Investment Strategy

The case for owning bonds in a diversified portfolio

Owning U.S. bonds over the past decade (2014 to 2023) has been a challenge for many investors considering the stellar performance of U.S. large-cap equities. This challenge has intensified since 2022 as the Federal Reserve (Fed) rapidly increased policy rates in light of sharp inflation increases.

While equity investors are more familiar with occasional periods of high price volatility, the losses from bonds in 2022 may create doubts about future performance expectations and bonds’ role and benefit inside a diversified portfolio. In this piece, we review how our long-term return projections, allocations, and diversification strategy within fixed income have evolved, and provide guidance on why we believe bonds are still an important component of a portfolio.

Since 2020, we have increased our projected long-term return for fixed-income asset classes and U.S. Large Cap Equities reflecting expected higher inflation, yields, and a longer time horizon. For example, from 2020 to 2024 our annualized return assumptions increased for U.S. Taxable Investment Grade Fixed Income from 3.1% to 3.9%, and from 7.1% to 7.8% for U.S. Large Cap Equities.¹ We similarly decreased our recommended allocations to U.S. Taxable Investment Grade Fixed Income allocations from the highs (21%) of the pandemic years, when we were most defensive, to 19% in 2024, and increased U.S. Large Cap Equities allocations from 18% to 20%.²

Besides stocks and bonds, we believe investors are better rewarded by owning a diversified portfolio. Although not our expectation, uncertainties around inflation expectations similar to the 1970s could push stocks and bonds down together. To hedge against any short-term loss of that diversification benefit, we favor considering Real Assets (commodities and real estate) and Alternative asset classes (e.g. hedge funds and private capital) which may still supply diversification benefits. Regular rebalancing has also contributed to long-term success as research shows that asset-class expected returns over the long run tend to revert to normal long-term trend levels.³

Furthermore, the fixed income asset classes shown in Table 1 on the following page reveal that most of the losses in bonds occurred in 2022. However, diversified fixed-income portfolios were able to recover some of the losses in 2023 and 2024 because they incorporate exposures in High Yield Taxable Fixed Income and Emerging Market Fixed Income. This has allowed a diversified fixed-income portfolio to beat the average performance of U.S. Taxable Investment Grade Fixed Income over the past decade.⁴

Table 1. Performance of a diversified fixed income portfolio vs. select fixed income asset classes

Assets	2014	2015	2016	2017	2018	2019	2020	2021	2022	2023	YTD '24	2014-2023 Average
Cash	0.0	0.0	0.3	0.8	1.8	2.2	0.5	0.0	1.5	5.1	5.1	1.5
Investment Grade Fixed Income	6.0	0.5	2.6	3.5	0.0	8.7	7.5	-1.5	-13.0	5.5	2.1	1.8
High Yield Taxable Fixed Income	2.5	-4.5	17.1	7.5	-2.1	14.3	7.1	5.3	-11.2	13.4	8.7	4.6
Emerging Market Fixed Income	5.5	1.2	10.2	9.3	-4.6	14.4	5.9	-1.5	-16.5	10.5	6.8	3.1
Moderate Growth & Income FI Portfolio	4.9	-0.7	5.2	5.5	-1.0	10.2	8.1	-0.5	-12.4	7.1	3.7	2.4

Sources: Wells Fargo Investment Institute. Data as of 12/18/2024 Table for illustrative purposes only and does not reflect actual investment. Past performance is no guarantee of future results Moderate Growth & Income is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 30% Bloomberg U.S. Aggregate Bond Index, 6% Bloomberg U.S. Corporate High Yield Bond Index, 5% JPM EMBI Global Index, 24% S&P 500 Index, 10% Russell Midcap Index, 6% Russell 2000 Index, 8% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 4% Bloomberg Commodity Index. An index is not managed and not available for direct investment. Asset class index definitions can be found at the end of this report.

Looking forward, why should investors consider bonds in their portfolios?

We enter 2025 with higher yields (lower prices) across many fixed-income asset classes. In our view, this offers a positive entry point for fixed-income investments; unlike 2022 and 2023, the income component alone (interest return) for many fixed-income asset classes have been positive and outperformed the inflation rate year to date.⁵ Meanwhile, emerging market bonds denominated in U.S. dollars continued to provide sustained positive real returns, adding further support to investing in bonds outside the U.S., issued in dollars and with attractive interest rates.

Furthermore, the shape of the U.S. Treasury yield curve has been moving toward a more “historically normal” upward sloping shape. As the Fed has started cutting interest rates and as long-term interest rates have climbed higher given continued economic growth prospects, the shape of the curve has begun to steepen. As a result, we favor moving a portion of the excess cash holdings into fixed-income investments with maturities in the intermediate and long end of the curve. We believe exposure in these tenors may allow investors to lock-in more attractive interest rates for a longer time, and avoid some of the whipsaw in returns, if yields remain volatile. And in the event of an unexpected crisis or economic slowdown, longer-term fixed-income investments could provide price appreciation if interest rates decline as we expect.

