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As the credit market continues to evolve, successful investors will need to be nimble to navigate bond sectors
A year of opportunity amid uncertainty?
Portfolios must be strategically positioned to benefit from lower interest rates, while also safeguarding against potential economic and credit risks. A key challenge will be effectively managing the increased dispersion within the bond market
Two things differentiate Columbia Threadneedle from our investment grade competitors: a bottom-up approach to constructing portfolios, and a real focus on downside risk management
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Over the next 10 years the US dollar will likely surrender another 10% share of global foreign exchange reserves – but there will be no single beneficiary, with 10 different currencies all growing their allocations
FX reserves and the 10-10-10 proposition
Geopolitics will dominate the investment landscape, with increased tariff and sanction regimes affecting trade. As a result of this, market volatility will argue for nimble active portfolio management as the best way to navigate potential headwinds
Economic nationalism will present a constant challenge for investors
With inflation cooling and the US Federal Reserve transitioning from rate hikes to a cycle of rate cuts, bonds are poised to perform well in 2025. We believe success in the coming year will depend on how well portfolios are positioned to take advantage of lower rates while protecting against potential economic and credit volatility. In our view, the key theme in 2025 will be how investors successfully navigate greater dispersion across bond sectors.
Gene Tannuzzo Global Head of Fixed Income
“We believe the rate-cutting cycle should create a favorable environment for high-quality bonds in the US, particularly mortgage-backed securities and municipal bonds”
As we assess valuations, it appears the market is not yet fully pricing in the potential for significant credit weakness across the globe. Therefore, we think a cautious approach to credit is warranted. In addition, we expect credit dispersion will increase in 2025. While high-quality bonds are likely to perform well, certain industries are expected to experience elevated default rates – potentially in excess of 10% in certain sectors over the next two years, while others may remain closer to 1%. This divergence stems from the differing balance sheet health across industries, with highly leveraged companies – particularly in the high yield space – facing greater challenges. As economic volatility potentially rises, these weaker companies are more vulnerable to credit deterioration. This disparity creates an environment where active credit selection – our core strength at Columbia Threadneedle Investments – becomes essential for avoiding pitfalls and capturing the most attractive opportunities.
Navigating credit dispersion with active selection
So far, the Fed appears to have engineered a “soft landing”, with lower inflation accompanied by a gradual slowdown in growth. But it is important to remember that, historically, that’s how most hard landings begin. The challenge facing bond investors in 2025 will be whether the current economic deceleration continues smoothly or whether it evolves into a more severe downturn. The labour market will likely be a key factor. Should weakness in job creation persist, the economic outlook could deteriorate further. We think inflation will continue to decline towards the Fed’s 2% target, and that the Fed will ultimately lower rates to below the neutral rate of 3% by the end of 2025. This expectation is based on our view that there is more softness ahead in the labour market and consumer demand. However, two key factors could prompt the Fed to adjust its approach: Sticky or rebounding inflation: If inflation reemerges – particularly in core services – the Fed may need to pause its cutting cycle and stabilise rates in the 3%-4% range. A significant demand shock: A demand shock, especially coupled with labour market weakness, could cause the Fed to cut rates more aggressively, pushing them well below the neutral level, as seen in traditional rate-cutting cycles. Regardless of which path unfolds, the Fed’s roadmap for 2025 remains flexible, with incremental rate cuts expected to reflect evolving economic conditions.
Soft landing supports bond performance – but will it last?
Given our base case, we believe the rate-cutting cycle should create a favorable environment for high-quality bonds in the US, particularly mortgage-backed securities and municipal bonds. These sectors, which are already starting from attractive yield levels, are well-positioned to deliver strong price returns as rates decline. We are taking a slightly more defensive stance on corporate credit, given the current level of risk premiums. In the event of a harder landing, bond markets may experience increased volatility. High-quality and longer maturity fixed income securities are likely to benefit in such a scenario, as investors seek save haven assets during periods of economic stress. Globally, as the Fed aligns with other central banks that have already begun easing monetary policy – the European Central Bank and the Bank of England among them – asynchronous opportunities in European and Asian credit markets may also arise. Diverging economic conditions across regions may create valuable entry points for global investors.
Opportunities in a rate-cutting environment
Fixed income investors are entering 2025 with a strong foundation. With yields at attractive levels and the Fed in a supportive, rate-cutting cycle, bonds are well-positioned to generate healthy returns. Importantly, with the so-called “Fed put” – the belief that the Fed will intervene to support the economy during periods of stress – bonds are regaining their critical role as portfolio diversifiers. This implicit backstop should give investors confidence that even if economic conditions deteriorate, fixed income markets will remain supported. Encouragingly, a significant macroeconomic shift is not required for bonds to perform well. Starting yields are currently above their 20-year average in most sectors. The tailwind from falling interest rates will only further boost total returns.
