Piton Webinar: Q2 2025 Fixed Income Update and Outlook

Welcome to Piton Investment Management's Q2 2025 Fixed Income Update and Outlook with CIO Brian Lockwood.

The second quarter of 2025 has been marked by unprecedented policy uncertainty and market volatility following the Trump administration's "Liberation Day" tariff announcements in early April. The Federal Reserve has maintained its key interest rate unchanged at 4.25%-4.5% throughout Q2, holding steady through May and June meetings as policymakers grapple with the dual challenges of potential tariff-driven inflation and signs of economic slowing. Today, Brian examines these dramatic developments and their implications for fixed income positioning as we move into the second half of 2025.

Recorded July 1, 2025

Q1. Following the tariff announcement in early April and subsequent market volatility, how have different fixed income sectors, such as treasuries, corporate municipals, and high yield, performed in Q2 2025, and which sectors have shown the most resilience during this period of heightened volatility?

Fixed income has had a pretty good first half of 2025. We've got the aggregate market up about 4%. We've got the riskier sectors of fixed income up about 6%. Municipals lagged a little bit. In general, fixed income markets had a good first half of the year. And that's despite taking a backseat to equity markets, which we had the Nasdaq up almost 18% and the S&P up 11% in the second quarter. While fixed income, once again, has taken a little bit of a backseat to the equity markets in the second quarter of this year, still some really good positive factors in there. And again, we have some good yields to have as a buffer despite risk markets having a great run.

Q2 2025 Fixed Income Sector Performance:

• Fixed income gained 4% in first half with riskier sectors up 6%, though equity markets dominated with Nasdaq rising 18% and S&P 500 up 11%.

• Municipal bonds lagged other sectors but still delivered positive returns during the volatile period.

• Strong yield levels provided important buffers against volatility, helping bonds maintain defensive characteristics despite equity outperformance.

Q2. With the Federal Reserve maintaining rates at four and a quarter to four and a half throughout Q2, and market expectations for rate cuts being pushed further out. How has the yield curve evolved and what implications does this have for duration positioning and investors who had expected earlier policy easing?

Let me take the yield curve part first. What we've seen throughout the year is what we would call a bull steeper, and that's where you see lower rates across the board but led by the short to intermediate sector. If you look at the yield curve at a snapshot in the beginning of the year and now, what you'll see is the three-to-five-year sector is down and longer duration bonds, 10–30-year bonds are down much less than that. But that has created some good performance in the intermediate sector. It's also created generally good performance in fixed income markets because not only are you getting good yields that we started the yield with, you're getting some capital appreciation on the bonds that you've been holding out throughout this year.

In terms of more of a macro factor, interestingly enough, it is not just fed policy that's driven the bond market and macro markets for that matter over the second quarter, there's a lot of things that drive macroeconomics or macro markets, the economy, inflation, fed policy, fiscal policy, technical factors in the bond market that would mean auctions and things like that and intangibles such as the U.S. entered a war in the Middle East. All those factors actually had something to do with what went on with both equity markets, fixed income markets, and the likes. All that being said, I think one of the most important things that came out of this, and we talked about it before, is Liberation Day – and that's fiscal policy that started to drive the increased volatility that we saw. But then we saw factors like inflation pop up and technical factors as well as the economy where we're seeing consumer confidence start to wane and we are starting to see some slower growth in employment. All of those things are contributing to where the fixed income markets are going and why we've seen a little bit of lower rates, all of that culminating to what we're gonna hear from the Fed soon.

Yield Curve Evolution and Duration Positioning:

• Bull steepening occurred with 3-5 year bonds falling while longer bonds declined less, driven by Fed policy, inflation, and geopolitical factors.

• Bondholders benefited from both attractive starting yields and capital appreciation, particularly in intermediate duration space.

• The intermediate sector outperformed due to defensive positioning advantages during policy uncertainty.

Q3. Inflation data through May 2025 show CPI at 2.4% and core PCE at 2.7% while Fed officials have revised their 2025 inflation forecast to 3%. How are you interpreting these trends and what other macroeconomic indicators are you monitoring most closely?

Inflation has been very important because it's been a tariff, sort of inflation worry with the Fed. Interestingly enough, I think some of the members of the Fed are starting to look over four, as a matter of fact, are starting to call for eases, two of them as early as July. And I think it's partly because they want to focus a little more on the economy and getting in front of the economy rather than inflation where the tariffs seem to be such a day-to-day operation. What's interesting about inflation is when you listen to the Fed talk about inflation, the one thing they don't want to get themselves into the mix of using any kind of word that is somewhat close to “transitory” because of the mistake that was made years prior and the inflation push.  They are trying to figure out, how long do the tariffs last? How long do the tariffs affect the economy? But without using the idea of looking at it as a transitory effect, which it may be to a point.

Inflation Trends and Macroeconomic Indicators:

• Tariff-related inflation concerns complicate Fed policy, with some officials calling for July rate cuts to support economic growth.

• The Fed avoids "transitory" language due to past mistakes, creating communication challenges around tariff duration and impact.

• Focus shifted toward balancing economic support as daily tariff volatility makes traditional inflation forecasting complex.

Q4. Treasury volatility has been elevated in Q2 with significant moves across the yield curve and the 30-year Treasury yield, briefly touching 5%, what fundamental factors are driving this volatility and how should investors position their portfolios for continued uncertainty?

