2025 Market Outlook: Fixed Income

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

So welcome back to the On Investing podcast. Last week we covered our 2025 market outlook for the U.S. economy, the stock market, and the global markets. This week we're going to focus on the bond markets and the fixed income outlook for the next year. And so I'm really happy to welcome my colleagues Collin Martin and Cooper Howard back to the show.

COLLIN: Hi, Kathy. Thank you for having us.

COOPER: Thanks for having me on, Kathy.

KATHY: Collin and Cooper are both directors at Schwab and fixed income strategists on my team. And they both have the Chartered Financial Analyst designation. Collin Martin specializes in the taxable credit markets and corporate bonds. Cooper focuses primarily on the municipal bond market.

And I want to remind our listeners that you can access all of our written reports with charts and graphs and illustrations at schwab.com/learn. So with that set up, I thought we'd start out with you, Collin. Can you give us a high-level summary of what investors might expect in the investment grade corporate bond market in 2025?

COLLIN: Yeah, we think the outlook is pretty strong for the investment-grade corporate bond market heading into next year. And a key reason for that are strong corporate fundamentals. That's something we've been talking about for a while. And just like we've seen the economy prove to be pretty resilient recently, we've seen that with corporations. We're seeing corporate profits remain high. They came down a little bit in the third quarter, according to data from the Bureau of Economic Analysis, but they're still near their record high levels, and noticeably they're significantly up relative to the pre-pandemic levels. We're also seeing pretty strong corporate balance sheets with liquid assets at pretty high levels. So fundamentals are pretty strong right now.

KATHY: But that leads me to ask you this question. You've started out your outlook piece for 2025 with strong fundamentals, rich valuations. So I think we probably, just went over the strong fundamental part, but can you now walk us through the valuation part?

COLLIN: Yeah, that's a really good point. This can be a pro and a con. The pro is things are good, strong fundamentals. The con is that valuations are a bit rich. When we talk about that, it's a bit jargony, but we're talking about the extra yields that investors earn by investing in corporate bond investments, whether it's investment-grade or high-yield corporate bonds. That extra yield—it's called the spread—they're near all-time lows. It varies on a day-to-day or week-to-week basis, but any way you slice it, spreads are very, very low right now. Now, they're low for good reasons. All those positives I mentioned before, strong fundamentals, that gives investors and lenders the confidence to lend to corporations and to accept kind of those slim margins. But again, the negative is that means we earn less risk compensation to invest in corporate bonds today. So there's a pro and con to that. And those tight spreads make us a little bit cautious. And that's something that we highlight in our 2025 outlook, that it's not so much of a concern of ours for investment-grade corporates, but for the lower-rated parts of the market, like high-yield bonds, it just means less margin for error. Should the economy or the economic outlook deteriorate a little bit, there's just not much wiggle room should that occur.

KATHY: And I think one point that you've made many times is that high-yield bonds tend to be correlated with equities, right? More than, say, with Treasuries, and therefore, you're taking kind of equity-type risk, maybe not getting as much yield to compensate you for that extra risk that you're taking.

COLLIN: Yeah, that's right. Junk bonds, or high-yield bonds, they're a type of corporate bonds, and they have sub-investment grade credit ratings. So if we look at the credit rating spectrum, starts with AAA as the highest rating and goes down. The high-yield bond market is marked by bonds with ratings of BB or below. They have those low credit ratings for a reason. They tend to have a lot of debt outstanding. They tend to be just riskier businesses, more volatile cash flows, things like that.

And because of that, and they have those low ratings because they have higher probability of default, it makes them riskier in general. And as we head into the new year, those risky bonds just aren't offering yields that are much higher than Treasury. So that's where we get that slight cautious tilt there.

KATHY: So given that you find investment-grade corporate bonds attractive, maybe a little bit more cautious on high yield, what sort of yields do they offer in the investment-grade area?