¹ “Historical Capital Market Assumptions,” Wells Fargo Investment Institute, July 2024.

² For the Moderate Growth and Income Illiquid Allocation. “Historical Strategic Asset Allocations of the Illiquid Allocation,” Wells Fargo Investment Institute, July 2024.

³ “Predictable time-varying components of international asset returns,” Bruno Solnik, The Research Foundation of the Institute of Chartered Financial Analysis, 1993.

⁴ For comparison of a fixed income diversified allocation within Moderate Growth and Income objective, non-fixed income allocations have been re-weighted based on strategic targets.

⁵ Bloomberg, data as of 12/17/2024. Inflation is measured by year-over-year U.S. Consumer Price Index.

Enjoy the party, but beware the hangover

The S&P 500 Index was up 0.38% month to date through December 17; during the same period, the Dow Jones Industrial Average (Dow) and the Russell 2000 Index were down 3.12% and 4.06% respectively. This divergence is due to a downshift in economic surprises, as the economy’s health has a greater bearing on the more cyclical companies found in the Dow and Russell 2000 Index. The Bloomberg U.S. Economic Surprise Index, which tracks the aggregate level of data releases relative to consensus expectations, peaked at 0.21 (it ranges between +1 and -1) in mid-November and has been trending lower since. It now remains just north of 0 (below 0 indicates negative economic surprises).

This is concerning in our view, given the level of positive positioning that has taken place in equity markets since the elections. Put a different way, it suggests that investors are only focusing on the possibly brighter future while completely ignoring the current disappointing data. Eventually, we think this disconnect will need to be resolved. Also, history suggests that markets can suffer from disillusionment post-inauguration as too-high expectations run into the realities of policymaking and legislating. We think now would be a good time for disciplined investors to make sure that their portfolio allocations to equities are not above recommended allocations, especially with long-term interest rates offering a solid alternative.

The chart below suggests that the S&P 500 Index (6051) remains in an uptrend but is close to overbought territory. On pullbacks, it should find support at the 50-day moving average (5920), followed by the 200-day moving average (5515). Data suggests resistance on the way up will be found at the recent high (6090).

Post election run leaves S&P vulnerableSources: Bloomberg and Wells Fargo Investment Institute. Daily data from December 17, 2021, through December 17, 2024. SPX = S&P 500 Index. SMAVG (50) = 50-day simple moving average. SMAVG (200) = 200-day simple moving average. RSI = relative strength index. An index is not managed and not available for direct investment. Past performance is no guarantee of future results.

Crosscurrents for municipal bonds in 2025

Although volatile interest rates in 2024 have been tough for municipal-bond performance, we believe that current yields may provide an attractive entry opportunity for municipal bonds as we turn to 2025. Municipal bond issuance is expected to rise next year and could increase significantly if the market begins to anticipate a potential change in legislation impacting the tax-exempt status of municipal bonds. Despite the increase in expected issuance, we believe that investor demand will remain strong because of the potential tax advantages and generally superior credit quality that municipal bonds offer relative to other fixed-income asset classes.

We also anticipate net fund flows to remain positive, especially if the Fed can continue cutting interest rates in the first half of 2025. However, any pivot from the Fed toward tighter policies could be detrimental to flows. Credit spreads across multiple municipal-bond sectors remain close to their 12-month lows, highlighting the overall positive credit sentiment prevalent in the market. In addition, overall state balance sheets generally appear in good order with tax revenues normalizing, spending moderating, and rainy day funds at or near record highs.

However, uncertainties on the tax treatment of municipal bonds present a potential risk for the municipal market going forward. While the elimination of tax exemption would have wide-reaching and significant impacts for municipal bond investors, we continue to believe it would be unlikely given that the reaction from state and local governments would be substantial, and the revenue from the municipal exemption is small compared to the overall federal budget. We remain neutral on U.S. Municipal Bonds (both investment-grade and high-yield municipals) and expect low single-digit returns in 2025.

Current municipal-bond yields provide attractive entry opportunitiesSources: Bloomberg and Wells Fargo Investment Institute. Daily yield-to-worst data from January 1, 2000, to December 17, 2024. The yield to worst is the lowest potential yield that can be received on a bond without the issuer defaulting. Yields represent past performance and fluctuate with market conditions. Past performance is not a guarantee of future results.

New technologies demand more power

The growing use of energy-intensive technologies, such as generative AI and large-scale data centers, has started to fuel significant new demand for electricity in the U.S. This is in contrast to the past decade, when U.S. demand growth has been relatively stagnant — the chart below highlights the relatively stagnant average annual growth rate of less than 1% between 2010 and 2020.

For perspective on the extra electricity demand required from AI, a single ChatGPT query needs 2.9 watt hours of electricity, which is roughly 10 times more than the average Google search.⁶ Considering that ChatGPT conducts roughly 200 million queries daily and that number is growing, it is no wonder that U.S. electricity needs are also expanding quickly.⁷

While renewable fuels will play an important role as the U.S. expands its power capabilities, we believe natural gas is poised to benefit. Today, roughly 60% of U.S. power generation is powered by fossil fuels, and 72% of that is fueled by natural gas. Natural gas has grown to be the dominant power generation fuel in the U.S. due to its abundance, low cost, reliability, and greener emissions profile versus other fossil fuels.

