La Française: Fixed Income Outlook 2025
Interview with David Montoya, Fixed Income Client Portfolio Manager at La Française
Do you think that this year we will have any surprises, not discounted, in interest rates?
Despite being only one month into the year, we have already witnessed significant surprises in interest rates that were not fully priced in. Volatility has been evident across US, UK, and German yield curves, with a particularly sharp move in 10-year UK Gilts and US Treasuries, both briefly approaching 5% by mid-January—levels last seen in September 2008 (UK) and November 2023 (US). Specifically, 10-year UK Gilts started and ended January 2025 around 4.5%, peaking at 4.89% on the 14th, while 10-year US Treasuries fluctuated between 4.5% and a 4.79% high on the same date. (Source: Bloomberg, as at 31/01/2025)
A potential surprise could come from the United States, with tariffs diverging significantly from the current consensus. While difficult to predict today, one could imagine that the ultimate priority of reducing inflation in the U.S. prevails, leading to lower tariffs. This could contribute to helping deflate inflation expectations and allow the Fed to adopt a more accommodative stance. Conversely, tariffs could also rise significantly, resulting in inflationary pressures and a negative impact on global growth. Ultimately, however, we believe that the current pricing (a 4% terminal rate in the U.S.) is asymmetric, which argues in favor of medium-term long positions, especially given the currently high growth expectations in the U.S. (Source: Bloomberg, 11/02/2025)
Looking ahead, we anticipate continued volatility, primarily driven by political uncertainties on both sides of the Atlantic. Additionally, while black swan events are, by definition, unpredictable, they remain an ever-present risk. Though not part of our base case, such shocks are not currently priced into rates and could lead to further market dislocations.
Do you see more opportunities in Europe or the United States in the fixed income segment?
It’s difficult to make a blanket call on fixed income as a whole, as we see attractive opportunities in both regions. However, the macroeconomic landscape on either side of the Atlantic is notably different, particularly in terms of monetary policy expectations. Currently, market-implied terminal rates for 2025 stand at 3.98% for the Fed and 1.86% for the ECB, suggesting a more aggressive rate-cutting cycle in Europe. (Source: Bloomberg, 11/02/2025)
A broader look at economic indicators further highlights these divergences: January 2025 Composite PMI came in at 52.9 in the US versus 50.2 in the Eurozone, both supported by resilient services sectors. Meanwhile, real GDP growth projections for 2025 stand at 2.2% in the US and 1.0% in the Eurozone, with unemployment expected at 4.3% in the US versus 6.5% in Europe (Sources: Markit, Bloomberg, 31/02/2025).
From a European investor’s perspective, currency hedging costs (currently 1.85%) erode some of the apparent yield advantage of US assets, making the decision more deal-specific rather than a broad regional preference. This also raises the question for those considering US rates—historically attractive in absolute terms—whether now is the right time to invest without hedging and accept the associated currency risk. (Source: Bloomberg, 11/02/2025).
Ultimately, both regions offer opportunities depending on one's strategy. Investors can adopt a carry-focused approach with low duration or position for higher duration exposure to benefit from expected rate cuts—while remaining mindful of potential volatility. In either case, selectivity is crucial, as the dispersion in credit spreads, fundamentals, and risk premia remains high.
What do floating rate bonds offer in this environment?
Floating rate notes (FRNs) generally offer the combination of lower volatility, attractive carry and higher seniority in the High-yield segment.
By design, FRNs have almost no duration, making them a natural choice in periods of heightened market uncertainty. Their reduced volatility is not only due to their structure but also to the fact that there is no FRNs ETF, and they are often excluded from major indices. Additionally, demand is primarily driven by buy-and-hold investors, such as CLOs and money market funds, which further stabilizes the asset class. A clear illustration of their lower volatility is the five-year volatility of US investment-grade (IG) FRNs (1.47%), which is over 80% lower than that of their fixed-rate (9.27%) counterparts. (Sources: Bloomberg Barclays indices, 31/01/2025)
Despite the loosening of monetary policies, FRNs should benefit from still high short-term rates, especially those denominated in USD, as we expect the FED to adopt a less aggressive stance on monetary easing compared to the ECB.
