It will not be lost on the reader that uncertainty has been a key component to fixed income returns thus far in 2025. While this observation may be too “on the nose,” it serves as a good reminder that volatility cuts through assets classes in different ways, especially during periods when returns are positive in sectors assumed to move in opposite directions. However, even in periods when both Treasury and corporate bonds have generated positive total returns, fixed income investors do not enjoy lagging behind Treasuries. Corporate debt investors expect corporate bond returns to exceed the return generated by simply investing in the Treasury market because, at the very least, corporate bond investors are assuming credit risk for which they expect to be appropriately compensated. While the first third of 2025 has been extremely volatile — and while treasuries and corporate debt have each generated positive return year-to-date — it seems an appropriate time to step back and ask how unusual this year has been and what should corporate bond investors do going forward.
One needs to look no further than the return of the Bloomberg U.S. Treasury Index versus the Bloomberg Corporate Index to see that a flight-to-quality trade of some substance has occurred this year. Frequently, positive returns on Treasuries are associated with negative returns in large swaths of the corporate credit market, but this year the Bloomberg Treasury Index has returned 2.91% year-to-date, 110bps (basis points) more than the positive 1.81% performance of the Bloomberg Corporate Bond Index. What is interesting and what may come as a surprise to some investors is that from 1987 to present, U.S. Treasuries have outperformed investment grade debt an average of 3-4 months every year and over the same timeframe, U.S. Treasuries have outperformed high yield bonds about four months of every year. With that as our backdrop, the relative performance of credit exposure this year is not all that uncommon nor unexpected.
However, with recency bias nipping at our heels, the purpose of the conversation today is to consider how do we, as asset managers and fixed income investors, account for this recent bout of volatility. How to we square the uncertainty it has generated for the rest of the year with investing our assets going forward? Do we make wholesale changes by radically altering sector exposure? Do we move quickly to increase our exposure U.S. Treasuries or a U.S. Treasury Index and away from credit? Do we modify the way we look at our relative value assumptions and move quickly up the credit stack into lower-coupon longer maturity corporate debt? Do we “try to catch a falling knife” with a quick duration change by swapping our duration exposure to parts of the treasury curve we believe will suffer less than other parts of the curve? These are all good questions and are all culled from conversations we’ve had since volatility began to rise dramatically beginning late February.
Readers of the fantastic set of authors found here on aamlive can likely recall a consistent theme throughout all the investing discussions had here: Investing isn’t about timing the market but rather about time in the market. Given that the market timer hall of fame is an empty room, the answer to the above questions as to what we change, is clearly “not much.”
When faced with uncertainty, it is incumbent upon investors to continue to rely upon a well-grounded approach. That well-grounded approach includes identifying your thesis, reflecting upon the history of how returns are generated in the fixed income markets, and experience in generating those returns across a wide variety of investing environments. Using a baseball analogy, what we do is simply get back to basics and focus on the fundamentals of batting singles and doubles.
As the graphs below highlight, fixed income returns can be influenced by price over shorter periods of time, but the preponderance of returns in a fixed income portfolio over longer periods of time are generated by income. Certainly, the prior four months bear witness to how broader economic and political events can influence fixed income returns in the shorter term and, to be fair, there are structural changes which will likely affect the level of yields moving forward. However, our focus is not what benchmark rates are going to do in the next 5, 10, or 15 days but rather how we continue to effectively and efficiently generate returns in fixed income portfolios over the next 5, 10, or 15 years.
Source: ICE Data Indices, LLC | Past returns are not indicative of future results.
Higher volatility in 2025 is one of the primary reasons that U.S. Corporate Credit has underperformed U.S. Treasuries this year. We are all familiar with volatility in the equity markets and how it is most often represented through the CBOE Volatility Index (VIX) as an expectation of the dimension of price uncertainty over the coming 30 days. Often though, fixed income investors give only a tacit nod to volatility in the bond markets, forgetting that uncertainty is a key component in fixed income expected returns across multiple dimensions.
Uncertainty affects bond pricing through:
- The uncertainty of real rate expectations or growth
- The uncertainty of inflation expectations
- The uncertainty related to the credit risk unique to each bond
All else equal, each of these uncertainties are important in pricing bonds in a manner which attempts to appropriately remunerate fixed income investors for not only the duration risk they are taking but so too, and perhaps more importantly, the credit risk which they are assuming.
As an economy improves, as witnessed in 2021-22, uncertainty related to credit risk tends to decline given higher confidence in the ability of companies to repay their debt. This reduction in repayment uncertainty draws investors into the lower reaches of the credit stack. This increasing demand raises prices and reduces yield while this reduction in uncertainty also reduces the spread being paid as compensation for an investor taking on credit risk. All else equal, lower spreads lead to higher prices, and like equity markets, momentum becomes an influential factor in fixed income returns as repayment uncertainty is reduced.
However, with rising uncertainty comes widening spreads. Wider corporate spreads result in higher yields and, as we all know, when yields rise prices fall. Our job as fixed income asset managers and fixed income investors is to look through the noise and determine if we are being appropriately compensated for the credit risk that we are taking given where we feel the economy may be headed. As the chart above illustrates, widening spreads tend to occur prior to a recession but on their own, spreads cannot be used as a market timing device. When taken in concert with higher volatility levels, uncertainty with present administration policies, and Federal Open Market Committee (FOMC) policy uncertainty we believe that in general, some slices in the credit stack may not be providing adequate compensation for credit risk near an event horizon which could see the FOMC working against a slowing economy with stickier inflation. It is possible that the recent tail in the 30-year U.S. Treasury auction illustrates that buyers of Treasury debt may feel the same way.
This uncertainty suggests that fixed income investors need to focus on the basics. Focus on “hitting singles and doubles.” Focus on fundamentals. There is value to be found in the corporate debt market, but we believe that focusing on fundamentals will enable fixed income portfolios to perform better over the long run.
CRN: 2025-0502-12534 R