From Credit Risk to Rate Volatility: Navigating 2025’s Fixed Income Landscape

As we step into 2025, it’s pretty clear that the strategies that worked wonders in 2024 might not cut it this year. Last year, the investment scene was all about carry and spread compression. Basically, taking on more credit risk paid off big time. High yield outshone investment grade credit, and investment grade credit did better than government bonds. The riskiest credits, like CCC-rated bonds, outperformed the BB space. 

Even in emerging markets, countries like Lebanon, Argentina, and Ecuador led the pack in hard currency emerging market indices. Spreads in most risk assets ended the year super tight, delivering some of the best information ratios, thanks to low volatility. So, why did this happen, and will it continue?

Well, it boils down to strong fundamentals, supportive monetary policy, and years of fiscal stimulus, along with a huge demand for yield. That demand for yield in our opinion was the driving force as any dips in credit performance resulted in strong inflows which then delivered stronger performance with little volatility.

(Fig. 1) U.S. High Yield and Investment Grade Corporate Bond Spread and Volatility

Performance quoted represents past performance which is not a guarantee or a reliable indicator of future results.

Sources: Bloomberg Finance L.P.; analysis by T. Rowe Price. Data as of 31 January 2025IG Volatility = VIX IG, HY Volatility = VIX HY, IG OAS = Bloomberg US Agg Corporate Avg OAS, HY OAS = Bloomberg US Corporate High Yield Average OAS.

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Is 2025 looking different? Absolutely. It’s almost impossible to see a repeat of 2024’s credit performance because we haven’t started a year with spreads this tight in ages, if ever. Spread compression seems unlikely so what is left is carry and interest rate risk.

There are quite a few reasons why credit might not outperform:

1. Valuations are stretched, especially in U.S. credit. 

2. The support from monetary policy cuts is nearing an end in the U.S.

3. We cannot rely on sustained fiscal easing given global debt levels

4. Central bank puts are well out of the money as they seem comfortable with spreads widening gradually this year.

5. Investor optimism looks stretched.

When analyzing the breakdown of total yield into government yield and credit spread, its evident that credit spreads now account for a much smaller portion of total yield. With credit spreads significantly compressed, the movement of government yields will have a far greater impact on total yield, as spreads offer less of a buffer against these changes.

(Fig. 2) Changes in the Composition of Yields

Performance quoted represents past performance which is not a guarantee or a reliable indicator of future results. 
Sources: Bloomberg Finance L.P.; analysis by T. Rowe Price. Data as of December 31, 2024.

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On the flip side, the pros are fewer and mostly about technicals, though credit fundamentals are still solid. One big support for credit is the ongoing demand for yield. We think this will stick around at least through the first quarter of 2025, or until the market starts worrying about the rising risk of interest rate hikes.

The good news is that when credit spreads are tight, they usually don’t widen suddenly. History suggests they bleed out over time, unless a big, unexpected event occurs. Plus, the market seems well-hedged right now, which lowers the risk of sudden outflows to cash corporate bonds in the event of a deterioration in risk sentiment.

What’s clear is that in 2025, credit performance will depend more on which names you own rather than just how much credit risk you’re taking. That’s a big shift from last year.

This year might be when we transition into the next phase of monetary policy. As a result, managing interest rates will be just as crucial, if not more so, than managing credit risk, for income-focused strategies like Diversified Income Bond. 

The market’s focus on a “soft landing” in the US will shift as that economic phase has been all but accomplished. Now, we need to look ahead. While interest rate cuts are expected in 2025, across central banks, we expect to see a hawkish turn with rate hikes potentially getting priced in sooner than the market currently expects. On the plus side, developed market government bonds ended 2024 with much higher yields, and real yields are more appealing than they were a year ago. Put another way, we are seeing inflation-beating rates of return that were deemed a fantasy only three years ago. So, does that mean now is the time to go long on government bonds? 

(Fig. 3) U.S. and German Real Yields

Performance quoted represents past performance which is not a guarantee or a reliable indicator of future results.
Source: Bloomberg Finance L.P. ; Analysis done by T.Rowe Price. Data as of December 2024.

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(Fig. 4) Supply still heavy

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Actual outcomes may differ materially from estimates. Estimates are subject to change. Figures show gross issuance.Source: Morgan Stanley, OBR, J.P. Morgan, Bloomberg Finance L.P. Please see Additional Disclosures page for additional legal notices and disclaimers. Analysis done by T. Rowe Price. Data as of December 31, 2024.

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Monetary policy shifts, global policy divergence, and excessive government debt funding means volatility in bond markets. Credit, with its tight spreads, won’t be immune to this volatility.

We believe our Diversified Income Bond Strategy has potential to deliver attractive income and total returns while managing risk for our clients. We use multiple active levers—active sector selection, issue selection, credit risk management, currency risk management, and importantly, global interest rate risk management.

To succeed in 2025, managers need to think and act differently from the crowd. It might sound cliché, but active management is crucial. This year, we believe it will be one in which effective interest rate management will determine success. We believe this is a rare skill for unconstrained managers, but one of our core strengths here at T. Rowe Price. By leveraging our expertise and staying agile, we can navigate 2025’s complexities and focus on delivering for our clients.