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Why bonds now

Key takeaways

  • A Fidelity bond manager believes the combination of relatively high current yields and lower interest rates ahead may deliver more attractive total returns for bonds in 2025.
  • That could make high-quality, low-risk investment-grade bonds an attractive alternative to cash in 2025, as well as a hedge against market volatility.
  • Bond mutual funds and exchange-traded funds (ETFs) may help investors diversify their bond exposure and target specific goals such as income or total return.

A combination of yields that are near multi-decade highs and interest rates that are expected to gradually fall through 2025 is creating an attractive opportunity for bond investors in the new year.

It’s been nearly 20 years since high-quality, low-risk investment-grade bonds could potentially deliver both attractive interest payments and more potential for capital appreciation than stocks or cash. Throw in bonds’ lower historical volatility than stocks and an increasing tendency to rise when stocks fall, and it’s easy to see why investors may want to explore this opportunity to earn reliable income, grow their portfolios, and diversify away some risk in the new year.

Michael Plage manages the Fidelity® Investment Grade Bond Fund () and he believes that 2025 is likely to be a good time for skilled bond investors to take advantage of that opportunity. “The all-important starting yields are higher than they’ve been for a long time and the Federal Reserve is reducing interest rates. That’s the combination I’ve been waiting for,” he says.

The Fed factor

According to Plage, his view is that bonds will become increasingly able in 2025 to play their historical role of delivering significant income and preserving capital by rising in price when stocks fall. He believes that the Fed holds the key to the return of “normal” bond markets by both lowering interest rates and reducing the size of its balance sheet. That would mean that willing buyers and willing sellers—rather than government policies—would once again determine prices and bond markets would behave the way they have for most of history, rising when stocks fall and helping investors diversify and reduce risk in their portfolios. This dynamic is already reappearing in the US Treasury market where yields on longer-maturity bonds have been rising even as the Fed has been lowering interest rates.

Despite 2 cuts in the short-term fed funds rate and the likelihood of more to come, 10-year Treasury bonds yield more as of December 3, 2024, than they did at the beginning of the year. Instead of responding entirely to the direction of short-term interest rates which are determined by the Fed, the Treasury market now shows signs of being influenced by investors who expect a term premium, which means extra yield as compensation for owning longer-maturity bonds. Plage says this an indicator of a healthy, functioning Treasury market and expects yields will move around within a range between 3.5% and 4.5% in 2025.

Plage believes that the Fed should be able to stay on its course toward lower short-term interest rates, potentially dropping the fed funds rate as low as 3.75% by the end of 2025. "Given the size of the national debt and the need for Washington to secure the finances of Social Security and Medicare, I'm not expecting many big government ideas with big fiscal consequences so I believe the Fed will have the flexibility to potentially keep cutting rates,” he says. “With the Fed now cutting rates, the big headwind of uncertainty that previously hung over the bond market should now be a modest tailwind over the next 12 months.”

Why bother with bonds amid a bull market for stocks?

With US stocks hitting record highs, it can be easy to overlook other investment opportunities, especially ones that have delivered modest returns in recent years. To understand the opportunity in bonds in 2025, it’s important to remember where bond returns come from. A bond can deliver return to its owner from 2 sources: interest payments known as coupons whose rate is set at the time the bond is issued, and changes in the price of the bond as it trades in the market.

The interest rate of the coupon remains the same until the bond matures but the price can rise or fall throughout the trading day. Because bond prices typically rise when interest rates fall, the best way to earn a high total return from a bond or bond fund is to buy it when interest rates are high but coming down. The last time the Fed gradually cut rates over time was in 2019 and early 2020, when what was known then as the Barclay’s Aggregate Bond Index rose by nearly 15%. Of course, past performance is no guarantee of future results. But in similar periods historically, investors have been able to lock in still relatively high coupon yields and also enjoy the increase in the market value of their bonds as rates come down.

Why bonds may be better than cash in 2025

Plage believes that bonds in 2025 present a unique and appealing opportunity for investors who have been sitting in money market funds or short-term CDs to not only lock in longer-term coupon income and seek potential capital appreciation, but also to reduce risk in their portfolios. While yields on CDs and money markets rose to roughly 5% after the Fed began raising short-term interest rates in 2022, those yields are likely to continue to move lower in 2025 and to stay lower than they had been. That raises the risk that investors who need a certain level of income from their portfolios won’t get it if they stay in cash.

