Quarterly Market & Performance

The final quarter of 2024 was particularly challenging for bond investors. Rising yields pushed bond prices lower as persistently high inflation and economic growth rates caused the Federal Reserve to take a cautionary tone towards future interest rate cuts, heightening investor uncertainty. The Aggregate Bond Index declined by 3.1% during the quarter, erasing much of the year’s earlier gains. Bond yields jumped, with index yields approaching 5%, near recent year highs[1].

Despite these headwinds, our conservative fixed income strategies proved resilient. By emphasizing shorter-duration bonds, our fixed income portfolios mitigated price declines. This approach allowed the income generated from our holdings to offset price volatility better than the broader bond market, resulting in attractive relative returns.

Federal Reserve policy continued to dominate market sentiment. The Fed implemented two rate cuts during the quarter, bringing the federal funds rate down to 4.5%. Policymakers’ December meeting minutes revealed a divided outlook on rate cuts for 2025, with projections pointing to a median federal funds rate target of 3.75% to 4% by year-end. Officials acknowledged stronger-than-expected economic growth and resilient consumer spending, while concerns about inflation’s stickiness and fiscal policy uncertainties additionally tempered their optimism.

The bond market’s struggles in Q4 underscore a critical lesson: forecasting interest rates is notoriously difficult. As the chart below illustrates, the actual path of the Fed funds rate has consistently diverged from market forecasts at various points in time. While market expectations initially priced in a swift pivot to rate cuts, solid economic data has created roadblocks to further easing. For investors, this unpredictability reinforces our focus on delivering defensible bond returns in any rate environment.

Figure 1: Interest Rates vs Expectations[2]

Source: Kovitz using data from Bloomberg Finance, L.P. from 12.31.1999 through 12.31.2024

2024 Bond Market Year Review

Reflecting on 2024, the bond market painted a mixed picture. Early in the year, optimism prevailed as inflation appeared to be moderating, and the Fed began easing monetary policy. By mid-September, the Aggregate Bond Index was poised to deliver a second consecutive year of 5%+ returns. However, the tide turned in the final months as inflation concerns resurfaced, prompting a more measured pace of rate cuts from the Fed and pressuring prices of longer-term bonds.

For the year, the Aggregate Bond Index managed a modest 1.3% gain, which was insufficient to outpace the 2.7% inflation over the course of the year[3]. This dynamic marked a continuation of the challenges faced by most fixed income investors in recent years, where rising prices eroded real returns.

Several themes shaped the 2024 bond market:

1.Inflation Persistence: Despite the Fed’s aggressive tightening earlier in the cycle, inflation remained above the Fed’s 2% target. The most recent core inflation readings showed prices growing 3.3% annually[4], driven by the continued rise in shelter costs across the US.

2.Diverging Yields: Short-term and long-term rates moved in opposite directions. While the 1-year Treasury yield fell over half a percent to 4.2% by year-end, the 10-year yield climbed by a similar amount to 4.6%, suggesting concerns that the Fed hasn’t done enough to quell persistent inflation and growth.

3.Credit Market Resilience: Municipal and corporate bond issuers are maintaining healthy balance sheets despite rising rates, with municipal and corporate leverage as a percent of GDP near decade lows[5]. These fundamentals contributed to compressed risk premiums and relative stability in higher-quality credit sectors.

Success in 2024 hinged on avoiding volatile duration risks, which we effectively managed. While the limited number of credit events lessened the need for a strict focus on high-quality investments, we believe it’s essential for bond investors not to take the favorable economic backdrop for granted.

2025 Bond Market Review

Looking ahead, the fixed income landscape is littered with potentially impactful uncertainties. Several factors will be critical to shaping the bond market’s trajectory:

1.Credit Health: While corporate and municipal balance sheets remain strong, interest expense will continue to be pressured higher as low fixed-rate debt matures and is refinanced at significantly higher interest costs. This shift could weigh on earnings and increase the potential for credit stress, especially in lower-quality segments.

2.Federal Reserve Policy: The Fed’s actions will remain a key driver of interest rates. Policymakers’ emphasis on data dependence suggests a slow and measured approach to future rate adjustments. Additional rate cuts in the new year will depend on inflation’s path and the strength of the labor market, which have been tough for the Fed to steer.

3.Political Landscape: The incoming administration’s fiscal and trade policies could introduce new dynamics to the interest rate environment. Proposals to lower taxes, increase tariffs, and curb immigration may impact economic growth and inflation. The debt ceiling debate, in particular, could weigh on market sentiment.

4.Valuation Backdrop: Bond market valuations broadly reflect investor optimism. While absolute yield levels are high, credit spreads are historically tight, suggesting limited compensation for investors taking on additional credit risk. We believe credit markets exhibiting such exuberance should be approached with a healthy dose of caution.

For 2025, we remain cautiously optimistic. Our strategy will continue to prioritize high-quality, shorter-duration assets while selectively seeking opportunities in sectors offering attractive risk-adjusted returns. With market volatility likely to persist, this disciplined approach ensures we are well-positioned to take advantage of whatever opportunities 2025 brings.

Conclusion

As we close the books on 2024, we are reminded of the importance of staying focused on long-term goals. Success in the past year required managing duration risk effectively while navigating a stable but evolving credit landscape. Given the uncertainties of fiscal and monetary policy in the year ahead and credit spreads starting the year at levels implying minimal risk, we believe success in 2025 will require similar levels of prudence and adaptability.

Thank you for entrusting us with your fixed income investments. We look forward to working with you to achieve your financial goals in the year ahead.

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[1]Bloomberg US Aggregate Bond Index. Yield measured as yield-to-worst.

[2]From 12/31/99 through 12/31/2024. SOURCE: Kovitz using data from Bloomberg Finance L.P.

[3]US CIP Urban Consumers YoY NSA as of November 2024.

[4]US CPI Urban Consumers Less Food & Energy YoY NSA as of November 2024, the Fed’s preferred inflation measurement.

[5]Board of Governors of the Federal Reserve System Debt of Nonfinancial Sectors as of Q3 2024.

DISCLOSURES

Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. The information and opinions expressed in this publication are not intended to constitute a recommendation to buy or sell any security or to offer advisory services by Kovitz. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to participate in any trading strategy, and should not be relied on for accounting, tax, or legal advice. This report should only be considered as a tool in any investment decision matrix and should not be used by itself to make investment decisions.

Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.