The new calendar year will bring in a new administration, along with tax, tariff, and trade policy proposals that could impact investment opportunities across asset classes. Fixed income is especially top of mind as investors look to position portfolios in a new interest rate regime.
Sylvia Yeh, co-head of municipal fixed income at Goldman Sachs Asset Management, dives into the outlook for 2025, and shares some key considerations for fixed income investors, especially in the municipal bond market.
Question: We are all talking about a new interest rate regime. Let’s start there — what’s your outlook for rates in 2025?
Sylvia Yeh: We can’t really speak about 2025 without acknowledging what we experienced this year. That is, the interest rate narrative shifted significantly from a “hard” to a “soft” landing environment.
Inflation continues to normalize, albeit at a slower pace than anticipated. The labor market continues to show strength, and the US consumer is propelling the US economy. This leads us to believe that yields may be “higher for longer.” In this “higher for longer “environment, we yields should be a little “stickier” because of stimulative fiscal policy and supportive economic growth steepening out yield curves.
We do also expect bouts of volatility intermittently throughout the year given U.S. policy uncertainty — specifically around Trade, Taxes, and Immigration.
Question: There’s renewed concern about inflation, given some of the proposed policies by the incoming administration. Has the outlook for fixed income as an asset class, specifically municipal bonds, changed post-election? Going into the election, we were talking about a great year for bonds in 2025. Is that still the case?
Yeh: The “Trump Trade” has certainly repriced most markets as policy impacts are assessed. Fixed income investors, for example, may have been looking ahead to lower interest rates, especially since the Fed started cutting rates in September. But now, investors — and markets more broadly — have turned their focus back to inflationary pressures and a rising deficit. That’s because Trump is keen to impose tariffs and establish or maintain a lower tax rates for both individuals and corporations.
That concern initially forced a repricing in rates, but we have returned to yield levels before the Presidential election. This is a precursor to the volatility we continue to expect in 2025.
As it relates to munis, we will be closely monitoring to the rhetoric surrounding tax reform. The red sweep makes it now likely that the individual tax provisions in the Tax Cuts and Jobs Act are extended to some degree. However, the likelihood of sweeping tax reform in 2025 is small, given the slim Republican majority in the House.
A key takeaway for fixed income investors is that yields remain elevated, so building out your core fixed income allocation is prudent. Active management, credit selection, and duration management can help optimize your bond portfolio and capitalize on opportunities created by policy uncertainty.
Question: From a macro perspective, what are the main drivers of results or points of concerns for municipal bond investors?
Yeh: The main drivers will be the direction of Treasury rates as the Fed continues to ease policy and navigate shifts in U.S. policy surrounding trade, taxes, and immigration.
General sentiment towards fixed income markets coupled with cross-market relative value will also drive muni flows as we kick off 2025. The record level of cash sitting on the sidelines in money market funds is worth keeping an eye on and should add support to municipal bond prices throughout the year.
From a valuation perspective. we’re entering the new year with narrow credit spreads and ratios slightly rich to fair value. Because of this, municipal investors will need to prudently manage risks in portfolios.
Even with the potential for bouts of volatility throughout the year, the opportunity set in munis, with elevated tax-equivalent yields alongside healthy credit fundamentals, should be supportive of positive flows into muni SMA/ETF/mutual funds.
Question: Are states in a good position to navigate a changing economic landscape, especially if any form of tax cuts materialize? NASBO projects slower growth next year, but suggests most states have enough reserves to keep projects going.
Yeh: Our outlook on municipal credit fundamentals remains cautiously positive. States have been meaningfully increasing reserves and rainy-day funds throughout this most recent period. And at current levels, average reserves provide a hefty offset to any future revenue declines should we see broader economic weakness.
Issuers have also de-levered, as debt service as a percentage of budgets has decreased. Positive equity performance will likely help pension funding ratios and add to income tax collections. And solid GDP growth (~2.5% range) should provide solid footing to keep sales tax growth firmly positive.
Question: How have muni bonds delivered value this year?
Yeh: We endured quite a rollercoaster ride this year, as the 10-yr U.S. Treasury rates opened the year at around 3.90% before selling off to around 4.70% in the late spring, before rallying back to around 3.60% in late summer and most recently retracing to 4.40%. Even amidst all this rate volatility, the Muni Agg has returned about 1.5% YTD.
Have munis delivered? We had two separate instances where the 10-yr U.S. Treasury sold off 70-plus bps and munis still managed to deliver positive returns. I think that would be an acceptable outcome for most return-minded fixed income investors. This speaks to the benefit of today’s higher yield environment and the need for active management as valuations shift in the muni market.
Depending on when investors deployed cash, the return profiles throughout this year could be vastly different. For instance, if investors deployed cash in municipals in May, it would be about +3%, approximately 150bps higher than putting money to work at the start of the year when valuations were extremely stretched given technical supply/demand balances.
Question: What can investors expect from munis in a new rate regime? Where are the key opportunities for 2025?
Yeh: We’re expecting to see increased investor interest in the asset class. Muni investors can expect durability from strong credit fundamentals and find attractive tax-equivalent yields.
We think investors will be drawn to the asset class because of higher yields and a need to extend duration as the yield curve steepens throughout the year due to continued Fed easing.
We’re also excited to see another year of increased issuance and the pockets of opportunities that may present. Whether it’s that issuers have gotten comfortable with the “higher for longer” theme, recent ballot approvals, growing infrastructure needs, and/or dwindling COVID-19 dollars, we expect issuers to continue to tap markets for capital spending projects and to further improve cash positions rather than spend down the reserves they have accumulated. The increased issuance creates opportunities for active investors to capitalize on and may also contribute to stickier muni yields in 2025.
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Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.
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