Junk Bonds Surprise With Strong Gains in 2024. But Are They Worth the Risk in 2025?

The bond market is poised to remain turbulent in 2025, even as investor sentiment about the U.S. economy has brightened following the presidential election. Persistent uncertainty around U.S. monetary and fiscal policies is driving volatility in interest rates, including the yield on the 10-year Treasury note. Michael Arone, chief investment strategist at State Street Global Advisors, highlighted these challenges in an interview, saying, “We expect interest-rate volatility to remain high next year.” Despite this, Arone maintains a positive outlook on credit, particularly high-yield bonds.

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High-yield bonds, often referred to as "junk" due to their below-investment-grade status, have outperformed the broader U.S. fixed-income market significantly in 2024. Earlier this year, when recession fears loomed, Arone predicted these bonds might deliver surprising returns, citing the potential for a "soft landing" in the economy despite aggressive Federal Reserve rate hikes. Reflecting on the year, Arone noted that the soft landing had materialized, with inflation cooling and the economy slowing but avoiding a recession. Both the labor market and corporate sectors, he added, remain in good condition.

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Nonetheless, the bond market continues to experience heightened volatility as investors grapple with questions about how fiscal policies under the incoming Trump administration might impact the Federal Reserve’s recently initiated rate-cutting cycle. Rate fluctuations pose risks, especially with inflation still above the Fed's 2% target despite significant easing.

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The ICE BofAML MOVE Index, a measure of bond market volatility, has dropped nearly 28% in 2024, reaching 82.66 as of December 12. While this marks a notable decline, it remains well above levels seen in late 2020, when the Fed slashed rates to near zero following the market upheaval caused by the COVID-19 crisis.

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Bond volatility surged during the pandemic as inflation soared, prompting the Fed to undertake a rapid series of rate hikes to rein in price increases. According to AllSpring Global Investments, this shift from ultra-low interest rates, combined with the Fed’s reliance on data to guide policy, signals a “new normal” for bond market volatility. The firm emphasized that a return to the low-volatility conditions seen after the 2008 financial crisis is unlikely.

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In 2025, investors will closely monitor trade and immigration policies under President-elect Trump, as concerns persist that more aggressive tariffs and deportation policies could fuel inflation. Mitchell Garfin, co-head of leveraged finance at BlackRock, described the current inflation trajectory as encouraging, saying, “We’re on the right path right now.” Garfin also highlighted a favorable market environment for risk assets, including high-yield bonds.

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Even if rising inflation pushes bond yields higher and pressures fixed-income asset prices, junk bonds may outperform longer-duration securities in an expanding economy, Arone explained. The yield advantage of high-yield bonds offers a buffer against potential losses from rising rates. Indeed, exchange-traded funds (ETFs) holding high-yield bonds have delivered strong returns this year.

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The SPDR Bloomberg High Yield Bond ETF (JNK) has posted an 8.5% total return through December 12, while the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) has gained 8.8%. These results significantly outpace the 2.4% and 3.2% returns of ETFs tracking broader investment-grade bond markets.

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High-yield bonds’ shorter duration has contributed to their resilience. Duration, a measure of sensitivity to interest rate changes, is significantly lower for high-yield bonds compared to broader fixed-income benchmarks. For instance, the iShares Core U.S. Aggregate Bond ETF, benchmarked to the Bloomberg U.S. Aggregate Bond Index, had an effective duration of nearly six years as of December 12. In contrast, the iShares iBoxx $ High Yield Corporate Bond ETF’s portfolio had a duration of just over three years.

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Longer-duration bonds, such as 10-year Treasurys, have experienced volatility, with yields rising throughout 2024. Meanwhile, ETFs focusing on long-term Treasury bonds, such as the iShares 20+ Year Treasury Bond ETF (TLT), have faced losses, dropping 4.5% on a total return basis this year.

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The spread between yields on junk bonds and comparable Treasurys, a key measure of risk, has narrowed to historically low levels. While tight spreads often signal optimism about the economy and corporate earnings, they also raise caution among investors. Collin Martin, director of fixed-income strategy at Charles Schwab, warned that U.S. high-yield bonds currently lack sufficient cushion to absorb potential widening spreads. He noted that this dynamic makes investment-grade bonds more appealing, particularly given global risks and the possibility of slower-than-expected economic growth.

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Historically, credit spreads tend to widen during recessions or market turmoil, which can hurt returns for riskier bonds. Borrowers with lower credit ratings face heightened default risks in economic downturns due to their heavy debt burdens. Janus Henderson Investors acknowledged the tightness of spreads in its 2025 high-yield bond outlook but suggested they could remain compressed during periods of economic stability.

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Despite these risks, Arone expressed a constructive outlook for credit in 2025, citing expected economic and corporate earnings growth, low default rates, and relatively high all-in yields for junk bonds. While he acknowledged the possibility of economic surprises, he predicted that the "high-yield Chicken Littles" — those warning of imminent trouble in the high-yield market — would likely be proven wrong, at least in the short term.

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Arone also endorsed floating-rate leveraged loans, another form of risky corporate credit offering higher yields. However, he cautioned that if the economy deteriorates unexpectedly, credit spreads could widen, negatively impacting these assets. "The big risk here is that we’re somehow wrong about the economy," he said.

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