What’s ahead for the credit markets in 2025? Which sectors are likely to perform best? What are the risks?
By Tim Crawmer, global credit strategist at Payden & Rygel
Main Points
- Central banks are going to be able to navigate a soft landing, and in that environment, we expect strong economic conditions, robust employment, and declining inflation.
- We expect 2025 to be a good year for fixed income, following two strong years in 2023 and 2024. If our soft-landing forecast holds up, we believe investors will be rewarded. We expect all-in returns on investment grade assets in the 5% area.
- We continue to overweight quality and liquidity. Spreads have narrowed to the point where you’re not getting paid to take on the risk of lower-rated or less liquid bonds.
The main risk to fixed income markets is inflation returning
Acceleration of inflation is the obvious risk out there, but that’s not our base case. We see inflation coming down. A lot of the noise out there around inflation is just the bumpiness that’s natural with inflation as it comes down or goes up. There’s going to be big lag effects on inflation because there are some parts of the contributors to inflation that take a lot longer to work themselves out, for example, the housing market.
If we’re wrong regarding inflation, one of the causes could be a Trump administration with control of Congress that starts passing an inflationary agenda like tariffs, lower taxes, curbs on immigration, higher fiscal deficits. We expect the ultimate Republican agenda to be less inflationary than feared by the markets. However, if the agenda does come to fruition in a manner that’s a lot more inflationary than what we’re expecting, the result could be a reacceleration of inflation that would be problematic for fixed income markets.
Quality and liquidity remain attractive
We’re still positioning ourselves with an overweight to credit across all strategies. We believe that central banks are going to be able to navigate a soft landing. In that soft landing environment, we expect strong economic conditions, robust employment, and declining inflation. That’s good for credit across the board.
Even though we have an optimistic outlook for the economy and the soft landing, you’re just not getting compensated to go down in quality and down in liquidity. There has been a big compression trade where less liquid credits have all outperformed their higher quality and more liquid counterparts. At this point you would be sticking your neck out to reach for those types of credits and exposing your portfolio to outsized risk versus the potential benefit of excess returns. We’d rather carry our overweight to credit via safer, higher quality parts of the market that would have less downside if something unforeseen happens.
Value in regional bank debt
In investment grade, corporate fixed income, the new administration will benefit banks. Less regulation on the banks allows them to be more profitable. Also, the banks will benefit from a stronger economy and lower corporate taxes will benefit the smaller cap and more regional businesses.
The specific banks that would benefit from that would be those regional banks that operate more in a geographically concentrated area, like the Midwest, or have a focus on middle market businesses. They are trading cheap versus other banks out there and should benefit from a Trump administration and a Republican Congress and Senate.
Outside of that, there has been a lot of compression between the sectors. There isn’t a lot of
low hanging fruit where one sector is trading significantly cheaper to the others. That means that when you pick your sectors, you must be more cognizant of what the downside could be than the upside. You want to be wary of cyclical or historically more risky corporate sectors. For example, in communications/media areas, where there is a lot of potential for merger and acquisition, sponsor, and private equity activity that could cause spread widening. Those are the areas where you could see some spikes in volatility and some downside.
Issuance will be steady, but M&A activity may surge
We think it’s going to be a standard year for issuance, close to in line with this year. Most of it’s going to be refinancing activity as issuers just continue to refinance any near-term maturities. That said, there is the possibility of more merger and acquisition activity that could drive issuance up with the Trump administration, which is likely to be more lenient in regard to approving M&A than what we’ve seen under the Biden administration.
Municipal bonds still attractive, especially in high tax states
Muni bonds will be a relatively safe place. Munis fall into the higher quality part of the market that we like. However, the sector has compressed, so there’s not a lot of free money to be made in municipals. Lower taxes could steer some money away from Munis. But overall, they should hold up well, especially in high tax states.