2025 Bond market outlook: Four sectors to watch

As inflation softens in 2025, and a robust jobs report recalibrates market expectations regarding future Federal Reserve interest rate moves, the fixed income market presents challenges and opportunities. Here are four bond sectors investors should consider for their portfolios.

Fixed income investments or bonds are loans that investors make to corporations or governments, which in return, pay back with interest. These are typically considered lower risk compared to stocks and are a fundamental part of a diversified investment portfolio. Common types of bonds include U.S. Treasuries, municipal bonds, and corporate bonds.

Several economic indicators could play a crucial role in shaping your fixed income strategy.

• The Consumer Price Index (CPI) and Producer Price Index (PPI) provide insights into inflation trends, which directly affect bond yields and prices.
• Central bank meetings, like those of the Federal Reserve and the European Central Bank, are pivotal as their policies influence interest rates and economic growth.

2025 has kicked off with significant movement in the fixed income market.

Central banks around the globe have maintained a cautious stance, including in the US where interest rates have stayed ‘higher for longer’. As a result:

• The 10-year US Treasury yield has escalated to 4.76%, a peak since November 2023.
• While the 30-year yield has surpassed the 5.00% threshold for the first time in over a year.

This increase in yields suggests a higher return on new bond investments but also indicates potential continued inflation concerns.

1. U.S. Treasuries

Despite the recent yield spike, there remains a strong case for maintaining an overweight position in U.S. Treasuries within taxable fixed income portfolios.

A neutral-duration positioning - where investors avoid drastically extending or shortening the average maturity of their bond investments - could help given the market’s anticipation of stable, yet elevated, interest rates.

The market's pricing of fewer rate cuts in 2025, and the absence of catalysts that could retract yields, suggests a higher-for-longer yield scenario, providing decent returns without excessive risk. This could offer attractive entry points, especially if upcoming inflation reports align with or fall below expectations.

2. Agency Mortgage-Backed Securities and TIPS

TIPS, which are designed to protect against inflation, currently appear less attractive due to higher interest rates and stable economic conditions, which diminish their appeal. For example:

• Inflation expectations have slightly increased, with consumer expectations at 3.3%. However, the progress towards reducing inflation has stalled, with key measures hovering around 3%.
• And the real yields (interest rates adjusted for inflation) on TIPS have recently increased, making them less appealing for capital appreciation. For instance, 10-year real yields rose from 1.5% in September 2024 to 2.34% as of January 2025.

On the other hand, agency mortgage-backed securities (MBS) might offer modest excess returns and a more balanced risk-reward profile, especially if rate volatility continues to decline. Their valuation when compared to other core fixed income assets like U.S. Treasuries and Investment Grade (IG) corporates appears fair. Keep in mind that:

• Agency MBS have recently benefited from a decrease in securitization rates and an increase in mortgages retained by banks, which is expected to lower future capital costs.
• And they have shown resilience in performance amidst rising Treasury yields despite high mortgage rates and a softening of agency MBS demand as a result of more all-cash home purchases,

As always, it's important to align investment choices with personal financial goals and market conditions.

3. Investment grade Corporate Bonds

Investment grade corporates appear moderately attractive due to their higher yields despite tight credit spreads. The sector is buoyed by a healthy macro backdrop, stable credit fundamentals, and robust demand. However, the potential for significant spread tightening appears limited, suggesting that total returns may primarily stem from yield pick-ups.

4. Municipal Bonds

Municipal bonds continue to be a viable option for tax-advantaged income, particularly in a stable economic environment with low unemployment and solid consumer activity. However, investors might face increased issuance and budgetary pressures as federal aid wanes. The sector could provide tactical opportunities for adding exposure during periods of seasonal supply increases.

The current environment favors a cautious yet responsive strategy, ready to capitalize on tactical shifts in the fixed income market prompted by economic data releases and central bank guidance.

In 2025, investors can effectively navigate the challenges and opportunities that the fixed income markets present with prudent strategies like:

• Maintain a balanced approach weighing duration risks against the potential for reinvestment across different maturities
• Keep a keen eye on economic indicators and central bank policies.
• Diversify your portfolio across different types of asset classes can reduce risk and help protect your investments from unforeseen downturns.

Stay informed. For a weekly recap of the markets and thoughts on the week ahead, visit our weekly Market Dashboard.

The source of this article, ‘2025 Fixed Income Outlook: Core Sectors’ was originally published by the Morgan Stanley Wealth Management Global Investment Office on January 14, 2025.

CRC# 4200098  2/2025