Fidelity Sterling Corporate Bond portfolio managers Ian Fishwick and Kris Atkinson share their outlook for 2025 and provide an insight into how they are looking to position the portfolio against an evolving macro backdrop.
What is your outlook for your asset class?
Starting with UK rates, levels of uncertainty remain elevated particularly following the election of Donald Trump and, closer to home, the Autumn Budget announcement. The Budget hopes to stimulate growth by increasing government spending and productivity, while aiming to keep a lid on inflation, but execution risk remains high. The longer end of the gilt curve may be susceptible to upward pressure as a result of increased government spending, and steeper curves seem likely from here. Policy rates remain restrictive and, so long as inflation remains subdued, should continue to fall thus supporting front end gilts. Overnight index swaps show the market expects the Bank of England to cut three times during 2025 at 25 basis points (bps) each, which seems fairly priced to us.
While rates seem fairly priced, sterling investment grade credit markets remain rich, with the additional income investors receive for lending to sterling investment grade corporates over gilts (the credit spread) a mere 102bps. To put that into context, our quantitative screens show that spreads have been lower than this just 9% of the time since 2006. Euro corporates look a little better value at 30% of the time tighter, while US Dollar corporates are at the tights since 2006 having never been lower. Demand for high quality credit remains high and so the technical picture is helping to keep a lid on spreads, however there is little compensation for risks in credit right now. While it is true that investment grade credit spreads at these levels still compensate investors even for a meaningful pick-up in default rates over the long term, it is hard to ignore how stretched valuations are. We view the year ahead as a coupon-clipping year.
The key risk to this view is if inflation comes back meaningfully. Should this occur, we would likely see both higher core government bond yields and wider credit spreads. The good news is that all-in yields remain attractive and so it would take quite a move to ‘wipe out’ a years’ worth of carry.
How are you looking to position your portfolio against this backdrop?
With rates markets fairly priced, it should come as no surprise that we are neutral in duration risk versus the benchmark. We are heading into 2025 with a view that the yield on 10 year gilts looks fairly priced around 4.5% and so any meaningful move higher or lower than this may prompt a move overweight and underweight UK rates respectively.
Credit markets are somewhat easier to call. With valuations stretched we are cautious on credit risk heading into 2025 and have dialed risk down in the portfolio through 2024. On our preferred measure of credit risk – duration-times-spread, or DTS – the portfolio has moved from a 1.3x credit beta position versus the benchmark at the start of the year to 1.1x heading into next year, while we are underweight in spread duration terms. This overweight DTS and underweight spread duration combination reflects our preference for shorter dated but higher credit spread bonds, coupled with an underweight stance to long dated credit which looks particularly rich when scanning the credit curve. This mildly positive credit beta stance, and the accompanying extra yield over the benchmark (5.9% versus 5.4%) that comes with this, should offer some positive carry should spreads stay tight in 2025.
From an asset allocation perspective, we have just under 10% exposure to gilts, which is more than normal, offering some dry powder should higher spreads present themselves in 2025. Our high yield exposure (capped at 10%) is lower than usual too, at 3%, with some credit default swap (CDS) hedges in place taking our net high yield exposure lower still.
We are underweight triple-B rated bonds while overweight higher quality single-A and double-A rated bonds, again in a bid to be somewhat defensive. From a sectoral perspective we continue to find the best value in financials and secured bonds while our largest underweight remains in quasi-sovereign and supranational bonds and utilities. The recent volatility and weakness in the water sector is a reminder that, despite being regulated, utilities ought not to trade perennially tight.
With rates market uncertainty high and credit spreads low, we expect to be more nimble and tactical in the year ahead. We also expect single-name corporate bond selection to be very important in generating alpha.
IMPORTANT INFORMATION
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity’s range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. FIPM: 8,672