COLLIN: Investment-grade corporate bonds on average can get you close to 5%. When I say on average, that's what the average yield to worst of the Bloomberg U.S. Corporate Bond Index is, but that includes bonds with maturities as short as 1 year, as long as 30 years, and credit ratings from AAA to BBB, the whole investment-grade spectrum. If you're an individual investor trying to kind of identify specific credit ratings or maturity ranges, maybe you're getting 4.5% or above, depending on if you're looking at single-A rated bonds with maybe intermediate-term maturity, say, 5 to 10 years or something like that. But we do think that's attractive. So we talk about kind of my cautious outlook with high-yield bonds because of those low spreads. Investment-grade spreads are low as well, but we're just not as concerned because they have those investment-grade credit ratings for a reason. Investment-grade corporations rarely default.

And usually when they do it takes time. It's usually a kind of a slow burn. And even though those spreads are low, those yields are pretty attractive. I think most listeners here probably aren't too concerned about spreads. They're probably more concerned about "Can I earn 4.5% or more with intermediate-term investment-grade corporate bonds?" And since that is the case today, we think that's attractive, knowing that that's still sort of on the high end of the, you know, 15-year range of where those yields have been.

KATHY: Yeah, I think that makes a lot of sense. One of the things that intrigued me in your outlook piece is you discussed floating-rate notes in your outlook. And we haven't really talked about floating-rate notes in a while now, since the Fed seems to be in the rate-cutting mode. So can you walk us through why you think that might be attractive?

COLLIN: Yeah, it might seem a bit counterintuitive to talk about floating-rate notes in an environment where the Fed's cutting rates. And just to kind of take a step backwards, what a floating-rate note is, those are bonds whose coupon rates are referenced to short-term rates that are usually related to the fed funds rate. So to be specific, a lot of them are based off of the secured overnight financing rate, or SOFR, but that's highly correlated to the fed funds rate. So if you are investing in floating-rate notes—or "floaters," as we call them—the direction of Fed policy is going to kind of drive what those coupon rates do. So the Fed is expected to continue to cut rates gradually over the next year or so, which should pull those coupon rates down. But where they are right now, those yields are above intermediate-term fixed-rate bonds because of the inverted yield curve today.

And considering that, we've kind of changed our outlook for how low the Fed might cut rates. Their terminal rate, where they eventually stop cutting rates, we expect it to be a little bit higher than where we expected it to be, say, six months ago. So that suggests maybe less downside with those coupons. But floaters tend to be more stable than fixed-rate bonds.

So if there's interest rate volatility that can keep their prices more stable, and if concerns we have about potential policies being inflationary down the road, and we see the Fed, say, stopping rates earlier than expected or, maybe worse, hiking rates again down the road, floaters can help protect you in that sort of situation. So it's a way to stay invested today, earn what we still view as attractive yields, but also can help offer protection in case yields stay elevated or end up moving higher down the road.

KATHY: Great. Now there's one other area I want to ask you about, and then we'll move over to Cooper with the muni outlook: preferred securities. We kind of put that into the fixed-income taxable market category. It's a little bit of an orphan in that it's a little bit equity, is a little bit bond, etc.

What about preferreds? It was an area that we liked last year and the year before. What do we think about them now?

COLLIN: We're less enthused with preferreds today, mainly due to the yields they offer. It's a similar theme with preferreds that we see with high-yield bonds, where the relative yields that they offer just aren't super attractive today. And you mentioned how they fit into the bond market outlook that we're talking about. They're hybrid investments. They have characteristics of both stocks and bonds, but we usually consider them part of the fixed income outlook because they tend to have fixed par amounts, they can be matured or redeemed by the issuer after a certain period of time, and they make dividend payments. So they have more fixed income characteristics. But they rank low in issuers' capital structure, or their priority of payments. So they rank below a traditional bond. 

But today, the yields they offer are pretty close to the yields that you can get with just a traditional bond with a similar credit rating. So you're probably taking a little bit more risk with preferreds because they rank lower, but you're really not being compensated with higher yields. So that gives us a little bit of pause with preferreds given … in today's environment. 

There is one little wrinkle though that does make them a little bit more attractive from a strategic standpoint, Kathy, especially for investors who were in some of the higher-tax brackets because many preferreds, but not all, that's a key point, but many preferreds make qualified dividend payments that are taxed at more preferential treatments than traditional interest income. And when you take that into account, their after-tax yields can look pretty attractive, and they can actually line up with high-yield bond after-tax yields.