Bottom line: bonds positioned for success in 2025
Return to home
“Third on the list of impossible things would be a TV personality winning the presidency of the United States in 2016 And again in 2024”
To prepare a presentation on what has changed for long-term investors during the past decade I dug out my notes from 2014. The results were sobering. In October 2014, macroeconomic factors were at the forefront of investor concerns. The International Monetary Fund (IMF) had forecast global GDP growth at 3.3% in 2014, following 3.3% in 2013. Not exactly exciting stuff. In 2014 a key consideration for investors revolved around the ongoing decline in US Treasury yields (the five-year note was around 1.5% in October of that year). For Central Bank FX reserves managers this led to a discussion on how best to diversify into higher yielding fixed income such as investment grade credit, public equites, and new currencies such as the renminbi. In 2014 we did not appreciate just how pivotal the year would be for geopolitics. In a cynical move just a few days after the closing ceremony of the Sochi Winter Olympics in the February, Vladimir Putin began his grab for Crimea. Annexation followed in March. Sanctions regimes were slowly mobilised after Crimea was annexed, and the election of Trump in 2016 facilitated a snowball effect of tariffs and counter tariffs (Figure 1).
Figure 1: The global backdrop – trade restrictions have risen sharply
We observe that the biggest drivers of financial markets in the past decade have been the impossible things that have overwhelmed our carefully considered medium-term quarterly economic forecasts. In 2014, investors might have considered the following six events as almost impossible to imagine: The most significant was the Covid-19 pandemic, a global health crisis that was predicted by nobody as it approached us – even though we know pandemics occur. We now have public deficit and debt numbers that were previously unimaginable. Russia’s invasion of Ukraine in 2022 triggered the most devastating war in Europe since the Second World War. The all-out invasion of Ukraine led to sanctions, disrupted supply lines and rapid increases in the price of gas and oil that boosted already increasing inflation rates. Third on the list of impossible things would be a TV personality winning the presidency of the United States in 2016 and again in 2024. In a world of frosty relations with China, Donald Trump was a willing actor when it came to taking the trade war to China and agreeing a policy of tariffs and sanctions.
Source: Global Trade Alert. *2024 extrapolated from September 2024 data
How do we break the spiral?
Next on the list would be President Xi of China engineering a job for life in 2018. The rollout of the Belt and Road Initiative began in 2013 when it was announced as a trade policy. Over the past decade it has taken on the appearance of an increasingly strategic geopolitical project. Trade and military alliances go together. The crisis in the Middle East will not have surprised many, but the Hamas incursion into Israel in late 2023 surprised everyone. Finally, don’t overlook Brexit. A local story, but one that opened the sores of populist and nationalist sentiment that have been bubbling in the UK for many years. The economic nationalism that ties all these events together has consequences. “Just in case” replacing “just in time” in global supply chains has implications for trade patterns and the price of goods. It will often mean paying more to ensure greater security of supply (ie a higher floor for CPI in future cycles). For FX reserves managers, who let’s not forget are government institutions, it may also have implications for constructing portfolios – ie building your friends into the asset allocation for what is effectively a national wealth portfolio, and perhaps having to choose which political bloc you want to belong to (for example, towards the US or, for some, towards China).
We can’t forecast unknown unknowns, but we can highlight known unknowns. In 10 years from now Iran’s supreme leader, Ali Hosseini Khamenei, will be 95, Putin will be 81 and Xi will be 82. Although North Korea leader, Kim Jong Un, will only be around 50, his health status is not clear. We predict that regime change in any or all of these countries is coming, but we don’t know what it will look like. This will be difficult for financial markets to price accurately and suggests that we will continue to see bouts of amplified volatility. When will the rubber band on fiscal policy – stretched like never before in 80 years – finally break? Led by the US, fiscal laxness argues for a higher floor for long rates in the longer dated future. Will bond investors refuse to buy, or will a first mover on fiscal consolidation enjoy a market response that eventually forces others to follow? Economic nationalism looks as though it is baked in. As we saw in the 1930s, tariffs and sanctions tend to lead to tit-for-tat responses, and a vicious spiral. It is very difficult to see how this problem can be defused, and it will likely be an important theme for the next decade. The question is how best to incorporate the theme into investment strategies. The argument is for a nimble approach to portfolio management. Periods of heightened market volatility will be an environment in which active management should beat passive. Investors should make their investible universe as wide as possible, utilise as many investment tools as their guidelines allow, and work with investment managers that have a strong track record.
What about the next 10 years?
Gary Smith Client Portfolio Manager, Fixed Income
“The extent of US dollar dominance will continue to erode due to the continued weaponisation of the currency”
The latest data from the IMF Currency Composition of Official Foreign Exchange Reserves (COFER) shows that the US dollar share of global foreign exchange reserves fell to 57.4% in Q3 2024. This is the smallest share since 1994 and represents a decline of almost 9% over the past decade (Figure 1).