Finally, FRNs offer higher seniority in the high-yield (HY) segment. Despite typically lower credit ratings than fixed-rate bonds, FRNs tend to offer improved seniority within the capital structure. In the EUR HY universe, for example, 93% of FRNs are secured, compared to 33% for fixed-rate bonds (Sources: Bloomberg Barclays indices,31/01/2025).
Given these characteristics, FRNs can be an attractive allocation for investors looking to mitigate duration risk while maintaining credit exposure; or even for those who lack the capacity to adjust duration exposure through other instruments, such as swaps.
Seeing that interest rates will in all likelihood continue to fall, especially in Europe and to a lesser extent in the US, is it time to lengthen duration and what is the optimal duration?
Currently in most of our portfolios, where possible, we have slightly increased duration, particularly in benchmarked strategies where we now sit modestly above most benchmarks. However, it's essential to remember that the contribution of duration to performance depends on the asset class.
The optimal duration varies by sub-asset class, requiring a close analysis of different yield curves.
- High Yield (HY): We prefer the belly of the curve (3–5 years), as we do not see sufficient compensation for the added volatility beyond this point. Beyond 5 years, the curve is flat, and in some cases, even inverted, such as in US HY, where the 5–7Y segment is inverted by 40bps and the 7–10Y segment by 80bps. [, the spread between buckets (YTW) is 3–5Y vs. 5–7Y: 44bps and 3–5Y vs. 7–10Y: 79bps, while in YTM, the spreads stand at 38bps and 85bps, respectively. (Source: Bloomberg, ICE BofA indices,31/01/2025).
- Investment Grade (IG): We find the sweet spot around 5-7 years, balancing risk and return more effectively.
What type of rating are you moving towards at the moment?
We favor issuers classified as Xover (BBs & BBBs), particularly those with a BBB rating, as they offer spreads of 90 to 100 bps (as at 11/02/2025, Source: Bloomberg, ICE BofA Indices) depending on the sector, providing an average pick-up of 25 bps compared to single-A rated issuers.
High beta asset classes, what do they currently offer?
First, let's take a look at last year's performance in high yield (HY) and subordinated debt, particularly AT1s. The strong performance was primarily driven by spread compression, with some additional contribution from duration effects.
Currently, spreads remain tight across both high-beta sub-asset classes, yet they still offer carry levels, above 5%. As of the end of January, EUR AT1s yield 5.4%, while EUR HY stands at 6%. (Source: Bloomberg, Bloomberg indices: yield to worst, 11/02/2025)
Fundamentals remain solid in HY and very solid in financial subordinated debt. However, in both cases, deep market knowledge and careful selection are essential. While overall valuations appear tight, a name-by-name approach is crucial to identifying the most compelling opportunities.
Subordinated debt of which entities?
We see value in the banking sector, particularly in Additional Tier 1 (AT1) CoCo bonds, which, in our opinion, continue to offer a relatively attractive carry (5.4% as of the end of January for € CoCos). Fundamentals remain robust, supported by stable credit trends and strong capital positions. Within this space, we prefer Spanish, Irish, and Benelux banks, given their superior macroeconomic outlook and profitability metrics compared to their French or German peers. (source: Bloomberg index, 31/01/2025)
Beyond banks, we find value in Tier 2 bonds from insurance companies, given their higher sensitivity to interest rates, which should support performance in an easing rate environment. Additionally, insurance sector fundamentals remain among the most stable in the broader credit market.
Lastly, in the corporate subordinated space, we favor hybrids from defensive sectors such as Telecommunications, Media & Technology (TMT) and Utilities, which can provide attractive carry with lower credit risk. Conversely, we remain neutral on issuers more exposed to geopolitical and trade uncertainties, including automotive, wind energy, industrials, and chemicals.
In High Yield, where do you see more investment alternatives?
In High Yield, we favor European securities, as we see attractive relative value, with defaults remaining between 2-3%, allowing investors to potentially benefit from the carry of the segment.
This quarter, we remain slightly more defensive, prepared to adopt a more aggressive stance once spreads widen sufficiently. As always, the key in this asset class is bond picking and deep issuer knowledge, leveraging expertise to identify the rising stars of tomorrow.
Lastly, we can also see value in convertibles, as implied volatility remains cheap, and the investment universe has less exposure to cyclicals such as autos, along with lower sovereign risk, as there are no banks in the segment.
