The decisive Republican victory has meaningful implications for interest rates. Credit investors face a wide range of variables and uncertainties heading into 2025.

With credit spreads at decades tight, interest rates are a key driver of performance. The high starting yield offers good carry prospects for credit investors, but higher rates could temper returns even in the absence of spreads widening.

We have downgraded US Treasury (UST) and Developed Market (DM) Investment Grade (IG bonds) from Neutral to Underweight. We believe Trump’s victory and a likely red sweep present clear upside risk to 10Y UST yields.

Moreover, the prospects of an even higher fiscal deficits, sweeping tariffs and tightening immigration next year are likely to increase fears over inflation in the long term.

Although the US Federal Reserve (Fed) is still set to cut interest rates in the near term by 25 basis points (bps) at its upcoming three meetings to March from 4.50-4.75% currently - to the benefit of risk assets - we think the fed funds rate will then be left unchanged at 3.75-4.00% after March with the risk that the Fed may need to raise interest rates again later in 2025 if core inflation gets stuck above 2.50%. We have thus raised our 12-month 10Y UST yield forecast to 5%.

Compared to the other sub-segments, DM IG has the longest duration profile, and is most exposed to the negative impact of higher rates. DM IG spread levels are also at historical tight levels, providing limited buffer against higher rates.

We have also downgraded Emerging Markets (EM) High Yield (HY) bonds from Overweight to Neutral.

We now hold a Neutral view on this asset class because, notwithstanding attractive carry, a stronger US Dollar (USD) and hawkish tariff policies under a Trump presidency would have a negative impact on EM HY credits. We note as well that the spread pick-up over DM HY is also at historical lows, providing limited buffer between DM and EM risk exposure.

We are also cognisant that higher rates could potentially offset the carry offered by EM HY bonds, given that the spread component in all-in yields is at historical low levels.

We are cautious on duration and view the front and intermediate maturities as the sweet spot.

Fixed income strategy

We hold a less constructive view on the fixed income asset class. Admittedly, the high starting yield offers good carry prospects for fixed income investors. However, higher rates next year could temper the outlook for returns, even in the absence of material spread widening. We take a cautious stance on duration risk given our view of further steepening of the yield curve over the next 12 months. Hence, we hold an Underweight position on segments of the credit markets with longest duration.

Rates and US Treasuries

With a decisive Republican victory, the rates market responded quickly to price in higher tariffs, a looser fiscal policy and prospects of fewer Federal Reserve (Fed) interest rate cuts.

10Y UST yields have risen sharply from 3.60% in September. The market has significantly reduced its expectations for future rate cuts and has begun pricing in higher inflation.

President Trump’s policies are expected to be broadly supportive of the US economy and spur more inflation. Tariffs and immigration policies are the most straightforward to implement and these policies could come into effect in 2H2025.

In addition, the incoming Trump administration is likely to extend tax cuts in 2026, likely increasing fiscal deficits and further driving upside surprises in inflation expectations. We expect the forward-looking market to start pricing in a looser fiscal policy ahead of the tax cut extension in 2026. In addition, a large fiscal deficit could also begin raising UST supply in 2H2025 which translates into higher term premiums.

For the above reasons, we expect 10Y UST yields to trade in a higher range over the next year and may return to the highs of 5% registered in October 2023. This forecast is predicated on the Fed being forced to pause its cutting cycle after March 2025, earlier than initial expectations. In addition, we have not ruled out the Fed increasing rates again later in 2025 if there are signs of a reacceleration in inflation.

Reflecting these expectations, we hold a cautious view on USTs and move it to an Underweight position. Meanwhile, we remain cautious on duration risk and prefer the front and intermediate term maturities. We see these as offering the best protection from rates volatility.

Developed markets

Within the DMs, although corporate yields remain attractive, much of the value stems from high UST yields while spreads are at decades low. In fact, with DM IG spreads at 18% of total yield, we see rates as the main driver of performance and expect lacklustre returns going forward.

At the index level, with DM IG heavily weighted towards multi-nationals and non-US companies, trade policy could have a meaningful impact on DM IG. On the other hand, DM HY is more domestically focused, so an expectation of higher tariffs could be less impactful for DM HY credits.

Through year end, we expect credit spreads to hover at historical tights, thanks to hopes of Trump’s deregulatory policies fostering growth while elevated all-in yields in fixed income continue to attract fund flows. However, over the next 12 months, we see reasons for caution as credit spreads are priced to perfection, leaving zero buffer for policy surprises. More importantly, our view on higher rates tempers returns expectations.

The tight US IG spreads and the high duration has led us to shift DM IG to an Underweight position. We prefer Japan and Australia credits, which are predominantly in the financial sector, and we expect to be less impacted by Trump’s presidency. We remain Neutral on HY and continue to prefer quality credits in the “BB”-rated segment for carry.

Emerging markets

With a wide range of variables and uncertainties going into 2025, we remain Neutral on EM credits. Higher USD and tariffs should translate into wider EM spreads over the next 12 months, but strong technical factors are important offsetting considerations.

Asia

Prospects of higher trade barriers, potential investment restrictions/sanctions, higher UST yields and a stronger USD are likely to lead to slower growth in China and the more open economies in Asia. Slower rate cuts by the Fed could imply a reduced room for rate cuts by Asian central banks to support growth.

We expect China to strengthen its policy response to reduce the negative growth impact from higher tariffs. The November National People’s Congress (NPC) offered no new economic stimulus, as the Chinese government reserves policy room until more clarity on trade and investment policies is unveiled. Next to watch are the Central Economic Work Conference in December 2024 and the Two Sessions meetings in March 2025. Within Asia credits, we prefer the financial sector, and more domestically focused corporates to navigate headwinds and market volatility better than corporates with high exposure to the US market or those with large unhedged FX exposures. We expect sectors such as hardware, semiconductor and electric vehicle battery manufacturers to be more impacted by new trade tariffs.

Key mitigating factors include supportive market technicals, driven by healthy local demand for USD credit exposure and the comparatively shorter duration profile.