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After enduring two years of underwhelming performance, the bond market may finally be poised for a comeback in 2025. Despite lingering skepticism, several compelling factors suggest that this year could indeed be favorable for fixed income assets. While U.S. Treasuries and government bonds have struggled to recover from the significant losses incurred in 2022 due to central bank interest rate hikes aimed at controlling inflation, recent trends indicate potential positive returns. Investors remain cautious, but data from the past four decades shows that current yield levels are associated with promising total returns over the next year. Moreover, robust demand for U.S. fixed income, attractive yields, and a strong likelihood of a soft landing for the U.S. economy further support this optimistic outlook.

Over the past few years, fixed income assets, especially U.S. Treasuries, have faced substantial challenges. The aggressive interest rate hikes by central banks in response to post-pandemic inflation and geopolitical tensions, such as Russia's invasion of Ukraine, significantly impacted bond performance. In 2022, U.S. government bonds suffered one of their worst declines, with the ICE BofA U.S. Government Bond Index barely managing modest gains in subsequent years. Corporate bonds fared better but still lagged behind the impressive gains of the S&P 500. This disparity has fueled concerns about bonds' viability as an investment during periods of high interest rates.

The narrative that bonds perform poorly when interest rates are elevated has gained traction, particularly as U.S. debt and deficit dynamics have worsened. Elevated borrowing costs and increased spending have led to higher term premiums, which represent the additional compensation investors demand for long-term lending risks. Consequently, Treasuries have lost their traditional role as a hedge against equity market downturns. However, some experts argue that historical data paints a different picture. Chris Iggo, chair of the AXA IM Investment Institute, points out that over the past 40 years, bond yields at current levels have often resulted in positive returns within the following 12 months. Since 1985, the Bloomberg Aggregate U.S. Government Bond Index has delivered positive monthly returns 90% of the time when yields were above 4.6%.

Historical context also supports this view. Before the Global Financial Crisis, credit costs were consistently higher, yet the ICE BofA U.S. Government Bond Index doubled in value and produced positive returns in all but one year. Meanwhile, the S&P 500 experienced three consecutive years of double-digit losses during which it halved in value. Although the era of zero interest rates is likely over, bond investors should not be unduly concerned. Liquidity remains abundant, default risks are minimal, and there is a high demand for fixed income assets. Recent record-breaking demand for French and Spanish debt sales underscores this point. Additionally, capital flows into U.S. bond funds surged to $435 billion last year, indicating continued investor confidence.

Several indicators suggest that bonds are currently undervalued relative to equities. Analysts at Citi note that the recent selloff in U.S. Treasuries ranks in the 85th percentile since 2000. The equity risk premium, which measures the difference between the S&P 500 earnings yield and the 10-year Treasury yield, is at its lowest level in 25 years and even negative in some cases. Even in the investment-grade corporate bond market, where spreads are historically tight, the gap between stock earnings yield and bond returns is the widest it has been in decades. These factors collectively hint at a potentially favorable environment for bond investments in 2025.

While caution is warranted given the uncertainties surrounding inflation, public finances, and policy changes, the evidence suggests that the bond market might be on the verge of a resurgence. Investors who have been hesitant due to recent setbacks may find that the third time is indeed the charm. With robust demand, attractive yields, and a strong economic outlook, the stage is set for a promising year ahead for fixed income assets.