Investing in a bond mutual fund or ETF

Buying shares of a bond mutual fund or ETF is an easy way to add a bond position. Bond funds hold a wide range of individual bonds, which makes them an efficient way to diversify your holdings even with a small investment.

An actively managed fund also gives you the benefits of professional research. For example, the managers can make decisions about which bonds to buy and sell based on huge volumes of information including bond prices, the credit quality of the companies and governments that issue them, how sensitive they may be to changes in interest rates, and how much interest they pay.

Not all bond funds are actively managed. Investors who seek bond exposure in a fund can also choose among exchange-traded and index funds that seek to track bond market indexes such as the Bloomberg US Aggregate Bond Index.

Here's more about the difference between investing in bond mutual funds or ETFs and individual bonds.

Investing in individual bonds

If you have enough money and believe you have the time, skill, and will to build and manage your own portfolio, buying individual bonds may be appealing. Unlike investing in a fund, doing it yourself lets you choose specific bonds and hold them until they mature, if you choose. However, you still would face the risks that an issuer might default or call the bonds prior to maturity. This approach requires you to closely monitor the finances of each issuer whose bonds you're considering. You also need enough money to buy a variety of bonds to help diversify away at least some risk. If you are buying individual bonds, Fidelity suggests you consider spreading investment dollars across multiple bond issuers.

Fidelity offers over 100,000 bonds, including US Treasury, corporate, and municipal bonds. Most have mid- to­ high-quality credit ratings that would be appropriate for a core bond portfolio.

Tools and resources for investors looking for individual bonds include:

Personalized management

Separately managed accounts (SMAs) combine the professional management of a mutual fund with some of the customization opportunities of doing it yourself. In an SMA, you invest directly in the individual bonds, but they are managed by professionals who make decisions based on factors such as current market conditions, interest rates, and the financial circumstances of bond issuers. Find out more about separately managed accounts.

Whatever your bond investing goals, professionally managed mutual funds, active ETFs, or separately managed accounts can help you. You can run screens using the Mutual Fund Evaluator and ETF/ETP Screener on Fidelity.com. Here are some ideas for intermediate core bonds as of December 10, 2024:

Bond mutual funds

  • Fidelity® Intermediate Bond Fund ()
  • Fidelity® Investment Grade Bond Fund ()

ETFs

  • Fidelity® Investment Grade Bond ETF ()
  • PIMCO Active Bond Exchange-Traded Fund ()
  • iShares Core US Aggregate Bond ETF ()
  • iShares Core Total USD Bond Market ETF ()

Research bonds quickly and easily

Get investment analysis to help you invest in bonds.

More to explore

Before investing in any mutual fund or exchange-traded fund, you should consider its investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus, an offering circular, or, if available, a summary prospectus containing this information. Read it carefully.

The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.

The views expressed are as of the date indicated and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments. The third-party contributors are not employed by Fidelity but are compensated for their services.

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.

Past performance is no guarantee of future results.

A bond ladder, depending on the types and amount of securities within it, may not ensure adequate diversification of your investment portfolio. While diversification does not ensure a profit or guarantee against loss, a lack of diversification may result in heightened volatility of your portfolio value. You must perform your own evaluation as to whether a bond ladder and the securities held within it are consistent with your investment objectives, risk tolerance, and financial circumstances. To learn more about diversification and its effects on your portfolio, contact a representative. The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-back securities (agency fixed-rate pass-throughs), asset-backed securities and collateralised mortgage-backed securities (agency and non-agency). The S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.

Lower yields - Treasury securities typically pay less interest than other securities in exchange for lower default or credit risk.

Interest rate risk - Treasuries are susceptible to fluctuations in interest rates, with the degree of volatility increasing with the amount of time until maturity. As rates rise, prices will typically decline.

Call risk - Some Treasury securities carry call provisions that allow the bonds to be retired prior to stated maturity. This typically occurs when rates fall.

