Weekly market wrap

A year-end look at fixed income

Key Takeaways:

• Fixed-income returns varied widely by asset class this year, demonstrating the value of diversification. Allocations beyond Canadian investment-grade bonds offered the opportunity to enhance performance.
• Bonds appear to be well-positioned to deliver income and diversification as we begin 2025, as central banks continue easing monetary policy toward a neutral stance, normalizing yields and potentially reducing interest rate volatility.
• Monetary policy easing is likely to continue, with the BoC targeting 2.25%-2.75% and the Fed 3.5%–4%.
• Canadian investment-grade bond yields appear likely to retake the lead over cash, supported by a yield advantage.

In 2024, fixed income investments delivered wide-ranging returns amid elevated interest rate volatility as markets adjusted expectations for inflation and Bank of Canada (BoC) and Federal Reserve (Fed) interest rate cuts. Key investment return drivers impacted major asset classes differently, offering the opportunity to enhance performance by diversifying beyond Canadian investment-grade bonds.

As we begin 2025, bonds appear to be well-positioned to deliver their key benefits of income and diversification as central banks ease monetary policy toward to a neutral stance, though at a slower pace, normalizing yields and potentially reducing interest-rate volatility.

A look back

Fixed-income performance demonstrated the value of diversification

The value of bond diversification was evident this year as returns varied widely by asset class. The key drivers of fixed-income returns - including central-bank monetary policy, yields, credit spreads, duration and currency - had differing impacts on the major fixed-income asset classes, providing the opportunity to enhance performance with exposure beyond Canadian investment-grade bonds.

• Canadian investment-grade bonds – Performance was generated primarily by income, as BoC rate cuts and a steepening yield curve roughly offset, leaving yields slightly lower and bond prices mostly stable.
• International bonds – With lower yields for much of the year, performance lagged the major fixed-income asset classes. Despite major central bank rate cuts, yields rose modestly as yield curves steepened, impacting bond prices.
• Global high-yield bonds – As the top-performing fixed-income asset class this year, global high-yield bonds generated solid returns that exceeded even those of Overseas stocks. Resilient economic growth drove solid fundamentals, tightening credit spreads – the excess yield above government bonds to compensate for default risk – well below their historical average. Bond prices benefitted from lower yields and longer duration, while international currency exposure, primarily U.S. dollar, further boosted returns.
• Cash – Cash yields exceeded intermediate-term bond yields for much of the year, known as an inverted yield curve. Cash outperformed Canadian investment-grade bonds for the third time in the past four years. However, cash yields have declined by about 190 basis points (1.9%) as the BoC cut rates, steepening the yield curve in what's known as a "bull steepener" and dropping below Canadian investment-grade bond yields.

Our outlook for what's ahead

1. Monetary policy easing is likely to continue, with the BoC targeting 2.25%-2.75% and the Fed 3.5%–4%

We see the BoC and Fed continuing their rate-cutting cycles in 2025 to gradually remove restriction on the economy. With the BoC policy rate at 3.25%, and the central bank's preferred measures of core CPI around 2.6%, which is within the 1% - 3% target range, we believe there is room to bring rates down to a less restrictive stance, with the rates perhaps settling in the 2.25% to 2.75% range. The Fed funds rate is now around 4.25%, and core personal consumption expenditure (PCE) inflation at about 2.8%, which should allow the Fed to lower rates to 3.5% to 4%.

This recalibration by the BoC and Fed is backed by improvement in inflation rather than an economic downturn, which will continue to support the expansion, likely keeping both economies on track for a soft landing. In general, a neutral monetary policy rate tends to be about 1% above inflation rates, which we see settling near 2% in Canada and 2% to 3% for the U.S. This implies perhaps a relatively shallow set of rate cuts ahead.

The BoC began cutting rates in 2024 as core inflation moderated toward its target range. The Fed followed suit as its employment and price mandates returned to better balance, with the labour market normalizing and inflation gradually moderating. However, the Fed’s preferred core PCE inflation gauge remains above the 2% target, and the pace of disinflation in the U.S. has slowed.

In addition, U.S. pro-growth policies could drive some resurgence in economic growth, potentially spurring more hiring, while immigration reform could reduce the number of available workers. Any tightening in U.S. labour markets or rise in inflation would reduce the need for rate cuts, while a deterioration in the growth outlook could cause the Fed to cut rates more than currently expected.

2. Bonds to take the lead over cash

While the backup in bond yields over the past few months has impacted bond prices, it also sets the stage for stronger performance ahead as yields are typically the key driver of fixed-income returns. Bonds to outperform cash in the year ahead, as they have in 16 years since 2003. Further BoC rate cuts could cause cash yields to fall more than intermediate- and long-term bond yields, likely steepening the yield curve and widening the yield advantage of bonds over cash.

Over the past few years, many investors have gravitated towards cash and cash-like instruments, such as money market funds and GICs, as these investments have offered favourable yields. However, while cash can provide important benefits, holding too much cash or cash-like investments can present risks, such as the potential for lower returns over the long term. For perspective, since 2002, cash has generated annualized returns of 1.9%, compared with 3.9% for Canadian investment-grade bonds.*

3. Opportunity in intermediate- and long-term bonds - Within Canadian investment-grade bonds, we see an opportunity to extend duration with intermediate- and long-term bonds and bond funds, which can lock in higher yields for longer. Bond prices typically rise in value when interest rates fall, and vice versa, providing the opportunity for higher values as the BoC continues cutting rates.

4. Credit spreads are tight but could remain range-bound - Credit spreads — which reflect the excess yield above Government of Canada (GoC) bonds to compensate for default risk — have tightened below their historical averages. We see modest opportunity for credit spreads to narrow further, and any potential widening could drive yields higher and bond prices lower. Resilient growth could provide a stable backdrop for credit conditions, allowing credit spreads to remain relatively contained.

5. 10-year government bond yields likely remain range-bound, with the GoC yield in the 2.75%-3.25% range and U.S. Treasury in the 4%–4.5% range

With the BoC policy rate likely heading toward 2.25% to 2.75% and the Fed targeting 3.5% to 4%, a positive yield curve should keep intermediate-term government bond yields above these ranges. The BoC's and Fed’s balance sheet reduction programs, known as normalization or quantitative tightening, are expected to end soon, allowing both central banks to participate more actively in GoC and Treasury auctions to replace maturing bonds. This additional demand should support bond prices, in turn helping to keep yields relatively contained to the upside.

While 10-year yields could temporarily overshoot or undershoot these ranges, we believe there are guardrails on both sides. Additional BoC and Fed rate cuts and bond purchases should help keep yields mostly contained from rising meaningfully. On the other hand, resilient growth, uncertainty around inflation and deficit concerns in the U.S. could prevent yields from sustainably falling much further, in our view.

Despite pulling back from their recent peak as the BoC cut rates and U.S. yields declined, GoC 10-year yields remain attractive, above their average over the past two decades. Since GoC bonds serve as the benchmark for most Canadian investment-grade bonds, higher yields should provide the foundation for solid returns ahead, with most of the contribution coming from income rather than price appreciation.

Each year brings its share of changes, and 2025 will be no different. It’s important to assess your situation with your financial advisor and focus on what you can control.

Brian Therien, CFA
Investment Strategy

Source: *Morningstar Direct. 

Weekly market stats

Source: FactSet, 12/27/2024. Bonds represented by the Bloomberg Canada Aggregate Bond Index. Past performance does not guarantee future results. * Source: Morningstar Direct, 12/29/2024.

The Week Ahead

Important economic releases this week include the U.S. ISM manufacturing PMI and U.S. housing price data.