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Asset AllocationMarch 3, 2025

With Interest Rates Elevated, It’s Time for Fixed Income

Investors are upping their allocations and focused largely on U.S.-based investments.

Art by OYOW

With interest rates at levels not reached since 2007 and expected to stay elevated despite a series of Federal Reserve rate cuts last year, fixed income investments have increasingly become an attractive asset class for allocators that, in recent years, have been under-allocated to some sections of rates and credit investments.

“The good news for investors is that higher rates bring higher yields,” says Van Hesser, chief strategist at the Kroll Bond Rating Agency. “Arguably, for the first time in 17 years, fixed-income yields are attractive, making good on its promise to do what investors expect [and] provide income and diversification benefits to the 60/40 portfolio.”

In a bid to capture some of those higher returns, asset owners are increasing their allocations to fixed income after years of scant results from Treasurys and other securities in the asset class.

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Our asset mix continued to shift toward a higher exposure to fixed income, where return opportunities remain attractive,” wrote Jonathan Simmons, chief financial and strategy officer at the Ontario Municipal Employees Retirement System, in a report detailing investment returns.

Among public pension funds, allocations to fixed income grew to 26.1% in the first half of 2024, up from 19.7% a year earlier, according to a recent survey commissioned by the National Conference on Public Employee Retirement Systems.

“We believe that the outlook for fixed income investors is positive when considering prospective returns as well as providing effective diversification to equities within multi-asset investment frameworks,” said Alexander MacKey, co-CIO, fixed income at MFS Investment Management, in a recent report.

Fixed-Income Outlook

What fixed-income securities do strategists recommend? Anders Persson, CIO for fixed income at Nuveen, recommends aiming a bit below investment grade; he also suggests areas like leveraged loans, collateralized loan obligations and certain other categories of securitized assets.

“Within securitized, we are stressing areas like CMBS and ABS—we’re still finding some dislocations there,” Persson says. “We are also stressing to think a little bit outside the traditional kind of investable universe and consider private placement, so private fixed income, from an investment grade perspective, parts of the private credit world, as well as a diversifier, making sure [investors are] leveraging the full opportunity set that fixed income is offering at this point.”

Margaret Steinbach, fixed-income investment director at Capital Group, says the firm is seeing increased interest in core and core-plus fixed-income offerings.

“It’s been an area where a lot of pensions have been under-allocated for the last several years because yields were much lower, and now with where yields are and the compression that we’ve seen in terms of risk premium across different credit categories, a lot of plans are increasing their allocations to core and core-plus,” Steinbach says.

Other areas of increased interest, Steinbach says, include multi-sector credit or flexible credit strategies, as well as multi-asset credit.

Mortgage-backed securities are also among the attractive options, according to Kevin Flanagan, head of fixed-income strategy at WisdomTree.

“U.S. corporate bond spreads reside at historically tight levels, but continued economic growth and a less restrictive Fed policy makes us neutral in the credit space,” Flanagan says. “We see better a valuation opportunity in securitized assets and are overweight agency mortgage-backed securities.”

Flanagan touts an active/passive fixed-income approach as WisdomTree’s theme for 2025.

“The passive cornerstone consists of Treasury floating rate notes, which offer income in a relatively flat yield curve setting without the potential volatility that has been heightened in fixed-coupon securities,” Flanagan says. “The active weight can focus on enhanced yield options or be more total-return-based.”

U.S. Fixed Income Preferred

Many strategists and asset managers see the U.S. bond market as a standout opportunity. Morgan Stanley, in its 2025 global fixed-income outlook, wrote that the most attractive opportunities in fixed income lie in securitized credit, particularly U.S. mortgage-backed securities.

“U.S. households with prime credit ratings maintain strong balance sheets, which should continue to support consumer credit and ancillary structures, especially as housing prices remain firm and the unemployment rate stays low,” the Morgan Stanley report stated.

Emerging markets bonds, however, are likely to face headwinds, the firm wrote: “Stronger U.S. growth, coupled with higher rates for an extended period of time and weaker global trade linkages, is typically not conductive to strong [emerging market] performance.”

Echoing this sentiment, Nuveen’s Persson says, “We’re favoring a little bit more of the U.S. over non-U.S. opportunity, and we’re comfortable going into that credit part of the opportunity set, given that we are not expecting default rates to be picking up.”

