AAM Viewpoints — Fixed Income Performance in Q2 and How it Influences Our Outlook for 2025

With the second quarter (Q2) 2025 in the rear-view mirror, it seemed timely to reflect on the unusual performance of fixed income over the prior quarter considering both recent and expected uncertainty. It is important to remember that throughout history, U.S. Treasury bonds tend to outperform corporate debt four to five times each year. Often these periods of outperformance are associated with rising market volatility, rising geopolitical concerns, or concerns about slower growth. While the remainder of the year is unclear, we have experienced an ample portion of each of those concerns thus far. Volatility for both equity and fixed income markets spiked dramatically during April but then tapered as we progressed through Q2 and this volatility spike, and subsequent fatigue, seemed to set the tone for the rest of the quarter. It is useful to recall that during the first month of Q2, tariff threats from the Trump Administration were the topic du jour, with volatility being the main course. The on-again, off-again nature of the administration’s policy stance combined with lingering growth concerns driving credit markets to finish the quarter with somewhat positive excess returns over a winding and circuitous path.

A key characteristic for fixed income investors is that, over longer periods of time, income generally drives the preponderance of returns in a fixed income portfolio. While the chart of ICE BofA Index Returns below does not account for relative value across the term structure of duration, it does clearly illustrate the increasing role which income plays in a fixed income portfolio over time. During shorter periods, price can and often does have an outsized contribution to return but this influence fades, often within a couple of months.
Source: ICE BofA Market Indices | Past performance is not indicative of future results.

Undoubtedly, concerns of a slower economy and tariffs pushed inflation expectations higher throughout Q2 and seem likely to do so for the duration of 2025. While the Trump Administration admonished Fed Chair Powell for not reducing interest rates during the quarter, the FOMC’s (Federal Open Market Committee) longstanding position was that tariffs continue to be an inflationary risk. Until there is material softness in the economic data which clearly supports reducing rates, the committee maintained that the policy rate was at an appropriate level. Tepid, but not soft, economic data combined with elevated levels of rate uncertainty and these forces contributed to the steepening of the U.S. Treasury (UST) curve throughout the quarter. Much of this steepening being driven by what bond folks refer to as a rise in the term premium: the additional compensation required for the variety of uncertainties faced by an investor going out the curve. As can be seen in the chart from the Federal Reserve Bank of St. Louis on this page, the factors mentioned above drove 2-year UST yields lower by 16bps (basis points) and 5-year yields lower by 15bps while also driving up 10-year yields by 2bps and 30-year yields by 21bps. Both the 2s10s (2-year Treasury vs 10-year Treasury) and 5s30s curves steepened to their higher levels since 2022 as the curves continue to normalize throughout Q2.

In addition to the factors which drove long-end rates higher, market expectations for FOMC policy rate action whipsawed throughout the quarter from the push/pull forces of concerns about higher inflation and concerns about a slower economy. At the beginning of Q2, Fed Funds Futures markets were pricing in three cuts by year end but by the end of April, these expectations had risen to four cuts. The ultimate delay of the punitive tariff threat quickly adjusted expectations lower, and we witnessed what could simply be described as volatility fatigue. By the end of the quarter only two rates cuts were being price into the market and recession odds began fading.

Source: ICE BofA Market Indices | Past performance is not indicative of future results.

While benchmark Treasury performance this year has been positive, credit slowly began to outperform during the quarter as credit investors looked beyond the April volatility spike. Clearly some uncertainty remained. However, the volatility decline which began in late April drove positive excess returns across the breadth of the credit stack as the quarter wore on.

The ICE BofA U.S. Corporate Investment Grade Index generated 1.79% total return during the quarter outperforming the U.S. Treasury Index by 1.05%. The ICE BofA Corporate High Yield Index returned 3.57%, also outperforming the U.S. Treasury benchmark 2.21% by the end of the quarter.

As positive as returns were during Q2, the graph of returns on this page also highlights how excess returns across the stack have now begun to turn marginally higher on a year-to-date (YTD) basis. This slightly positive YTD excess return highlights how after February, credit exposure had an uphill battle following the months in which Treasuries caught a bid from the uncertainties mentioned earlier. The performance of corporate credit during Q2 can be seen as a combination of both improving optimism of expected risk adjusted returns, along with underlying demand during a period of softer bond issuance lower in the stack.

As the table illustrates, ICE BofA U.S. Corporate Investment Grade Index yields remain attractive on a duration relative basis and finished the quarter with a yield-to-worst of 5.01%, remaining well above the trailing 5-year average of 4.07%. High Yield Corporates finished the quarter with a yield-to-worst of 7.05% with a duration of 2.89.

Source: ICE BofA Market Indices | Past performance is not indicative of future results.

While it may sound like a broken record, we continue to be cautiously optimistic on corporate credit in 2025, though we continue to highlight how diversification across sectors has become increasingly important to generating attractive relative returns. Taxable Municipal Bonds, Agency-backed MBS (mortgage-backed securities), and even U.S. Treasuries have attractive yields within their term structure which we feel demand attention on a risk-adjusted basis. However, in the corporate space careful credit selection can continue to add attractive relative value while mitigating spread widening which we believe continues to be likely as we close out 2025 and move into 2026.

We also continue to believe that there are structural forces such as ongoing deficits and inflationary pressures which tilt the risk in benchmark rates higher. As this occurs, the added uncertainty is likely to widen spreads in some portions of the credit market given the underlying assumptions upon which credit compensation is based. While there are attractive opportunities within the corporate credit market, we continue to be students of history and maintain a keen eye on the level of credit compensation being offered to the level of credit risk being taken.

We remain constructive on valuations and are cautiously optimistic about the return potential for fixed income investors in 2025. At times like these we remind investors to focus on long-term investing and look beyond the headlines. The headlines may add volatility in fixed income assets, but an diversified allocation across the breadth of taxable fixed income continues to be attractive for investors looking to earn higher yields without taking too much additional credit risk.

CRN: 2025-0710-12713 R