We believe short-dated bonds remain the sweet spot on the back of steepening yield curves and attractive yields, with divergent monetary policies creating the opportunity for alpha generation.
Throughout 2024, investors dialled back their expectations of rate cuts due to stickier-than-expected inflation and robust economic growth, particularly in the US. This drove government bond yields higher, with UK Gilts significantly underperforming US Treasuries and German Bunds, on the back of fiscal sustainability worries and inflation concerns.
Conversely, credit spreads tightened globally, with UK spreads outperforming Euro and US ones, driven by positive surprises in UK economic growth early in the year, attractive yields, resilient fundamentals, and sustained demand.
Despite rising global government bond yields, short-dated fixed-income indices posted positive performance in 2024 thanks to an attractive level of carry and as tighter credit spreads helped offset higher government bond yields.
The 2025 outlook for short-dated bonds is positive not only due to very attractive yields but also because lower interest rates should lead to lower yields at the front-end, specifically for Europe and the UK, helping the asset class to outperform cash and all-maturity bonds. This year is anticipated to be highly volatile due to the combination of divergent monetary policies, unpredictable and inflationary US policies, and political uncertainties in Europe. Exploiting market dislocations across the entire short-dated fixed-income universe will be key.
Below are three reasons why investors should be optimistic about short-dated bonds in 2025.
Short-dated bonds remain the sweet spot on the back steepening yield curves
We expect to see a strong steepening of yield curves in 2025 on the back of lower front-end yields, supported by central banks cutting interest rates, while yields at the longer-end of the curve should fall by much less or even rise as long-term pressures such as ageing population, defence spending and climate transition should lead to increased borrowing from governments. Furthermore, Trump’s upcoming inflationary policies should specifically lead to a much steeper curve in the US, also impacting the UK and Europe, with term premia increasing.
As such, we expect short-dated bonds to outperform cash and all-maturity bonds in 2025 by directly benefitting from the fall in front-end yields on the back of lower interest rates, specifically in Europe and the UK.
Central Bank policy divergence creates opportunity for alpha generation at the front-end
In 2024, the US Federal Reserve (Fed) and the European Central Bank (ECB) both cut interest rates by 100 basis points (bps), while the Bank of England (BoE) cut interest rates by only 50bps. We expect further divergence in monetary policies for 2025 in response to their respective economic challenges.
Firstly, the Fed path for 2025 remains uncertain. While investors still pencil in two cuts, one could easily envisage an environment where the Fed does not cut at all in light of the uncertainties surrounding Trump’s upcoming policies that should lead to higher US inflation through tariffs, tax cuts and immigration restrictions.
Meanwhile, we believe the ECB may have to be more dovish than current market pricing due to the potential negative impact of Trump’s tariffs, sluggish growth and political instability in France and Germany. Finally, we also believe that the market pricing for the BoE is too hawkish. A weakening labour market, anaemic growth and falling services inflation should lead the BoE to cut interest rates more aggressively, despite the mildly inflationary policies announced in the Autumn Budget.
This expected strong divergence in monetary policy in 2025 should create opportunity for alpha generation at the front-end of the market which is much more correlated to policy rates when compared to the long-end.
Credit spreads at GFC levels but yields remain elevated
Credit spreads tightened substantially in 2024 across asset classes, now reaching levels not seen since the Global Financial Crisis. Spread tightening was supported by resilient economic growth, solid fundamentals and continued demand, despite significant upheavals caused by political turmoil and heightened concerns around valuations and recession risks over the year.
While the all-in yield remains very attractive due to high government bond yields, there is a sharp asymmetric risk for credit spreads, as we believe there is limited upside for further tightening, while we could easily see a move wider given current tight valuations, an uncertain outlook for the Fed and very fickle market sentiment that could exacerbate moves in the event of a negative surprise in the US around tariffs, inflation, growth or the labour market.
This is why we remain conservatively positioned while looking to be nimble to benefit from pockets of dislocation between valuations and fundamentals, such as in the UK water sector.
