State Street's Michael Arone expects interest-rate volatility to remain elevated next year, as investors watch Fed rate path and Trump policies
The bond market risks remaining volatile in 2025, despite the burst of investor optimism about the economy following the U.S. presidential election.
Uncertainty about monetary and fiscal policies in the U.S. is fueling interest-rate volatility, including for the yield on the 10-year Treasury note, Michael Arone, chief investment strategist at State Street Global Advisors, said in a phone interview. "We expect interest-rate volatility to remain high next year," he said, adding: "I still like credit and high-yield in particular."
High-yield bonds - a type of risky corporate credit known as "junk" because it is rated below investment grade - have widely beat the broader U.S. fixed-income market so far this year. In February, when many investors worried about a potential recession hurting riskier assets, Arone told MarketWatch that high-yield bonds might deliver "surprise" outperformance in 2024, saying the economy might manage a soft landing despite the Federal Reserve's aggressive rate hikes.
"The soft landing has happened," Arone said. He pointed to inflation trending down, after the Fed battled it with a series of rate increases that investors feared would tip the U.S. into recession. Now, "the economy is growing at a slower rate than it was a year ago, but it's not expected to be in recession," he said. The labor market and companies are in "good shape."
Yet bond-market volatility remains elevated, with investors facing rate uncertainty as they question how fiscal policies under the incoming Trump administration may influence the Fed's recently started rate-cutting cycle. Investors risk getting burned by potential spikes in rate volatility, particularly with inflation remaining above the Fed's 2% target despite easing substantially.
The ICE BofAML MOVE Index, a gauge of volatility in the bond market, has dropped almost 28% this year through Dec. 12 to 82.66, according to FactSet data. That's still far above levels seen in late 2020, when the Fed lowered its benchmark rate to near zero after the COVID-19 crisis roiled markets in March of that year.
Bond volatility climbed as inflation surged during the pandemic. That prompted the Fed to embark on an aggressive campaign of raising rates in a bid to bring inflation under control.
"The shift away from 0% interest rates" and the Fed's "data dependency" when setting monetary policy imply "we have reached a new normal for volatility," AllSpring Global Investments said in a presentation during a media briefing in New York on Dec. 10 on its 2025 outlook.
"We do not expect a return to post-GFC conditions," the firm said in the presentation, referring to the ultralow rates seen for several years after the 2008 global financial crisis.
'Right path right now'
Investors will be watching closely in 2025 for details on trade and immigration policies under President-elect Donald Trump, amid concern that the potential for more aggressive tariffs and mass deportations risks being inflationary.
"We're on the right path right now" in terms of inflation's trajectory, said Mitchell Garfin, co-head of leveraged finance at BlackRock, in a phone interview. The market backdrop is currently "constructive for investing in risk assets."
Should inflation pressures push up rates in the bond market, hurting prices of fixed-income assets, junk bonds may fare better than longer-duration securities in a still-expanding economy, according to Arone. That's because junk bonds have "a yield advantage," providing some cushion on a total return basis should a rise in rates erode the value of bonds, he said.
Exchange-traded funds that hold high-yield bonds have seen strong total returns this year.
The SPDR Bloomberg High Yield Bond ETF JNK has returned a total 8.2% in 2024 through Friday, while the iShares iBoxx $ High Yield Corporate Bond ETF HYG has gained a total 8.4% over the same period, according to FactSet data.
Those gains over the same stretch trounced the 2% total return for the iShares Core U.S. Aggregate Bond ETFAGG, which tracks a broad index of investment-grade fixed income, and the total 2.8% return for the iShares Core Total USD Bond Market ETF IUSB, which provides exposure to investment-grade as well as high-yield debt.
"High-yield had a very good year," said Garfin, who co-runs the actively managed iShares High Yield Active ETF BRHY alongside BlackRock's leveraged-finance co-head David Delbos. The U.S. high-yield market is in fundamentally "strong" shape, Garfin said, adding that some of the sector's riskiest borrowers have moved into the leveraged-loan and private-credit markets.
Duration risk
High-yield bonds have benefited from their relatively shorter duration, according to Arone.
Duration, a measure of their sensitivity to changes in interest rate that relates to their maturities, is about twice as much for the Bloomberg U.S. Aggregate Bond Index, known as the "Agg," as for the high-yield benchmark, he said.
The iShares Core U.S. Aggregate Bond ETF, which is benchmarked against the Bloomberg U.S. Aggregate Bond Index, had an effective duration of almost six years as recently as Dec. 12, according to data on BlackRock's website. That's compared with slightly more than three years for the portfolio of the iShares iBoxx $ High Yield Corporate Bond ETF as of the same date.
Among longer-duration bonds, the 10-year Treasury yield BX:TMUBMUSD10Y has seen some swings this year, remaining up year to date. Bond yields and prices move in opposite directions.
Meanwhile, the iShares 20+ Year Treasury bond ETF TLT has lost 5.5% on a total return basis this year through Friday, FactSet data show.
High-yield 'Chicken Littles'
The so-called spreads for junk bonds, or the extra yield over comparable Treasurys that investors demand for holding them, have narrowed to historically low levels.
Although stock and bond investors may view that as a positive sign for the U.S. economy and the outlook for corporate earnings, tight spreads have also raised a sense of caution.
U.S. high-yield bonds don't currently have a large amount of cushion before a potential widening in spreads risks wiping out the compensation that investors receive for the risk of holding them, according to Collin Martin, director of fixed-income strategy at Charles Schwab.
"We're a little bit cautious there," Martin said by phone. He said he prefers investment-grade bonds, cautioning about the potential for slower-than-expected growth as well as the possibility that markets may be "a bit too complacent" as risks pile up globally.
Read: Corporate bond spreads hit a record low last week - and may be an early sign of a bubble
Credit spreads tend to increase in a recession or in times of market tumult, hurting returns. Borrowers with below-investment-grade ratings are riskier, as their heavier debt loads make them more vulnerable to default in an economic downturn.
"Spreads are tight but it is not unusual for them to stay tight for long periods," Janus Henderson Investors said in a note on its 2025 outlook for high-yield bonds. "Spreads spike higher during a crisis and take some time to retreat while staying low during a period of economic stability."
Although investors have plenty of risks to monitor globally beyond fiscal and monetary policies in the U.S., the outlook for credit in 2025 is "constructive," according to Arone. He said both the U.S. economy and corporate earnings are expected to grow, while default rates are low and the all-in yield on junk bonds remains relatively high.
Eventually "the high-yield Chicken Littles will be proven right," he said. "I just don't think that will be in the next 12 months."
Arone said that he also likes floating-rate leveraged loans, a form of risky corporate credit that, like junk bonds, is below investment grade but provides a slightly higher yield.
"The big risk here is that we're somehow wrong about the economy," he said. "If the economy is somehow in worse shape than we anticipate, then credit spreads will widen and that will be negative to credit."
-Christine Idzelis
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