For fixed-income investors, 2025 will be all about coupon clipping

Fixed-income returns may be stunted in the U.S. this year, as the Federal Reserve responds to potentially inflationary conditions, says Siena Sheldon, vice-president, client portfolio manager, with Brandywine Global Investment Management.

On the latest episode of the Soundbites podcast, Sheldon suggested return opportunities will be more idiosyncratic, with rates moving lower at a slower pace than previously expected.

“Fiscal policy uncertainty as well as growth outperformance are creating a murky picture for rate cuts,” she said. “You still have relative growth outperformance in the U.S. You also now have policy uncertainty under the incoming Trump administration that includes the potential for some deregulation and fiscal spending, as well as potential tariffs. All of this means terminal rates are likely now higher in the U.S.”

She suggested investors focus on credit markets that are offering sufficient yield to compensate for interest rate volatility.

“This year will be a story that is largely about clipping coupon,” she said. “Yields are still high. So it is still very much about income in this environment.”

According to Sheldon, there will be less consensus among central banks over interest rates, as the inflation story plays out differently around the world.

“There will be more monetary policy divergence in 2025 on the government-bond side. But this creates more idiosyncratic alpha opportunities in fixed income,” she said. “In this environment, it’s really important to have an active duration manager that can tease out where inflation is falling, where the policy landscape and real-world yields look favourable so you can create those alpha opportunities.”

She said Europe is facing more aggressive rate cutting as a response to falling inflation, weak growth and the potential for punitive U.S. tariffs. Some emerging markets continue to offer attractive yield, compared to developed markets, although the strong U.S. dollar could prove to be a headwind.

As for Canada, where inflation is already at the Bank of Canada’s 2% target, she expects the central bank to continue to be more dovish than the Fed.

“That said, we do believe they will proceed at a more gradual pace of 25 basis points, as they have already indicated,” she said. “The unemployment rate has risen, and tariff threats are a potential headwind to growth.”

Even if those tariffs are not implemented, she said uncertainty around trade policy could hold back investment in Canada.

Within fixed-income sectors, Sheldon currently prefers shorter-dated, high-yield corporate credits within the U.S.

“You have a strong growth backdrop in the U.S. that is likely further supported by the incoming Trump administration. You also have strong fundamentals in the high-yield market, as well as great yields and prices in the 90s. So shorter-dated high yield is a great place to be,” she said.

Sheldon also likes other spread sectors such as mortgage-backed securities.

“MBS does offer a yield premium over U.S. Treasuries and provides lower credit risk, relative to those investment-grade corporates markets,” she said. “At the same time, the U.S. housing market is also sound heading into this year.”

And finally, high-yield corporate credits are attractive, even if tight spreads pose a risk that must be managed, Sheldon said.

“If you’re overexposed to stocks, it might make sense to shift into fixed income that is giving you some coupon-like high-yield corporate credit,” she said. “Although spreads are tight, fundamentals and continued demand mean it’s still a great asset class to be in.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.