Time to shine: Why bonds offer compelling opportunities in 2025

Over the past year, the fixed income landscape has demonstrated resilience, with bonds returning an impressive 7% as measured by the Bloomberg AusBond Composite 0+ Yr Index in the 12 months through to the end of October. For several years, the prevailing high cash rate has led many Australian investors to maintain substantial cash reserves in the form of term deposits. While the Reserve Bank of Australia (RBA) has yet to initiate its easing cycle, expectations are building for rate cuts to commence in the first half of 2025. In anticipation of this shift, Australian banks have already begun to reduce term deposit interest rates, a development that carries significant implications for savers reliant on consistent income streams.

Consequently, there has been a marked increase in investor appetite for bonds, driven by the desire to capitalise on current attractive yields before the anticipated rate cuts take effect. This strategy not only offers the potential for capital appreciation as interest rates decline but also positions investors to benefit from a more stable income source.

Looking ahead to 2025: Yield advantage and diversification benefits

As we approach 2025, the fixed income sector continues to present compelling opportunities. Investors still have a window to capitalise on high yield levels, with the potential to realise capital gains and hedge against expected economic headwinds. The current environment of volatility and economic uncertainty is particularly conducive for active asset managers, who can navigate these challenges to uncover value.

High-quality core bond portfolios are currently yielding between 5-6%, presenting a persuasive case for investors to lock in these elevated yields. Historically, starting yields have served as a reliable predictor of returns over the subsequent three to five years, reinforcing a positive long-term outlook for fixed income. Importantly, these yields can be secured on high-quality bonds without exposing investors to excessive interest rate, credit, or liquidity risks. As the RBA embarks on its rate-cutting journey, the potential for further capital appreciation becomes increasingly attractive.

Moreover, as inflation expectations stabilise, the inverse correlation between fixed income and riskier asset classes, such as equities, is re-emerging. This restoration of the inverse relationship underscores the diversification benefits of bonds, which can serve as a crucial buffer against equity market downturns.

Navigating risks in 2025

However, Australian investors must remain vigilant regarding potential risks within the fixed income market. A particular area of concern lies within the highly levered floating-rate segments, including senior secured loans and certain private credit markets. For years, the economic backdrop boosted these sectors given we haven’t seen a major recession since 2009, with lower-quality credit performing strongly. However, we could be at a significant turning point. 

In the recent era of high interest rates, floating-rate lending has meant full pass through of restrictive policy, which has been causing distress for highly levered borrowers. As interest rates come down next year, particularly if that coincides with a period of economic weakness, then investors in floating-rate instruments could face a situation of falling yields, rising distress and default rates, along with liquidity challenges. This contrasts with higher-quality fixed-rate bonds where declining market yields drive capital appreciation for these instruments.

Given the uncertain macro backdrop in the context of credit spreads that are on the tighter end of historical ranges, we are adopting a highly selective approach to corporate bonds, focusing on high-quality investment-grade holdings that offer attractive yields without excessive credit or liquidity risks. We anticipate these investments will perform well in a slowing growth environment.

Additionally, geopolitical risks remain a significant source of global uncertainty, with potential ramifications for markets and economies. The prospect of Donald Trump’s second presidential term raises concerns over more aggressive US tariffs, which could adversely affect global growth and inflation.

High-quality segments of the bond market offer the most attractive opportunities in 2025

Investors need not expose themselves to material credit or liquidity risk to secure attractive income from the bond market in 2025. Some of the most attractive segments of the bond market right now are yielding above 5% while maintaining robust AAA or AA credit ratings.

Heavy borrowing demands from many state governments in Australia have pushed their spreads to Commonwealth government bonds to the widest levels in many years. Although this fiscal loosening has led to some deterioration in credit metrics, the semi-government bond market remains a resilient AA-rated sector. With 10-year bond spreads ranging from 75 basis points (bps) to 95 bps over Commonwealth government bonds and with yields north of 5%, this sector offers attractive real income, diversification from riskier assets, and resilient return prospects in a broad range of economic scenarios over the next year.

The AAA-rated securitisation market in Australia stands out as an appealing avenue for fixed income investors in 2025. Predominantly composed of residential mortgage-backed securities (RMBS), this sector also includes securities backed by other loans, such as autos, personal loans, and green energy loans for solar panels and batteries. Notably, Australia is poised to become the second-largest market for public securitisation outside the U.S. in 2024. This influx of supply has kept spreads elevated, even as credit spreads have tightened materially in other sectors of the bond market.

These AAA-rated, floating-rate bonds offer spreads exceeding the cash rate by 90 to 120 bps and are designed to self-liquidate as the underlying loans are repaid over a weighted average life of one to three years.

To further enhance portfolio yields, investors can explore select pockets within the Australian investment-grade corporate bond market that benefit from strong macroeconomic tailwinds and offer compelling valuations relative to comparable global markets. Notable examples include infrastructure assets, such as toll roads, airports and regulated utilities. These sectors are bolstered by strong population growth, revenues linked to inflation, and predominantly fixed cost structures. In a challenging macroeconomic environment, they are expected to demonstrate resilience, offering yields in the range of 5.5% to 6.0%.

Seize the opportunities in fixed income in 2025

Looking ahead to 2025, the bond market presents a compelling opportunity, marked by attractive yields, potential for capital appreciation, and diversification benefits that outshine riskier assets. The current climate of uncertainty and volatility favours active fixed income investors, while high-quality bonds have proven resilient through various economic cycles, including soft landings and recessions.

Reinvestment risk is real – investors sitting on cash could be missing out on the lucrative returns that bonds can offer. With interest rates remaining high and equity valuations elevated, now is the perfect time to diversify portfolios by adding core bonds.