury inflation protected securities in a diversified portfolio.

Key takeaway
Non‑investment‑grade sectors and emerging market bonds offer attractive yield opportunities even if government bond yields decrease.