WisdomTree’s Flanagan also touts a U.S. focus. “Our focus would be more on U.S.-based solutions for fixed income. This helps mitigate some of the uncertainty surrounding currency risk and gives fixed-income investors the opportunity to take advantage of the return to a more ‘normal’ rate setting here in the U.S.”

While Europe offers opportunities in fixed income, the U.S. is preferred, Persson notes: “We think Europe could offer some good rates, we’re comfortable going longer duration, given the ECB is cutting rates in Europe pretty aggressively, but generally from a credit perspective, we’re more comfortable staying in the U.S.”

Capital Group’s Steinbach concurs: “I think the U.S. is really standing out from both a growth and relative value perspective, so that’s what is causing people to have those views. It is likely that U.S. exceptionalism continues into the future. However, there are select opportunities within say, emerging markets. But from developed market relative value, the United States continues to stand out in terms of being most attractive.”

Inflation and Fed Policy

With the Federal Reserve signaling that interest rates may remain elevated, inflation remains top of mind for many market participants, who are also evaluating the impact of President Donald Trump’s policies, including tariffs. “The big question mark is policy implications coming out of the new administration,” Steinbach says.

“We do expect that there will be some upward pressure on core PCE related to what the final tariff impact is,” Persson says.

How are investors approaching policy?

“Persistent inflation not abating, along with rising debt concerns voiced by bond vigilantes, has made domestic participants hesitant to purchase much on the long end of the curve,” says Michael Ashley Schulman, partner in and CIO of multi-family office Running Point Capital Advisors.

“Based on the macro/inflation outlook and prospects for a less aggressive rate cutting policy from the Fed, we are neutral with respect to duration,” Flanagan says. “We would highlight how extending too far out in duration has proven to be a fleeting strategy and do not see that situation changing any time soon.”

Is the Shine Coming Off of Private Credit’s ‘Golden Age’?

Private credit funds are sitting on piles of money, but the slowdown in M&A is having an impact.

By Bailey McCann

Art by OYOW

This was supposed to be the year M&A activity bounced back.

At the end of 2024, analysts were forecasting continued cuts in interest rates and the uptick in deal activity that private equity general partners and many investors have been anticipating. Indeed, January showed a 12% increase in deal activity compared with December 2024 for transactions valued at more than $100 million. Overall, 132 deals were completed, amounting to $155 billion in value, according to data from Dealogic.

Despite that, sources say, many buyers and sellers are getting cautious and feeling uncertain about how the rest of the year will shake out. The dearth of exits in private equity is starting to trickle down to some private credit funds that are at the end of their investment periods.

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More companies are using pay-in-kind financing arrangements, which is adding risk to balance sheets and portfolios. Liability management exercises, sometimes known as creditor-on-creditor violence, are also becoming more common. Inflation concerns, labor issues and potential tariffs are all making it difficult to forecast what business conditions will look like over the next month, let alone the five-to-10-year timeline on which private credit and private equity typically operate.

These are not the data points of a boom year for mergers and acquisitions.

Shifting Timelines

“There is more concern out there generally,” says Michael Ewald, global head of Bain Capital’s Private Credit Group. “If you look at where inflation is, that’s raising some concerns. There is still a mismatch on valuations. The cost of capital is still high. There’s more uncertainty overall. I think people realized they weren’t going to be able to hit the ground running in January and need to wait and see how the dust settles. To the extent that a big burst of deals is going to come to market, I think people are pushing that at least six months out and hoping to get more clarity between now and then.”

If the bulk of the M&A story for 2025 is written in the second half of the year, that would not be totally unusual historically. The problem, sources say, is that many firms and companies do not have unlimited time to wait.

Over the past few years, lenders have been willing to extend and amend loans for companies, but now it is more of a hands-on process. Ewald says that lenders are no longer automatically willing to offer an extension for an amendment fee. They want to see what the two-to-five-year plan is for the business. They are taking a much closer look at financials.

“You aren’t seeing these deals get done with debt only anymore,” he adds. “Some equity has to be in the mix. There is more structure to these deals overall.”