Figure 1: US dollar share of global currency reserves on a downward trend (%)
The key driver of this has been a reaction to the increased “weaponisation” of the dollar. This has always been an aspect of the “exorbitant privilege” associated with the US dollar being the primary reserve currency . The country has been in the enviable and unique position of being able to use financial assets to achieve its foreign policy and (sometimes) military objectives without deploying soldiers. This has grown in importance since the 9/11 terror attacks (2001) and reached a recent peak in 2022 after the full-scale Russian invasion of Ukraine. Weaponisation will also be a driver of the next 10% decline in the dollar share. As early as 2017 the then US Treasury secretary Jack Lew acknowledged that the use of this weapon would push some players to avoid the dollar in the future, thereby reducing the extent of its dominance. We think that over the next 10 years another 10% will be eroded from the dollar weight within IMF COFER statistics, and if that happens 10 different currencies will benefit.
Source: IMF COFER, January 2025. Figures on a quarterly basis
The top 10 countdown
Over the past decade, it is the smaller currencies that have taken up most of the slack. Some of these such as the Japanese yen, UK sterling, the Australian dollar, the Canadian dollar and the Swiss franc are named in the IMF COFER report. All of them will continue to grow as the US dollar share declines (Figure 2).
A non-traditional currency we think will win is the South Korean won. It is named in the COFER report but is not measured individually, sitting in the “Other” category within the IMF data. It is this category that has made biggest gains in the past three years. Perhaps the IMF should publish more granular data? South Korea is economically and geopolitically connected. It is the 12th largest nation in the world in terms of GDP and is an important cog in the US association of like-minded nations. In May 2024 it emerged that South Korea was in discussions around joining the military security partnership between the US, the UK and Australia known as AUKUS . So, security agreements as well as trade flows (and the associated financial flows) underpin the argument for the won. A new name we think could appear on the list for the next decade is the Indian rupee. India is the world’s fifth biggest economy and its most populous nation. Size counts in this debate, as we saw a decade ago with the initial adoption and enthusiasm for China’s renminbi. India is “non-aligned” and keen to have cordial relations with a wide list of nations. Comparisons to the internationalisation of the renminbi are instructive. The Chinese currency began to be held as a reserve currency by central banks from 2010 onwards, despite a lack of currency convertibility. While not a substitute for deep, liquid and open capital markets, large FX reserves do help dampen currency volatility. And in the case of the rupee they may also provide comfort to global central banks looking to diversify their currency exposure. A bold forecast, but a small slice of this story will surely benefit the rupee.
The euro and renminbi will also win, albeit modestly
Source: IMF COFER, January 2025. Major reserve currency shares ex-US dollar and euro
Figure 2: The rise of ‘Other’ – currencies picking up the reserves slack
At the turn of the century the newly launched euro was expected to go toe-to-toe with the US dollar. Since then, the euro’s weight in FX reserves has barely changed. The lack of capital market union and failure to develop a single issuer bond market to rival the depth and liquidity of the US Treasury market are two reasons for this. Nevertheless, we think the euro, as the principal alternative to the US dollar, will take a small extra slice of the pie and remain in clear second place. The renminbi is currently home to around 2% of global FX reserves. We note that the share has declined since the Russian invasion of Ukraine. The renminbi story has also been hampered by capital market reforms that have fallen short of expectations, and most recently by Chinese bond yields that have fallen sharply. At current levels of yield, new buyers of renminbi bonds might be discouraged. However, geopolitical fracturing has two sides to it. For some nations China will be a friend rather than a foe, it will command a larger share of the trade flows with these nations, and the renminbi will appeal to the managers of those reserves. China is the largest trading nation for more than 120 countries and trading flows are potential payment flows for the renminbi. So, despite headwinds the yuan should continue to gain a modest FX reserves share over the next decade. Finally, the Singapore dollar should benefit. It already has a small slice of the FX reserves pie and could grow modestly from here. The currency should continue to ride on the coattails of the renminbi – large renminbi trade invoice flows through Singapore have led to rapid growth in the demand for Singapore dollar FX swaps. This will likely underpin future appetite.
The extent of US dollar dominance will continue to erode due to the continued weaponisation of the currency. But even if the weight of the greenback falls to 50%, we believe its primary dominance will be maintained because there will not be a single challenger from the pack. Instead, the next 10 years will see 10 currencies take a small slice of the next 10% wave of dollar erosion. We will also increasingly see the internationalisation of up-and-coming currencies as bond market reforms around the world improve and encourage access for foreign investors. This in turn should trigger an evolution of the leading global bond indexes. A convenient way for investors to position for these opportunities will be to invest in broad-based products benchmarked against emerging market and global aggregate indexes.
What it means for investors
Sources 1. OMFIF, Giscard d’Estaing: Architect of euro and sdr, 3 December 2020 2. Reuters, South Korea discusses joining part of AUKUS pact with US, UK and Australia, 1 May 2024 3. The Non-Aligned Movement (NAM) is a forum of nation states not formally aligned either with or against any major power bloc and is dedicated to representing the interests and aspirations of developing countries
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Alasdair Ross Head of Investment Grade Credit, EMEA
