Will bonds finally recover in 2025?

It’s a sad truth of investing that a ‘cheap’, unloved asset can stay that way for a long time. UK equities spent several years effectively moving sideways, while Japanese shares had decades in the doldrums. Value investing of any sort can require lots of time and lots of patience.

It’s been a similar case in recent years for bonds. A savage combination of high inflation and rising interest rates battered the asset class in 2022 but also managed to bring them back to seemingly ‘cheap’ valuations, which in turn brought out the bulls.

Yields on 10-year government bonds in both the UK and US (which move inversely to prices) breached the 1 per cent threshold in early 2022 and only continued upward from there.

This meant that bonds started to look attractive as an income investment for the first time in many years. The prospect of interest rate cuts also created room for optimism on the capital growth front. Finally, valuations have been cheap enough to add weight to the idea that the safest fixed-income instruments do well when equities fall: ie, they could once again work as a diversifier.

But fast forward to late 2024 and the big fixed income recovery is still proving elusive, for now. Yields on 10-year government bonds in both the US and the UK are higher than they were at the start of the year, amounting to around 4.2 per cent at the time of writing.

As our first chart shows, fund performance has been somewhat mixed accordingly: the average UK government bond fund had made a 1.7 per cent loss for 2024 as of 4 December, though there is some nuance to this figure (see below).

Corporate bond funds have done relatively well, with riskier high-yield bond funds posting a strong return. This dynamic is also reflected in the performance of the ‘strategic’ bond funds with the flexibility to roam across the asset class, with more high-yield-focused strategies such as Man Dynamic Income (IE000RA2ZI45) and Royal London Sterling Extra Yield Bond (IE0032571485) having good years.

The weak performance of government bonds in particular might seem surprising, given that interest rate cuts should boost their valuations. But investors have been focused on ‘risk’ assets such as equities this year in another period of rising markets, translating into less demand for defensive assets. Decent economic performance has had the same impact. On top of this, markets’ tendency to factor in future trends means that, while base rates have started to fall this year, a renewed paring back of rate cut expectations has weighed on the asset class. As part of this there’s also a new worry for bond investors in the form of prospective fiscal expansion in the UK and US.

And yet the bond investor still has reasons for optimism, in keeping with the points outlined above. Valuations are low enough, creating potential for capital gains (especially at times of equity market stress). What’s more, investors are getting paid well to hold such debt, even if the income from a bond won’t rise over time as it should do with an equity dividend.

As such, fixed income instruments remain useful, be it as part of a balanced portfolio alongside equities or as a fairly stress-free source of income. This is particularly the case when it comes to investing in UK gilts directly: those holding instruments to maturity will, absent a UK default, receive a specified level of income and often enjoy a ‘pull to par’ that provides modest capital gains, too. But opinion diverges sharply on exactly what kind of bonds to hold.

Government bonds

With interest rates falling, the case for government bonds in particular is fairly easy to make. As Axa IM Investment Institute chair Chris Iggo notes, lower interest rates are good for bonds, adding:  “The prevailing level of yields in developed bond markets provides the basis for robust income returns, which should remain above inflation.”

Julien Houdain and Lisa Hornby, fixed income heads at Schroders, add that the asset class “stands to benefit from both broader economic trends and the high starting point in yields”.

That’s a valid enough point. As noted, a benchmark government bond yield comes to more than 4 per cent, while much higher rates are available for those who go further up the risk spectrum and buy companies’ own debt. Investment platform Interactive Investor lists debt from Skipton Building Society available at a yield of nearly 13 per cent, for example. Bond funds with a focus on high yield can offer something attractive too: Man Dynamic Income, for one, lists a running yield of 7.6 per cent.

But for government bonds, the fact remains that fiscal risks loom large.

As Iggo puts it: “There are risks around longer-term interest rates coming from policy uncertainty and the profile of government debt in many countries. This has already led to a cheapening of longer-term government bonds.”

There is other evidence of this: the IA UK Gilts sector’s long-duration funds have suffered the most in 2024, with short-duration portfolios performing better. 

Iggo believes that the latter could continue to do well, be it in the government bond space or in other subsectors, such as high yield, that tend to be relatively unaffected by rate moves.

“For short and intermediate maturities, the bond market looks healthy,” he says. “We see yields as fairly valued given the interest rate outlook – so much so that investors are unlikely to experience similar duration shocks to those seen in 2022 and 2023.”

Caution ahead?

Iggo also takes a positive view on corporate debt. “On the credit side, despite spreads being tight, the additional return and the continued healthy state of corporate balance sheets underpins the attractiveness of both investment-grade and high-yield bonds. Of course, investor sentiment towards credit will be subject to the uncertain evolution of policy and geopolitical risks, but on a risk-adjusted return basis, credit is attractive,” he says.

Not everyone is quite so optimistic, however. Some have more reservations about the tightness of spreads, otherwise known as the difference in yield on offer between corporate bonds and ‘safe’ debt such as government bonds.

State Street Global Advisors notes in its 2025 outlook that “credit seems fully priced at current spreads, albeit with solid fundamentals”. That could limit the returns available, although the prospect of a US economic soft landing and a resilient global economy does seem to lessen the risk that high-yield bond issuers default on their debt.

Diversifying diversifiers

Bonds’ performance, and the yields they trade on, can have major implications for all manner of assets and portfolios. Higher yields mean the traditional 60/40 portfolio of equities and bonds once again looks viable as a simple diversification option for the cautious investor. Meanwhile, wealth preservation trusts such as Ruffer (RICA), which tend to use a mixture of the two asset classes, look to be on a steady footing.

Recent years have also provided a reminder that many ‘alternative’ asset classes ultimately have a high correlation to government bonds.

Consider the sight of infrastructure trusts being hit by rising yields. An era of structurally higher yields would likely put further pressure on this sector.

There are plenty of questions, therefore, about whether trusts like these can truly offer diversification at least. Prices arguably look compelling: the average trust in the AIC’s Infrastructure sector traded on an 18.8 per cent discount to net asset value (NAV) and a share price dividend yield of more than 6 per cent at the time of writing.

All the same, some are now keen on looking beyond bonds (and infrastructure), partly out of scepticism about the diversifying credentials of fixed income. The BlackRock Investment Institute argues in its 2025 outlook that an “erratic correlation between stock and bond returns has defined the new regime, and government bonds have become a less reliable cushion against equity sell-offs as a result”.

It adds: “We see the potential for other diversifiers, old like gold and new like bitcoin, to step in. This is not about replacing long-term bonds to find diversification but instead seeking new and distinct sources of risk and return.” The institute adds that it is key “to monitor how the performance of these alternatives changes relative to traditional asset classes – and be nimble in using them”.

There are challenges to this take. For one, investors might take a cynical view of an active manager which, eager to find new sources of revenue, needs to find exciting ‘alternative’ assets on which to charge rich fees. The suggestion that bitcoin is an uncorrelated asset also requires much more evidence. We should also note that bonds have performed their diversifier role to a degree in recent times: while they did fall in tandem with equities back in 2022, the sell-off that briefly struck US equities in July and August this year coincided with yields falling on 10-year US Treasuries.

Whatever preference they have, investors can take some solace from the fact that bonds and other conventional diversifiers (gold aside) are still looking cheap, meaning they are – in theory – spoiled for choice.