Companies that cannot offer up equity—or companies that end up in a liability management exercise with existing lenders who want to ensure they will recover everything the lenders are owed—could end up finding that refinancing is hard to come by or much more expensive than they anticipated. Sources say that while they do not expect a significant uptick in defaults, weaker companies may face a harder time getting to a workout arrangement on which everyone agrees.

Ewald adds that exit issues, which have plagued private equity funds for the past two years, are starting to impact private credit funds. Evergreen funds and business development companies— vehicles without tight investment timelines—are not as affected by slow exits. But fund structures with defined investment periods can run into trouble, even on the lending side.

“It’s just a persistent problem where sellers can’t get the price they’re looking for if they exit right now, so they want to find some way to extend,” Ewald says. “We were looking at a deal recently with a single lender who had to get out – they had capital they had to return to investors – and told the [borrower] if they wanted an extension to go find someone else. It’s not an existing portfolio company of ours, so we would be coming in as another lender to do the refinancing and solve their maturity problem.”

These dynamics are making Ben Radinsky, a private credit partner in HighVista Strategies, more cautious about private credit overall.

“We’re seeing distributions back to investors slow down, and it’s not necessarily a reflection of poor credit quality; it’s a reflection of structural issues in the broader transaction environment,” he says. “That liquidity problem is coming alongside indications of higher distress at both the senior debt level and the mezzanine level. I think that’s being driven by the fact that interest rates remain elevated, and earnings are not keeping up with elevated rates. We are starting to see covenant compression in some areas. The net result is more companies are turning to [payment-in-kind] loans, and whenever you have that, you have a whole host of risks emerge that eat into your loan-to-value and eat into the liquidity investors are expecting and not getting because there’s no cash [paid] on a PIK.”

The use of PIK loans is growing out of necessity, sources say, but almost no one seems to like it.

David Ross, head of private credit at Northleaf Capital Partners, says PIK loans can be a valuable tool for companies to get the financing they need, especially if liquidity is tight otherwise. But, he says, as a lender, it requires extra due diligence up front.

“We are very cautious about our portfolio’s exposure to PIK interest loans, which is focused on supporting strong, performing borrowers, but it is also critical to be transparent with our investors about the current market dynamics and what our PIK exposure is,” he explains.

But even with that transparency, investors ultimately do not have many options or outs if they are not comfortable with adding risk. In this way, the growing use of PIK financing is similar to the use of other liquidity solutions like net asset value loans or continuation funds. All of these tools have grown in popularity as the result of the tough liquidity environment for both sponsors and investors, but they all come with trade-offs.

Radinsky explains it this way: “The dilemma is if you’re in a credit fund as an LP right now and you’re coming up to end of lifecycle, the managers will come up to you and say, ‘OK, I’ll show you all the underlying assets which are performing fine, but we have a problem, because the fund expires.’ If they force a refinancing, it will come at a loss. LPs can take that loss, try to sell their stake on the secondary market or try rolling it into some new vehicle. If you, as an allocator, have the liquidity to deal with it, you’re probably taking Option 2 or 3, but those are fast-moving options. The terms might be subpar. LPs don’t like it.”

Uncertainty Ahead

Alongside the increased use of complex financing solutions, business conditions are getting harder to predict, which could lead to problems for lenders. Recent inflation prints have come back higher than expected. If that trend continues, companies may face persistently higher labor costs, says Michael Guarnieri, managing partner in Evolution Credit Partners.

“We’ve all been focused on the labor question for the past few years, and that’s unlikely to change,” he says. “It does impact how you assess company financials and long-term forecasts.”

Rising tariffs could also have an impact.

“It’s very, very difficult to follow the supply chain for a given business all the way through end-to-end and determine how tariffs will or won’t impact each part of it,” Guarnieri says. “Even if a single company is relatively insulated, there are knock-on effects of these policies throughout the economy. It’s hard to say how that will ultimately play out.”

Tariffs tend to be inflationary, and if inflation continues to rise, that could put the Fed in a tight spot. If recent layoffs in the federal government and private sector start putting pressure on the other part of the Fed’s dual mandate, Federal Reserve Chairman Jerome Powell could be forced to act on interest rates, and that would likely lead to a lot of volatility in credit.

Ewald says if the Fed holds rates where they are, the market will not be happy about it but can likely muddle through.

But “if the Fed raises rates, even nominally, that would really spook the market—we’d see a lot of volatility in that scenario,” he says.