Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.
Where should you invest in 2025? Because the days of 5% returns on cash are so 2024. Some cashlike investments like Treasuries and CDs are maturing now when yields are lower. Morningstar’s 2025 Outlook points to a path where investors could find returns as interest rates fall. I talked with Dominic Pappalardo from Morningstar Investment Management. The chief multi-asset strategist explained why it’s time to think globally.
Great to have you here, Dom.
Dominic Pappalardo: Great to be here with you, Ivanna. Thanks for having me.
Why Cash Is No Longer King
Hampton: Cash reigned as the top low-risk investment for a while, but that has now ended. How should investors think of this new phase?
Pappalardo: No doubt, cash was king for quite some time, and it made a lot of sense for investors to hold outsize positions in cash allocations. It was yielding over 5% for quite a while, and literally no risk of losing money on that investment.
Unfortunately, that environment has come and gone, though. And yield on cash investments was unusually attractive because the US Treasury yield curve was inverted, meaning that yields on the shorter-term maturities were higher than yields on the longer-term maturities. It’s uncharacteristic for it to have that dynamic, and that has begun to reverse. Cash yields are currently down to about 4.3% to 4.4%, and at the peak that was up as high as about 5.5%, so it’s come down quite a bit already. And these unusual circumstances have begun to normalize, and the yield curve now is much flatter, meaning that yields are relatively similar across all the maturities ranging from about 4.2% to about 4.4% right now.
Is a 3% Interest-Rate Forecast a Wake-Up Call?
Hampton: Morningstar’s economics team is forecasting interest rates will sit around 3% at the end of 2025. Is this the wake-up call? Why or why not?
Pappalardo: Yeah, that’s certainly true. We believe interest rates will come down from the current levels, and we could debate the exact percentages or time frames ad nauseam, but the point that we want to focus on is the direction of the move. We believe that they will be lower, especially through the first half of 2025. Equally as important, though, is our belief that the shape of the yield curve will normalize like we just talked about, meaning that moves toward historical norms where investors earn higher yields for longer maturities than they do on short-term maturities, which is the opposite of what we saw in 2022 and 2023.
I’m not sure if it’s a wake-up call per se, but our view stems from the belief that those historic rate increases we saw in 2022 were maybe overdone or at least not needed anymore at this point in the economic cycle. I’m not saying they weren’t necessary. They were. The Fed had no choice but to aggressively fight the postpandemic inflation spike we saw.
But that inflation battle seems to be mostly won as of right now, which means rates don’t need to stay as high as they have been given today’s economic environment. The Fed initiated this regime change by implementing their first rate cut in September of 50 basis points. That was their first cut since 2022, so the shift has already begun. This signaled the Fed maybe shifting their focus away from that inflation battle toward sustaining economic growth. In other words, they really want to preserve the likelihood of the soft-landing scenario they’ve talked about a lot in the news. So far, so good on that initiative: Recent economic data suggests the economy is still doing well. Unemployment’s in the low 4% range, up a bit year over year, but certainly in the full employment category. And GDP is still expanding at about a 3% annual rate for 2024, which is quite healthy.
Why It’s a Good Time for Investors to Move Out of Cash
Hampton: Now, some investors may want to continue to hoard cash, but doing so can be risky. Explain why.
Pappalardo: Cash allocations can serve multiple purposes in a diversified portfolio. It’s important to understand other factors like opportunity cost and the benefits of fixed-income duration in those scenarios we just discussed. A timely example to demonstrate opportunity cost is the recent US presidential election. If an investor had moved into cash because they were worried about the outcome or uncertainty around the election, they’d probably regret that today. S&P 500 gained about 2.5% just in the one day following the election and rallied about 6% in the month following that election. So, it’s over one year’s worth of cash returns in a really short period of time that they would have missed out on had they overallocated to cash in favor of equity.
Additionally, that yield on cash is not locked in. It resets basically daily. So, if the rate forecast we discussed comes to fruition, the ability for cash to generate income will dissipate rather quickly. And finally, recent estimates suggest there’s about $7 trillion in cash on the sidelines—an all-time high. We just frankly believe that’s way too much again in 2025 and some redeployment should be done.
Why Investors Should Move Longer Term in Fixed Income
Hampton: That seems like a lot. Now, you and other Morningstar authors have written about the need to move longer term in the fixed-income slice of the portfolio. Can you talk about that?
Pappalardo: Yeah, that’s true. That was one of the key themes of our 2025 Outlook is it’s a good time to move out of cash. And not only does the income generation of cash erode as rates decline, but by definition, cash can’t deliver any price appreciation. It is what it is. And unlike longer-term bonds, which will experience price appreciation if and when interest rates decline as we believe they will. So, the longer-term bonds can offer total return both from income and price appreciation. The move out of cash today is more appealing because it requires less of a yield give-up, picking any point since 2022, as the shape of the yield curve shifts. Trades, cash yields trade in line with longer-term Treasury bonds right now.
Are Corporate Bonds Still Attractive?
Hampton: So, let’s shift from government bonds to corporate bonds. Should folks consider them or steer clear?
