Head of U.S. Investment Specialists, Global Fixed Income
In Brief
- Interest rates are likely to settle at today's higher levels, providing bonds with more ability to offer income, diversification and stability in balanced portfolios.
- A positively sloped yield curve means that fixed income investors are once again compensated for moving out of cash and locking in yields.
- Active fixed income managers have the ability to capture additional yield and returns by moving beyond the constraints of the benchmark index.
Investors in 2024 were persistently concerned about the Federal Reserve (Fed) underdelivering on rate cuts, but we view the situation differently. The Fed has ushered in a healthy environment for fixed income characterized by higher interest rates.
Interest rate volatility was high in 2024, with the yield on the 10-year Treasury moving in a range of 3.60% to 4.70% and ending the year more than 70 basis points (bps) higher. Despite the volatility, fixed income delivered positive returns for the year.
Indeed, short-term investment grade credit returned 5% and the high yield bond market returned nearly 8%. Importantly, intermediate bonds have performed as a diversifier when equity markets have come under pressure. While interest rates ended the year higher, the Bloomberg U.S. Aggregate Index (U.S. Aggregate Index) finished up 1%, reflecting the cushion a higher-yield environment provides during interest rate volatility.
With the Fed likely to reach the end of its easing cycle in 2025, the bond market will settle into this higher-rate paradigm. The starting yield generally reflects forward return expectations in fixed income, suggesting that total returns for bonds are likely to be compelling going forward. In addition, a positively sloped yield curve means that fixed income investors are once again compensated for moving out of cash and locking in yields.
Current yields imply attractive forward five-year returns
Source: Bloomberg, FactSet, J.P. Morgan Asset Management. Returns are 60-month annualized total returns, measured monthly, beginning 1/31/1976. R² represents the percent of total variation in total returns that can be explained by yields at the start of each period. Guide to the Markets – U.S. Data are as of December 31, 2024.
The abundance of yield also creates a distinct opportunity for active fixed income managers that can allocate to sectors and securities outside the benchmark index to capture additional yield. With roughly 47% of the U.S. bond market excluded from the U.S. Aggregate Index, passive strategies have limited opportunities to generate income.
Importantly, a higher-rate environment means a world where bonds serve as an important allocation for diversification, income and stability. The key question for investors is, "What role do bonds serve in your portfolio?"
Diversification
During 2024 as well as year to date, we have seen bonds perform and fulfill their role as a ballast on several occasions including last August when equity markets were hit with an unforeseen shock and expectations on the economy turned sour. Today’s yield levels provide an attractive entry point and ample room for rates to move lower in a risk-off environment. At the same time, a higher starting yield of nearly 5% for the U.S. Aggregate Index provides a cushion to protect against interest rate volatility, illustrated by 2024 performance. This protection against interest rate volatility is relevant for the year ahead where we see the 10-year Treasury yield trading in a range of 3.75% to 4.75%.
The risk and return of fixed income is skewed to the upside
Source: Bloomberg, FactSet, Federal Reserve Bank of Cleveland, Standard & Poor’s, U.S. Treasury, J.P. Morgan Asset Management. Sectors shown above are provided by Bloomberg unless otherwise noted and are represented by – U.S. Aggregate; MBS: U.S. Aggregate Securitized - MBS; ABS: J.P. Morgan ABS Index; IG Corporates: U.S. Corporates; Municipals: Muni Bond; High Yield: Corporate High Yield; Leveraged Loans: J.P. Morgan Leveraged Loan Index; TIPS: Treasury Inflation-Protected Securities; Convertibles: U.S. Convertibles Composite. Convertibles yield is as of most recent month-end and is based on U.S. portion of Bloomberg Global Convertibles Index. Yield and return information based on bellwethers for Treasury securities. Yields shown for TIPS are real yields. TIPS returns consider the impact that inflation could have on returns by assuming the Cleveland Fed's 1-year inflation expectation forecasts are realized. Sector yields reflect yield-to-worst. Leveraged loan yields reflect the yield to 3Y takeout. Correlations are based on 15-years of monthly returns for all sectors. ABS returns prior to June 2012 are sourced from Bloomberg. Past performance is not indicative of future results.
Guide to the Markets – U.S. Data are as of December 31, 2024.
Income
A resilient economy has resulted in another year of strong returns for credit and income-focused strategies. For example, the high yield index has outperformed the US Aggregate Index for a fourth year in a row. We believe credit sectors will continue to perform and should be used to capture attractive yield and total return. There is a particular opportunity for managers without benchmark constraints to source the best opportunities for yield while mitigating risk by diversifying across credit sectors.
For taxable accounts, municipal bonds offer an attractive tax-equivalent yield of over 6% with the safety of a government-backed sector, while the high yield municipal market yields around 9% after tax. Municipal balance sheets are healthy with strong rainy day fund reserves, in stark contrast to the federal government.
High-income bond strategies can offer yield and total return in the high single digits, effectively delivering equity-like returns with a fraction of the risk of equity markets.
Fixed income is once again offering income across sectors
Source: Bloomberg, FactSet, J.P. Morgan Credit Research, J.P. Morgan Asset Management. Indices used are Bloomberg except for ABS, emerging market debt and leveraged loans: ABS: J.P. Morgan ABS Index; CMBS: Bloomberg Investment Grade CMBS Index; EMD (USD): J.P. Morgan EMIGLOBAL Diversified Index; EMD (LCL): J.P. Morgan GBI-EM Global Diversified Index; EM Corp.: J.P. Morgan CEMBI Broad Diversified; Leveraged Loans: JPM Leveraged Loan Index; Euro IG: Bloomberg Euro Aggregate Corporate Index; Euro HY: Bloomberg Pan-European High Yield Index. Yield-to-worst is the lowest possible yield that can be received on a bond apart from the company defaulting and considers factors like call provisions, prepayments and other features that may affect the bonds’ cash flows. *All sectors shown are yield-to-worst except for Municipals, which is based on the tax-equivalent yield-to-worst assuming a top-income tax bracket rate of 37% plus a Medicare tax rate of 3.8%. **Sectors shown may not exactly match all sectors represented in the Bloomberg U.S. Aggregate Index. Sector level weights are shown, and index constituents may not match. Guide to the Markets – U.S. Data are as of December 31, 2024.
Stability
Investors have continued to flock to cash-like instruments for yield and stability, doubling the assets under management in money market funds to nearly $7 trillion. While cash remains a viable asset class, cash rates have moved steadily lower by roughly 100bps to below 4.5% as the Fed has cut front-end rates. As short-term interest rates continue to move lower, investors can capture additional yield and total return while maintaining stability by stepping out of cash and into the front end of the yield curve.
For example, the 1–5-year investment grade credit index provides a yield of 4.9% with a duration of 2.5 years. If interest rates in the front end move lower by 100bps, the total return for the year would be just above 7%; if interest rates moved higher by 100bps, total return would be around 2%. The attractive asymmetry in the front end of the yield curve is unique to today's bond markets.
Investors can capture additional yield by stepping out of cash
Source: Bloomberg as of December 31, 2024.
From the perspective of a whole portfolio, significant gains in equities over the past five years have left many investor portfolios unbalanced. A typical 60/40 stock-bond portfolio from 2019, without rebalancing, would now be a 79/21 portfolio—meaning that the amount of risk investors are taking has increased unintentionally (based on analysis by the J.P. Morgan Asset Management Market Insights Team). A higher interest rate environment presents an opportunity for investors to bring portfolios back into balance.
Investors should strive to embrace the current bond market. As zero interest rates and negative yields are an increasingly distant memory, bonds are reclaiming their status in a diversified portfolio.