2025 is a volatile year for the bond market, so be selective

Be selective in the sensitive bond market

It's already been a volatile year in bonds. But what's ahead in this market, and where investors’ direct their dollars, could have a crucial effect on policy.

So, what is going to happen?

Yield curves shift upward, driven by longer maturities

Yield curves, the map of short-term and long-term interest rates, are steepening due to declining front-end rates and persistently higher longer-term yields. This is because of changing expectations in monetary policy, with markets factoring in an anticipated rate-cutting cycle from central banks (in response to weakening economic activity).

However, long-term yields remain sticky. This is down to a few stubborn factors. One is persistent concern over structural inflation due to such issues as deglobalisation, supply-chain realignments and green transition costs. Another is credit risk concern, where governments' fiscal expansion and debt overhang continues to create worry. So investors are demanding greater reward (higher yields) for holding long-dated government bonds.

Growth concerns could drive yields lower

You might not have heard about it in a while, but the debate over whether economies will face a hard or soft landing is intensifying. That's because economic data is mixed: while inflation moderates, growth in developed markets remains fragile.

Any indication of weaker growth (or any other economic shock) will affect the increasingly sensitive bond market. Such indicators could be weak manufacturing purchasing managers' indexes, soft consumer spending, or potential spillovers from geopolitical tensions (such as US-China trade frictions).

Despite recent volatility, bonds may reclaim their traditional role as a hedge if recession risks escalate in the second half of 2025.

High-yield bonds offer increased risk premiums

Credit spreads in the high-yield segment have widened, particularly in Britain and the eurozone, reflecting investor caution as default risks rise and liquidity tightens. The high-yield bond segment is facing particular stress due to slowing earnings, tighter financial conditions, elevated leverage and refinancing risks.

In contrast, investment-grade spreads remain tight, suggesting strong investor demand for quality credits despite macro concerns.

So markets are increasingly discriminating between sectors and issuers: weaker-rated bonds in real estate, retail, and cyclicals are under pressure; while defensive sectors such as utilities or healthcare are more resilient.

A better trade off between risk and return in emerging markets

Several emerging markets – especially in the Asia-Pacific region (India, Indonesia, Vietnam) and parts of Latin America – are benefiting from a number of economic factors at present. These include central banks' rate-cutting cycles (already underway), improved fiscal discipline, strong external balances and foreign-exchange reserves.

For commodity export markets (such as Brazil and Chile) bonds are regaining their appeal due to stable currencies and higher real yields.

In short, the broad-based risks of emerging markets that we're familiar with are no longer so broad. The traditional risks of emerging-market investing such as currency volatility and political instability are now more country specific.

What does this mean for investors?

1. Investors could maintain a globally diversified bond portfolio and rotate into countries that benefit from easing tariff tensions, supply-chain restructuring and domestic support measures.

2. When investing in stocks and exchange-traded funds, investors may prioritise defensive sectors such as government, quasi-government and utilities. Investors have the opportunity to buy high-quality assets at attractive valuations.

3. Slowing economic growth means central banks may ease their policy stance, especially in countries where inflation has fallen. Asian local currency bonds may present an attractive investment opportunity due to higher real yields and stronger economic fundamentals. In addition, such bonds have a low correlation with developed market assets and are gradually included in major bond indices, which enhances their diversification benefits. Therefore, in the event of a significant sell-off in interest rate markets, investors can consider increasing the duration of the Asian and emerging-market local currency bond portfolio.

4. In terms of currencies, tactically there could be advantage in increasing holdings of the US dollar as a hedge during extreme volatility. Concern about the dollar's reserve currency status has led investors to question long-term foreign demand for US treasuries. However, in the short term, treasuries are expected to maintain their safe-haven status with liquidity support from the US Treasury and Federal Reserve.

This information is general in nature and has been prepared without considering your financial objectives, situation or needs. Consider the appropriateness of this information in light of your personal circumstances before making investment decisions.