Pappalardo: Yeah, it’s a great question. Portfolio construction choices are always important, and now is no exception. If you look back, owning corporate credit in 2024 was a great trade, a great decision. Corporate bonds dramatically outperformed US Treasury bonds. That means, though, that valuations have shifted, and going into 2025, we don’t find them as attractive as they have been.
I’ll try to be a little technical for you here. The yield spread, meaning the additional yield an investor earns over and above a Treasury, is historically low right now for both investment-grade corporates and high-yield corporates. This creates a bit of a conundrum for investors because the all-in yield on these asset classes looks appealing, but the valuation component in terms of yield spread is quite unappealing. To be a bit more specific, using high yield as the example, the all-in yield is about 7.2%, which on the surface is very much in line with historical averages, maybe even a bit above some historical averages. However, the yield spread component is only about 2.6%. That ranks in the fifth-percentile lowest samples throughout history. So only 5% of the time has that number been lower. So we just don’t believe that there’s sufficient margin of safety for investors to take on that additional credit risk associated with high yield right now, despite the attractive headline all-in yield number that they offer.
High yield has returned over 9% this year, and Treasury bonds have been in the 3% to 4% range, depending on maturity. So again, strong outperformance in 2024. Investment-grade corporates are in a similar situation. It’s not quite as extreme as high yield, but again, we don’t believe there’s sufficient margin of safety there to take a lot of additional credit risk right now.
Hampton: What would be a good margin of safety or room for error?
Pappalardo: We established fair values around those numbers, and for investment grades, it’s about double what we’re seeing today. We’re seeing about 80 basis points of yield-spread protection on investment-grade corporates. Our fair value range is in about the 1.5% range, so pretty substantial difference. And as you would expect, given the stats I just referenced, high yield is even more extreme. So that’s about 2.6% today. We think that should be up over 400 basis points before that asset class becomes appealing from a valuation standpoint.
Where We Are Seeing Promising Yields From Global Bonds
Hampton: Got you. Well, Morningstar is encouraging investors to think globally when it comes to bonds. Where is the team seeing promising yields?
Pappalardo: If we compare those US high-yield corporate bonds to some global examples, emerging-markets debt comes to mind. Again, it’s below-investment-grade-rated, but there’s some far more attractive valuation examples there. In those markets, one lens we use to assess valuation is real yield. Real yield is the yield of the bond minus the local inflation rate, meant to gauge what investors are actually earning over and above inflation increases. So for example, Brazil’s five-year bonds yield over 14%, Mexico’s five-year bonds yield around 10%, and those are both compared with local inflation rates in the mid-4s. So you have substantial real yields in some of these emerging-markets countries, which we think is far more appealing than US corporates at a similar credit rating profile.
What to Keep in Mind When Investing in Global Bonds
Hampton: And what should investors keep in mind when investing in global bonds?
Pappalardo: Investors should approach those emerging-markets bonds with the same caution they would use when evaluating US high-yield corporate bonds. They’re all below-investment-grade for a reason. The emerging-markets bonds are likely to be more volatile than higher-rated bonds from developed countries like the US, most of Europe, even Japan. But we believe the valuation mostly is in line with those risks right now, unlike high-yield corporates. Other risks associated with emerging-markets bonds or any global bonds could be currency fluctuation, geopolitical risks in their regions, and certainly less liquidity than US Treasuries, for example. Investors should be mindful of how they size those allocations. Don’t just blindly chase the higher yields they offer.
Hampton: So does it also require really paying attention to what’s happening in those countries?
Pappalardo: It does. It’s certainly a research-driven view, and there is perhaps a different lens that you have to look through when evaluating foreign markets, foreign governments, things of that nature as opposed to the things we see every day in the US. They definitely do behave different.
Where to Invest in 2025
Hampton: And any final thoughts on where to invest in 2025 now?
Pappalardo: Yeah, for sure. As we discussed earlier, today’s yields offer some real benefits when talking about overall portfolio construction, which really hasn’t been the case for the last couple of years. That being said, it’s important not to just chase yield, as we’ve talked about. Not all fixed-income valuations are the same today.
Higher bond yields can be positive for investors, and that’s maybe not always intuitive to people, but there are benefits. Bonds are now in a place where they benefit investors in a few ways. Treasuries now offer positive real yields, as we’ve explained previously, yielding around 4%, with CPI in the 2.6% range. So not as generous as the emerging-markets debts, but in a far safer, far less volatile packaging.
Today’s rates also offer a bit of hedging protection for diversified portfolios. If we see an environment where stocks or other risk assets do start to sell off and experience price declines, we would expect interest rates would fall in that environment, allowing the fixed-income allocations of the portfolio to deliver some stability and ballast as their prices appreciate to offset potential equity declines.
Lastly, 2025 will undoubtedly have some volatile periods across financial markets. There are a lot of moving pieces right now. We have a new administration coming into the White House, a change in course from the Fed, and several geopolitical conflicts. So as always, we remind investors to stick to their plan with discipline, maintain a longer-term view, and not overreact to the short-term volatility you will inevitably experience.
Hampton: Those are good tips. Dom, thank you for coming to the table, and Happy New Year.
Pappalardo: Thank you very much. It was great to be here.
Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake Vankersen and Associate Multimedia Editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