There's a lot of factors that are driving macro markets and obviously the yield curve. We did see the supply demand push of the treasury market, where it hasn't been important for many years. Auctions in the treasury market are now important, not just in U.S. markets, but in the global bond markets – Japan as well. Not only technical factors, but there are certainly the fundamental things that are driving the market that really are going to push both market participants as well as the Fed into what they say and what traders do. When you look at things like the economy, consumer confidence, all the jobs’ numbers are very important, inflation data, the PCE (Personal Consumption Expenditures) is still going to be one of the most important things. And then signs from the fed – how close are they to cutting rates. The key is nobody's talking about the Fed raising rates right now. We are still on what I would say, a stable environment within the Fed to more of a lowering of rates from the Fed because as you recall, we are still in a restrictive area within terms of our rate policy and so we do feel that we will start to see rate cuts at least by the end of the year.

Treasury Volatility and Positioning Strategies:

• Treasury volatility remained elevated due to supply-demand dynamics making auctions critically important for global bond markets.

• Key drivers include weakening consumer confidence, employment changes, inflation metrics, and Fed policy signals about rate direction.

• Markets focus on timing of rate cuts rather than increases, with cuts expected by end of 2025 given restrictive policy stance.

Q5. Credit fundamentals remain generally solid, yet spreads have widened amid growth concerns. Meanwhile, municipal bonds are offering some of the most attractive valuation in years. How are you evaluating credit risk across sectors and where do you see the best risk adjusted opportunities?

In the sectors of safe fixed income, we saw corporate bonds start to see some spread widening in the first quarter, but then they came back in sympathy with equity markets that rallied. And now, the spreads are below a hundred basis points, which is generally historically tight for risk premium spreads in investment grade markets. High yield markets have also done all right in terms of coming back in sympathy with equities. Municipal bonds very interestingly saw some underperformance, if you said the municipal aggregate market was actually flat to slightly negative in the first half of the year. Shorter maturity municipal bonds fared better, our intermediate portfolios we're up about 2%.

When you think about municipal bonds, there's some sector things going on there – there was a ton of supply happening when all this volatility was happening, so supply is going to start to go away in the summer months. At the same time, you have a lot of reinvestments. You have a lot of funds, SMA managers, all the people that have maturities coming up to the tune of a hundred billion in the next two months – that is all going to have to be put to work. It should be a better backdrop for municipal bonds and I agree they've gotten to the point where their fair value to even a little bit better than fair value in terms of where they are versus the treasury curve. So good potential for municipals in a stable macro environment.

Credit Risk Evaluation and Sector Opportunities:

• Corporate spreads tightened to below 100 basis points, reaching historically tight levels with limited risk premium compensation.

• Municipal bonds faced issuance challenges but now offer fair value with $100 billion in upcoming reinvestments providing technical support.

• High yield recovered alongside equities while supply-demand imbalances should improve as summer issuance declines.

Q6. Given the Fed's apparent shift to a more cautious stance and evolving economic conditions, what strategic portfolio adjustments should fixed income investors be considering for the remainder of 2025? How should asset allocation strategies adapt to this environment?

I think there's a couple things here in the question of what should fixed income investors start to look for? And you see how we mentioned before that the intermediate part of the curve was the outperformer. We think that is probably going to continue. There is a port in the storm in the front end of the bond market that is a safety zone. That coupled with the fact that we do still have these deficit problems. And the big beautiful bill that may be coming, while it's also stimulative to the economy, it also means we have to have more treasuries in the market. So, that could start to hurt the long end as people continue to worry about the deficit problem. We still like to be in that belly of the curve, if you will, but we also enjoy that rates are at decent levels, so we don't need to be in the spread product markets too heavy right now.

What we can do is we can shift towards government bonds, lower our asset allocation and credits. And there's other places to play. The secured markets, obviously, the taxable muni markets, some of those markets offer some really good yields with some great diversification and we want to be in there, but we also want to keep these portfolios liquid because we do think the next move by the Fed will be a lowering of rates, and we do think that will be positive for the bond market so, we want to have some duration in our portfolios, increase interest rate risk, but lower our credit rate or credit risk as spreads are still back to tighter levels than we would like to see in the market.

Strategic Portfolio Adjustments for 2025:

• Continue emphasizing intermediate curve positioning in 3-5 year bonds for defensive characteristics and attractive yields.

• Shift toward government bonds and reduce credit allocations given tight spreads, while exploring secured and taxable municipal markets.

• Maintain portfolio liquidity to capitalize on expected Fed rate cuts and bond market appreciation opportunities.

Q7. As you look beyond 2025, what considerations should investors think about?

One of the most important things is that fixed income, while it hasn't in this decade so far seemed like a great part of an asset allocation, where yield levels are right now, it has become an important piece of the asset allocation process. And when you look at where yields are, and you take just the first half of this year, despite other markets doing better, when you look at fixed income markets that are up 4% in six months and poised to do well in the second half of the year, you are going to have a pretty decent fixed income market. And when you think about the average of what you should be getting in safe fixed income, why you're invested in safe fixed income, the 50 years, a hundred year return profile of safe fixed income is somewhere in the five and a half percent range. And here we are talking about a first half of the year where the aggregate was up 4%. Munis are up a little bit and even the intermediate section of the curve is up 4%. All of that says we have a good buffer zone in where you can get coupons and we also have some decent ability to have capital appreciation in the bond market. That is really important to total return and fixed income. And we think it is poised to have a better second half of the decade than it did in the first half. We don't foresee another 2022 coming into the bond market, and I think that's really important for investors to know that this is still a good ballast in your overall asset allocation.

Beyond 2025: Long-term Fixed Income Outlook:

• Fixed income regains strategic importance due to attractive yield levels, with potential to approach historical average returns.

• The 4% first-half gain positions bonds for meaningful portfolio contribution rather than merely defensive holdings.

• Second half of 2020s outlook appears more favorable with little expectation of repeating devastating 2022 bond performance.

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Supporting notes at the date of recording.