Inflation risk - With relatively low yields, income produced by Treasuries may be lower than the rate of inflation. This does not apply to TIPS, which are inflation protected.

Credit or default risk - Investors need to be aware that all bonds have the risk of default. Investors should monitor current events, as well as the ratio of national debt to gross domestic product, Treasury yields, credit ratings, and the weaknesses of the dollar for signs that default risk may be rising.

Credit and default risk - While MBS backed by GNMA carry negligible risk of default, there is some default risk for MBS issued by FHLMC and FNMA and an even higher risk of default for securities not backed by any of these agencies, although pooling mortgages helps mitigate some of that risk. Investors considering mortgage-backed securities, particularly those not backed by one of these entities, should carefully examine the characteristics of the underlying mortgage pool (e.g. terms of the mortgages, underwriting standards, etc.). Credit risk of the issuer itself may also be a factor, depending on the legal structure and entity that retains ownership of the underlying mortgages.
 
Interest rate risk - In general, bond prices in the secondary market rise when interest rates fall and vice versa. However, because of prepayment and extension risk , the secondary market price of a mortgage-backed security, particularly a CMO, will sometimes rise less than a typical bond when interest rates decline, but may drop more when interest rates rise. Thus, there may be greater interest rate risk with these securities than with other bonds.
 
Prepayment risk - This is the risk that homeowners will make higher-than-required monthly mortgage payments or pay their mortgages off altogether by refinancing, a risk that increases when interest rates are falling. As these prepayments occur, the amount of principal retained in the bond declines faster than originally projected, shortening the average life of the bond by returning principal prematurely to the bondholder. Because this usually happens when interest rates are low, the reinvestment opportunities can be less attractive. Prepayment risk can be reduced when the investment pools larger numbers of mortgages, since each mortgage prepayment would have a reduced effect on the total pool. Prepayment risk is highly likely in the case of MBS and consequently cash flows can be estimated but are subject to change. Given that, the quoted yield is also an estimate. In the case of CMOs, when prepayments occur more frequently than expected, the average life of a security is shorter than originally estimated. While some CMO tranches are specifically designed to minimize the effects of variable prepayment rates, the average life is always at best, an estimate, contingent on how closely the actual prepayment speeds of the underlying mortgage loans match the assumption.
 
Extension risk - This is the risk that homeowners will decide not to make prepayments on their mortgages to the extent initially expected. This usually occurs when interest rates are rising, which gives homeowners little incentive to refinance their fixed-rate mortgages. This may result in a security that locks up assets for longer than anticipated and delivers a lower than expected coupon, because the amount of principal repayment is reduced. Thus, in a period of rising market interest rates, the price declines of MBS would be accentuated due to the declining coupon.
 
Liquidity - Depending on the issue, the secondary market for MBS are generally liquid, with active trading by dealers and investors. Characteristics and risks of a particular security, such as the presence or lack of GSE backing, may affect its liquidity relative to other mortgage-backed securities. CMOs can be less liquid than other mortgage-backed securities due to the unique characteristics of each tranche. Before purchasing a CMO, investors should possess a high level of expertise to understand the implications of tranche-specification. In addition, investors may receive more or less than the original investment upon selling a CMO.

Investments in mortgage securities are subject to prepayment risk, which can limit the potential for gain during a declining interest rate environment and increase the potential for loss in a rising interest rate environment.

You could lose money by investing in a money market fund. An investment in a money market fund is not a bank account and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Before investing, always read a money market fund’s prospectus for policies specific to that fund.

Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Your ability to sell a CD on the secondary market is subject to market conditions. If your CD has a step rate, the interest rate of your CD may be higher or lower than prevailing market rates. The initial rate on a step rate CD is not the yield to maturity. If your CD has a call provision, which many step rate CDs do, please be aware the decision to call the CD is at the issuer's sole discretion. Also, if the issuer calls the CD, you may be confronted with a less favorable interest rate at which to reinvest your funds. Fidelity makes no judgment as to the credit worthiness of the issuing institution.

Indexes are unmanaged. It is not possible to invest directly in an index.

The Fixed Income Analysis tool is designed for educational purposes only and you should not rely on it as the primary basis for your investment, financial or tax planning decisions.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917

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