But preferreds tend to have higher credit ratings than high-yield bonds. So from a tactical standpoint, relative yields are a bit low. But from a long-term investment standpoint, especially for investors who are in some of the higher tax brackets, if you focus on preferreds that do make qualified dividend payments, then they can make sense.

KATHY: OK, thanks, Collin. This has been great. 

COLLIN: You're welcome, Kathy. Thank you for having me.

KATHY: And it's a good segue into talking to Cooper about municipal bonds, because we're talking about after-tax yields, so to speak. So Cooper, let's discuss what you're expecting for the muni market in 2025.

COOPER: Yeah, I'll reiterate it was a very good transition over to me because you're going to hear a lot of the similar things that Collin had touched on. So Collin had done a little bit of the heavy lifting, and in terms of the corporate market, a lot of what he covered is going to be applicable to the muni market, but in more of kind of a municipal-bond sense. So one of the things that we are looking forward to in 2025 is it's likely to be a tale of two halves, Kathy. So we think that given the new administration, tax law changes are going to probably dominate the first half of the year, and then the municipal bond markets likely to kind of adjust to those tax law changes going into the second half of the year. But we do think that right now, high-credit-quality munis, they do offer a compelling case of attractive absolute yields and then strong credit quality. 

So just to give an example, if you look at the yield to worst on a broad index of municipal bonds, in about the middle of December, that's about 3.4%. Now on the surface, I know that compared to other alternatives, that may not sound too attractive. But one of the reasons why it's a little bit lower than other fixed income investments is because of the tax advantages that municipal bonds offer. Like you kind of mentioned early on the question, munis do have tax advantages. So they generally pay interest income that's exempt from federal income taxes.

And if you purchase one from your home state or where you file your taxes, it could potentially also be exempt from state income taxes as well. So to compare a fully taxable bond, if you were an investor in that high tax bracket, say, the top federal tax rate in any high-tax state like California or New York, that 3.4%, if you're that high income investor, would get grossed up to about 6.9%.

So we do think on the surface for high-income earners, that is relatively attractive. Where we're a little bit more cautious is relative to other types of fixed income investments. So one of the metrics that we'll commonly follow is called the MOB spread, so it's "munis over bonds" or the muni-to-Treasury ratio. And really what it is is the yield on a AAA-rated municipal bond relative to a Treasury bond before considering any implications of taxes.

So like Collin covered, there's spreads in the corporate bond market of what's that additional credit compensation that you're investing in. The muni market equivalent of that is the MOB spread, or the muni-to-Treasury ratio. It's a metric that we look at and say, "Is now an attractive time to enter into the muni market, or is it not?" Those continue to hover right now in the low 60-percents. Going back a longer period of time, that's below its three-year averages right now. So

on a relative basis, those yields aren't too attractive. Now, in terms of what we do think for 2025, we're a little bit cautious on longer-term bonds and those that are lower rated. Really, if you've read Kathy's outlook, you'll see that the outcome of the election, it's raised the probability that inflation and potentially yields move higher. There's also the potential probability that, given the policies that have been proposed by the incoming administration, maybe there is a little bit of a growth piece to that. So overall, we don't ultimately know what will come of immigration policies, taxes, tariffs coming into play, but they do, taken all together, have the implication of potentially raising inflation, and therefore longer-term bonds will increase as well, which would hurt their prices. So we're a little bit more cautious taking on duration risk, and that also applies to the muni market as well, Kathy.

KATHY: Yeah, there's a lot in play in 2025, as we've discussed, and a lot of uncertainty from, particularly for muni investors', tax policy. Although it may take a while for that to get ironed out, I think that could have some implications, particularly for those of us who live in the higher-tax states. But what about credit quality? For the past few years, a theme of yours has been that credit quality is fairly strong.

Have we hit the peak? Are we on the downside? Or do you think that continues to be the case in 2025?

COOPER: You know, I would say that we have hit the peak. We probably are on the downside, but let's call this Everest, OK? We're maybe on the downside of a very, very high mountain. So we're not deteriorating substantially to where we're getting all the way to kind of a scary point. I'd say that credit quality is still generally strong going into 2025. If you look at where many state and local governments are just sitting now, coming out of COVID, fiscal aid provided a lot of money.