The bottom line is that we believe U.S. electricity demand appears set to rise over the coming decades. As more U.S. power generation is added, natural gas will likely remain the fuel of choice. As for renewable fuels, their use is likely to grow over the coming decades too, but we believe their intermittency (for example, the sun does not always shine) will need to be balanced with the consistency of fossil fuels, such as natural gas.

U.S. electricity generation is increasingSources: Energy Information Administration and Wells Fargo Investment Institute. Annual data is from 1949 – 2023.

⁶ International Energy Agency, “Data Centres and Data Transmission Networks,” July 2023.

⁷ RW Digital, “How Much Energy Do Google Search and ChatGPT use?” October 2024.

Distressed prospects remain despite improving economic outlook

As interest rates began their steady rise in 2022 and 2023, the mantra of many small- and middle-market companies facing rising interest costs and refinancing deadlines was “survive ‘til 25.”₈ Many corporate leaders believed that the era of higher interest rates would be short-lived as the Fed sought to tame rising inflation and that 2025 would bring relief in the form of lower interest rates and a more sanguine environment to refinance existing liabilities.

While the Fed began to cut rates in mid-2024, the resilient labor market, stickier inflationary pressures, and rising equity markets have combined to lower expectations of further interest-rate reductions. Concerns that additional stimulus may bring about a resurgence in inflation has caused Fed policy makers to take the slow road toward a more accommodating stance.

The conventual default rate continues to moderate, yet this metric alone may not accurately reflect the level of stress that remains. Many struggling companies are instead opting to avoid the courts and preemptively restructure their debts. Termed “distressed exchanges,” the goal of these transactions is to improve the overall health of the company by reducing debt, extending maturities, or reducing regular debt-service payments.

Despite the rising probability of an economic soft landing, the growing number of distressed exchanges suggests the opportunity set for Distressed Credit managers may remain robust into the initial stages of the economic recovery. As shown in the chart, the past 12 months of defaults and distressed exchanges have continued their upward trajectory. Given these ongoing dynamics, we remain favorable on Distressed Credit strategies — we believe the opportunities remain robust for those seeking to create viable paths forward for many overleveraged businesses.

Decline in U.S. loan default rates by issuer count more than offset by the increase in distressed exchangesSources: Pitchbook (Leveraged Commentary and Data), Morningstar (Morningstar LSTA U.S. Leveraged Loan Index), and Wells Fargo Investment Institute. Data as of November 30, 2024.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

⁸ US Special Situations: Distressed CRE conference takeaways, Evan DuFaux LevFin Insights, September 25, 2024.

Cash Alternatives and Fixed Income

Equities

Real Assets

Alternative Investments**

Source: Wells Fargo Investment Institute, December 23, 2024.

*Tactical horizon is 6-18 months

**Alternative investments are not appropriate for all investors. They are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. Please see end of report for important definitions and disclosures.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Investing in distressed companies is speculative and involves a high degree of risk. Distressed companies most likely will declare bankruptcy shortly, could currently be in bankruptcy proceedings or are just emerging from bankruptcy. Because of their distressed situation, these securities may be illiquid, have low trading volumes, and be subject to substantial interest rate and credit risks.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

An index is unmanaged and not available for direct investment.

Bloomberg Commodity Index is comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

Bloomberg 1-3 Month U.S. Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and non-convertible.

Bloomberg Municipal Bond Index is an unmanaged index composed of long-term tax-exempt bonds with a minimum credit rating of Baa.

Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.

Bloomberg U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt.

Bloomberg U.S. Economic Surprise Index measures the degree to which U.S. economic data releases surprise to the upside or downside relative to market expectations.

Consumer Price Index (CPI) produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.

Dow Jones Industrial Average is an unweighted index of 30 "blue-chip" industrial U.S. stocks.

JPMorgan Emerging Markets Bond Index Global (EMBI Global), which currently covers 27 emerging market countries. Included in the EMBI Global are U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

Morningstar LSTA U.S. Leveraged Loan Index is a market value weighted index designed to measure the performance of the U.S. leveraged loan market. The legacy payment default rate includes Morningstar LSTA U.S. Leveraged Loan Index constituents where the company files for bankruptcy, the facility gets downgraded to D by S&P (excluding distressed exchanges and sub-par buybacks), or the interest payment is missed without a forbearance. Distressed exchanges include all liability management transactions considered a distressed exchange or default by S&P Global Ratings.

MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.

Relative Strength Index (RSI) is a momentum indicator that measures the magnitude of recent price changes to analyze overbought or oversold conditions.

Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index.

Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 90% of the total market capitalization of the Russell 3000 Index.

Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee to its accuracy or completeness.

Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.