Bond investing in 2025: Keep duration short and look for quality

LAST year, short-duration bonds trumped long-duration securities amid a normalisation of the yield curve, with short-end yields falling by less than initial market expectations, and long-end yields climbing significantly.

Meanwhile, high-yield bond markets outshone their investment-grade counterparts, helped by their shorter duration exposure and continued spread tightening.

For 2025, we continue to advocate a shorter-duration exposure in your portfolio, as investors can continue earning attractive yields here without incurring excessive duration risks. We also prefer higher-quality bonds such as investment-grade ones with attractive yields without going too far down the credit spectrum.

Preference for short duration

In September 2024, the US Federal Reserve cut policy rates by 50 basis points, and markets expected massive rate cuts ahead, with the forecast of end-2025 policy rates at around 3 per cent. At that time, we believed these expectations were too optimistic; we were eventually proven correct, and markets are now pricing in terminal rates at around 4 per cent instead.

At the moment, labour market metrics in the US remain decent. The unemployment rate has stabilised around the low-4 per cent region, similar to levels in 2017 and 2018. Wage growth also looks healthy, with the Atlanta Fed estimating wage growth in the high-4 per cent region in December 2024.

Inflation also remains sticky at close to the 3 per cent level, with potential upside risks in services inflation, including decent wage growth and a resilient housing market, as evidenced by various leading indicators.

We think the Fed has little reason to cut rates massively today, considering the labour market and inflation. Market expectations look more realistic today, with about one rate cut priced in this year; we generally agree that policy rates should remain elevated. This means that short-maturity bonds should continue to offer attractive levels of yields for some time.

Meanwhile, longer-end yields could potentially move even higher if long-run inflation expectations reprice upward. We witnessed a glimpse of this last week, with 10-year yields momentarily hitting 4.8 per cent.

With that said, even though 10-year US Treasuries technically offer higher yields than shorter-maturity Treasuries, we think the compensation for duration risks remains insufficient.

With the yield differential between 10-year Treasuries and shorter maturities of less than a year currently at under 0.5 per cent, it would take an upward shift of just around five basis points in the 10-year Treasury yields for mark-to-market price losses to erode this yield pickup.

Taking our views on the short-end and long-end together, we think the balance of risks continues to favour short-end bonds. Investors will likely be able to enjoy attractive short-end rates for an extended period without incurring excessive duration risks, especially if the Fed opts to maintain its hawkish stance.

Favour quality

We also prefer higher-quality bonds in general heading. Valuations – primarily indicated by credit spreads – look more compelling for investment-grade bonds relative to high-yield ones. For instance, high-yield spreads look tight compared to their historical averages, suggesting investors may not be sufficiently compensated for their corresponding risks.

In addition, the extra yield investors can earn for high-yield bonds compared to investment-grade bonds has narrowed in recent years. This means there is less reason for investors to scale down the quality ladder today.

Global investment-grade bonds now offer decent yields of close to 5 per cent in US dollar terms. These entry levels look attractive to us. Historically, such yields have resulted in annualised returns of over 5 per cent over the next five years.

For long-term investors seeking to buy and hold bonds in their portfolios, investment-grade bonds may be a suitable choice as they seek to ride out short-term market volatilities.

Finally, we highlight the diversification potential of investment-grade bonds. High-yield bonds are traditionally more “equity-like” in nature, with stronger correlations to equity markets.

In contrast, global investment-grade bonds have historically displayed fairly low correlations against major equity indices, including the S&P 500 in the US, and the Straits Times Index in Singapore.

Hence, high-quality bonds offer decent yields and also serve as diversifiers and hedges within your broader investment portfolio.

Tip for bond investors: follow the yields and yield curve

Bond markets may seem daunting for investors, especially after last week’s sharp movements in US Treasury yields. Our investment tip is to focus less on the exact number of rate cuts priced ahead, and more on just following where attractive yields lie.

Investors should ask themselves whether they are getting enough yield with each fixed-income investment, especially for longer-maturity bonds and/or higher-risk bonds.

We think that short-maturity, high-quality bonds and money market funds (usually those under a one-year tenor) continue to offer attractive yields while allowing investors to sleep relatively soundly at night.

Meanwhile, those who wish to add on duration should be selective. For long-tenor bonds, we prefer high-quality corporate bonds as the corporate bond curve is much steeper, and investors can get reasonably higher yield pickup from extending duration.

The writer is a senior analyst in the Bondsupermart team at iFast Financial, the Singapore subsidiary of SGX-listed iFast Corporation