We also saw tax revenues increase quite substantially. And many issuers actually used a substantial portion of those funds to put towards their rainy-day funds. Now, a rainy-day fund, Kathy, that's like a savings account for you or I or an individual. So states have rainy-day funds that they can tap into if there is a potential slowdown in tax revenues. So even if we see the economy start to deteriorate, that substantial liquidity positions and kind of position that they're sitting in right now, that can go a long way to help shoring up any sort of credit concerns. We also look at the current state of the economy, the current backdrop. It continues to be relatively favorable for many municipal bond issuers. GDP continues to hover around the 3% area. The unemployment rate, yes, it has ticked up to 4.2 % recently, but historically speaking, that's still relatively low.

We've also seen a dramatic increase in housing prices since the onset of COVID. And all of this boils down to positive tax revenues for many municipalities. Most municipalities, states, for example, rely on income taxes. So a strong labor market or an OK labor market is generally positive for most states. Most local governments, they rely on property taxes. So a strong property market, that generally bodes well to tax revenues for them.

However, one thing that we're a little bit more cautious on is taking on too much credit risk. And this is similar to the point that Collin had made about the corporate-bond market, Kathy, is that those spreads for lower-rated issuers, they tend to be very low. So you're not getting too compensated for taking on the added credit risk. So we'd be a little bit more cautious of those bonds that are, say, in the BBB-rated category.

KATHY: Yeah, I think in general, we've always thought that with munis, staying up in credit quality makes a lot of sense. It's not an investment that most people look to kind of take a lot of risk in their portfolios. Just a quick question for you here about things to be concerned about. Are there sectors or areas of the market you think investors should be cautious about?

COOPER: Yeah, so even though I think that the credit backdrop, and kind of the current state of credit quality in the market, is generally favorable, there are starting to be few more bad actors that are starting to pop up or a few more kind of warts in the market that are starting to pop up. And one of the things that I mentioned earlier is that the substantial fiscal aid that went a long way, and many municipalities used that to shore up their liquidity positions, but that's going to be waning in 2025 and into 2026. So the money that was provided under the American Rescue Plan, that has to be designated by the end of this year and then spent by the end of next year. Now, a risk going into next year and even beyond is that some issuers chose to spend that money on or use that money for continuing expenses, rather than a one-time expense.

So they're going to have to find ways to either raise other revenues, cut expenses, to then do something once that fiscal aid runs out. So those are the issuers that I think that I'd be a little bit more cautious about. Also, we're a little bit more cautious about issuers with larger business risks. So things like higher education, private higher education, those that are smaller schools, that's an area that could potentially see some concerns in 2025 and beyond.

Healthcare and hospitals, for example, that could be another area that could experience some credit stresses going beyond. But again, overall, the backdrop for credit quality is generally favorable, but I would not be surprised if we start to see some more bad actors pop up in the market next year and beyond.

KATHY: OK, last question for you before we move on to our overall outlook. You mentioned tax law changes that might take place, and as our colleague Mike Townsend, who does the WashingtonWise podcast, has told us, all of this can take time. But what tax law changes are you looking for, are you watching, that might have an impact on the muni market?

COOPER: Yeah, and I will also reiterate the plug for Mike Townsend's podcast. I think Mike does a very good job of boiling down all issues Washington into something that we can all fully understand and really understand how they impact our portfolio or potentially what would happen with the markets. But given the red wave, I do think that it's highly likely that they'll try to extend the Tax Cuts and Jobs Act. This was something that was passed in 2017. And it is going to expire or sunset next year or so. Our expectation is that that's going to get extended in some form or fashion. Now, I do think, though, that adding additional tax cuts, that's going to be difficult because the way that they're likely going to pass the extension of the Tax Cuts and Jobs Act is through budget reconciliation. Budget reconciliation just requires a simple majority, but it does shine a higher, stronger light—or a brighter light, I should say—on debt and deficits.

