Inflation is moderating, but remains slightly above the Fed's target of 2%, supported by easing goods prices, but persistent wage pressures in the service sector remain a problem. Consumer confidence and business surveys  indicate weakness and increasing risks of stagflation which has led to a fall in treasury yields and a recent outperformance of US rates. However, fiscal deficits and rising public debt pose risks to long-term bond yields.

The labour market is softening gradually, with unemployment at 4.2%, but participation rates are remaining stable. These trends support expectations for more caution around rate cuts from the Fed in 2025. Amidst this weaker data, the Fed is now priced to deliver three rate cuts over 2025 and US real yields have come down relative to global peers, prompting weakness in the dollar. Uncertainty surrounding tariffs, political dynamics and inflation persistence will keep volatility elevated. 

Corporate earnings are stable, with earnings before interest, taxes, depreciation, and amortization (EBITDA) margins improving slightly for investment-grade issuers. Interest coverage remains robust at 9.3x for higher-rated credits. Refinancing risks are muted in the short term due to staggered maturities, with most issuers not exposed to higher rates until 2026 or later.

Investment grade spreads of ~84bps over US treasuries remain tight by historical standards, offering limited room for further compression. Relative value opportunities still exist in select industries such as  energy and infrastructure, where spreads remain wider than pre-pandemic averages.

Strong inflows into investment grade (IG) credit funds and ETFs support demand-side dynamics. Reduced issuance in Q4 2024 also helps maintain spread stability. Relative performance versus government bonds remains attractive, particularly for medium duration corporate bonds. However, the absolute performance is weak across most major time frames as spreads compressed leading to increased sensitivity to rising yields.

Earnings resilience in high yield (HY) issuers is notable, with revenue and EBITDA growth of 3.2% YoY in Q4 2024, driven by energy and leisure sectors. Defaults remain near historical lows, but are projected to rise modestly during 2025.

HY spreads of approximately 297bps over Treasuries are tight relative to historical averages (5-year average: 427bps), limiting return potential. However, the risk premium remains attractive compared to IG credit (albeit this is has also compressed) and equities. Relative value opportunities exist in selective B-rated issuers within outperforming sectors

There remains strong technical support from robust inflows into high yield ETFs and funds. Year to date issuance trends are healthy, with investor demand offsetting refinancing pressures. Liquidity conditions are favourable, with secondary market activity robust across most high yield categories. Despite the shorter term weakness in absolute terms, the medium and longer range dynamics are positive, while the relative price actions are firmly favouring high yield over investment grade and government  bonds.

Fixed income investors should continue to focus on quality income and avoid unnecessary duration or credit quality risks and we remain short duration relative to our fixed income benchmark.