This is a sponsored article from L&G.

Author: Matthew Rees, Head of Global Bond Strategies

For corporate bond investors, the key question for 2025 is what matters most, high total yields? Or the skinny extra yield you pick up for taking on credit risk (the credit spread)?

We think the continued inflows into fixed income answer this debate. In our view, these flows have been driven by the yields on offer, which has, in turn, led to spreads compressing to multi-decade tights. It’s easy to argue that fundamentals are also supportive, both from a top-down position with strong US growth and bottom-up with improving credit quality.

The main downside risk would be if core inflation rebounds, driving the US Federal Reserve to pivot towards a hiking cycle, sending investors running for short-term deposits for fear of negative total returns.

That said, recent experience shows that any increase in yields is initially met with waves of investor demand. We think it would take multiple months of upside inflation data, or the actual implementation of aggressive Trump policy, to reverse the current trend. We are, therefore, comfortable maintaining a long credit bias across our portfolios.

This logic also influences our government bond market outlook. The disinflation momentum that started in 2023 has been strong, and the beneficial negative correlation between rates and credit spreads that investors enjoyed for much of the 21st century has re-asserted itself after the shock of 2022/23. Therefore, we think there is insurance value in duration for fixed income investors.

Trouble with forecasts

Digging deeper into the government bond markets, we think there are opportunities from the overconfidence of our investment peers. We are particularly interested in unsustainable overconfidence when the consensus can be easily disproven by subsequent events.

Forecasting economic growth and inflation is hard. The International Monetary Fund (IMF) is one of the most respected macroeconomic institutions on the planet. It has a staff of over 3,000 (including over 1,000 economists) and spends over US$100 million per annum on ‘macro-financial surveillance’.

But even with this economic firepower, the IMF has found it difficult to accurately forecast recessions. Taking the 30 years between 1992 and 2022 into consideration, we found only 8% of recessions had been forecast by the IMF’s economists the year before they started. That rose to 71% for the years during which the recessions took place.

In other words, the IMF finds it easier to open the window and realise that it is raining than to anticipate when the clouds will break. This failure does not stem from an institutional over-optimism. False alarms are also worryingly common. 50% of the IMF’s recession forecasts have not materialised.

Exploiting overconfidence

And yet, this does not undermine confidence in forecasts. The chart below looks at range forecasts for key US economic variables provided over six decades. Participants in the survey were asked to calibrate their level of confidence that unemployment, inflation and growth would fall within certain ranges.

Forecasters are reasonably good at identifying what they don’t know. In the bottom left-hand corner, the observations are close to the 45-degree line. Events expected to happen 20% of the time subsequently happened around 20% of the time.

But forecasters came unstuck when their confidence outpaced their predictive capability. Forecasts made with 90-100% confidence turned out to be correct only six times out of 10. Forecasts made with 80-90% confidence were wrong as often as they were right.

Our investment philosophy is based on finding opportunities to exploit such overconfidence. We believe that this can be well rewarded when others have not taken enough uncertainty into account.

Outlooks for 2025 emphasise the new Trump administration and the sharp reductions in European growth that could result from a combination of Trump’s tariff policies, economic challenges in Germany and political dysfunction in France.

We think the risk to the US consensus view is to the downside, as the touted tariff package is several times larger than that of Trump’s last term of office. This supports our constructive view on US duration and our underweight position in US credit, where spreads at similar tights have not been seen since 1998.

In Europe, we see an abundance of caution. Hence, we are positioned against the consensus, with a preference to be short on German duration and continue to prefer EUR over USD credit.

It doesn’t matter if you are unsure about your economic forecasts if other investors are overconfident about theirs.

Click here to explore L&G’s active fixed income strategies. For more thought leadership pieces from L&G, please click here.
 

---

Key risk warnings

The value of investments and the income from them can go down as well as up and you may not get back the amount invested. Past performance is not a guide to future performance. The details contained here are for information purposes only and do not constitute investment advice or a recommendation or offer to buy or sell any security. The information above is provided on a general basis and does not take into account any individual investor’s circumstances. Any views expressed are those of LGIM as at the date of publication. Not for distribution to any person resident in any jurisdiction where such distribution would be contrary to local law or regulation.

Issued by:
Hong Kong: Legal & General Investment Management Asia Limited, a Licensed Corporation (CE Number: BBB488) regulated by the Hong Kong Securities and Futures Commission (“SFC”). This material has not been reviewed by the SFC.

Singapore: LGIM Singapore Pte. Ltd (Company Registration No. 202231876W), regulated by the Monetary Authority of Singapore (“MAS”). This material has not been reviewed by the MAS.

This is a sponsored article from L&G.