So it's really going to all come down to a math problem of "Are there enough tax law changes and enough offsets to make the math work?" Now, one thing that's really been talked about in some muni circles is expiring or removing the municipal-bond tax exemption. So like I mentioned earlier, munis pay interest income that's generally exempt from federal income taxes.

There's been some concerns that maybe that gets repealed. I think that there's probably a low probability that it gets repealed because it would do more harm than it would do good. Now, the Treasury releases a report, and it projects out "What is the 10-year cost of many tax law changes?" and the municipal bond tax exemption quote-unquote "costs" the Treasury about $500 billion. Now, that's a big chunk of change.

But if you look at extending out 10 years of the Tax Cuts and Jobs Act, that's projected to be about $4 trillion. So I think it is a small drop in the bucket of helping to pay for it overall, and it would really do more harm than it would be good. It would likely curtail infrastructure investment, and that would probably hurt many municipalities. It would cause their borrowing costs to increase. So I think it's a low probability that it ultimately gets repealed.

What could potentially come to fruition, and this is could, big if, maybe, I'll caveat this in every possible way that we can, is maybe some issuers have the ability for them to issue tax-exempt debt. Maybe that gets repealed. In the original version of the 2017 Tax Cuts and Jobs Act, in that it was proposed that issuers like airports or higher-education issuers, that they would no longer be able to issue tax-exempt debt.

Something like that seems like a higher probability than a full repeal. But again, a full repeal of that, I just don't see that happening in 2025. But don't say that nothing can ever happen.

KATHY: OK, thanks Cooper. Yeah, there's always, whenever taxes come up, there's always some talk about eliminating the muni exemption. I think that it's never happened. So I agree with you. It's probably a low probability. Cooper, that's terrific wrap up on the muni market. Thanks for this.

COOPER: Thanks so much for having me, Kathy.

KATHY: So I'm just going to wrap up here with our overview on the fixed income market. So just three points I'll make.

We do look for a few more rate cuts by the Fed in this cycle, but it's likely that the terminal rate, the low for the cycle, is going to be in the 3.5% region. That's higher than we had previously anticipated. And that means short-term rates still have room to fall from here, maybe about 100 basis points or so. But when you look at longer-term yields, they've already discounted much of the Fed easing cycle. And in our view, 10-year Treasury yields are kind of fairly valued right where they are at about roughly around 4.25%, give or take. That seems like a reasonable level to us for many reasons, but one is just if you look at the long-term historical relationship between the fed funds rate and 10-year Treasury yields, you know, a good amount of the time, maybe 40 to 50% of the time, that's roughly around 90 to 100 basis points.

So if you have a fed funds rate at 3.25 to 3.5%, 10-year yields at 4.25 to 4.5% are pretty fairly valued in terms of, you know, the historical trend. So we don't see a lot of room for those yields to fall unless we get a much weaker-than-expected economy. And then finally, we do see some upside risk to yields, even though we do still see inflation edging lower.

And that's because of some of these policy changes that we've discussed, you know, tariffs, tax cuts, immigration reform, those all could have some inflationary impact on the economy. Too soon to know what that is, and that's likely to make it a very choppy year as we go through all these proposals. But you know, the overall outlook is a steeper yield curve with short-term rates coming down relative to long-term rates, but some upside risk to those longer-term yields and a fair value roughly around 4.25% or so in 10-year Treasuries. 

That's it for us today. Thanks for listening. If you've enjoyed the show, we'd be thrilled if you left us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. You can also get a lot more detail about our 2025 market outlooks on social media. Just check out x.com/SchwabResearch, and I'll have a link to that in the show notes. 

And we're taking a break over the holidays. This is our last episode of 2024. We'd like to thank some of the people who helped make the show possible. The On Investing podcast is produced by Matt Bucher and edited by Kory Hill. Patrick Ricci is our executive producer. They are fabulous, and they do a wonderful job helping us get this out the door every week. Special thanks to Chris Batchik, Mason Reed, Diane Jacobs, Adrienne Beata, and Deborah Hinton-Brown, who behind the scenes do so much to make this possible. 

Happy holidays, and thanks for tuning in.

For important disclosures, see the show notes or schwab.com/OnInvesting.