The New Role of Stocks and Bonds in 2025

Key Takeaways

• Rethink Bonds: The traditional role of bonds as a hedge is no longer reliable. Discover how to optimize your portfolio for investment cash flows, appropriate discounting, and volatility.
• Income Over Interest: Prioritize income in fixed income investing. Learn how diversified, income-oriented portfolios can deliver strong returns.
• Equities Keep On: U.S.-based companies continue to show strong growth potential. Understand the factors driving their robust cash flows and advantages.
• Future-Ready Portfolios: Embrace a fresh perspective on portfolio construction, emphasizing flexibility, income optimization, and strategic allocation across asset classes.

As we look ahead for positioning in 2025, we find it a perfect moment to reevaluate the purpose of each asset class in portfolios today. The relationship between stocks, bonds, and the real economy has changed dramatically in the last few years. Their role in portfolios have changed alongside this. Stripping these assets down to their basics, with consideration to the macro environment, facilitates a fresh framework for building future-ready portfolios.

What is a bond?

A series of cash flows over a prescribed period with a defined date for final repayment.

What is a stock?

The residual of a company’s cash flow stream with no defined end date.

What does this mean for portfolios today?

The traditional notion of bonds serving as a hedge is no longer reliable. In this environment, portfolio construction must optimize for:

• Investment cash flows
• The appropriate discounting of those cash flows, and
• The volatility tied to that discounting mechanism

Past performance may not predict future results, but 2024’s scorecard reveals important insights into the evolving role of bonds in modern portfolios. The interest-rate oriented Bloomberg US Aggregate (US Agg) again underperformed cash last year, trailing cash by 4.0%. In contrast, income oriented Fixed Income exposures outperformed cash and equities delivered standout returns, with the S&P 500 and Nasdaq outperforming cash by 20%, driven largely by seven tech giants that achieved a market-cap-weighted gain of 67%.

In Fixed Income, the ‘risk-free’ moniker looks more like a misnomer when it comes to performance. Indices of sovereign debt across the U.S., Europe, and emerging markets all underperformed cash, with the Long Treasury Index lagging by nearly 12%. During the 40-year bull market from 1981 to 2021, traditional fixed income strategies—anchored in heavy interest rate exposure—excelled as both a source of returns and a reliable equity hedge. However, in today’s environment of heightened rate volatility and greater two-way risk, the role of bonds must fundamentally evolve.

Returns across the universe of 70,000 debt securities last year showed a clear pattern: they were negatively correlated with duration and positively correlated with starting yield. The takeaway is straightforward—when hedging value is negative, and repayment schedules come with historically high certainty, fixed income investing today should prioritize income over interest rate risk. Consider that a diversified, income-oriented portfolio utilizing the full global fixed income universe would have markedly outperformed the US Agg every year since the pandemic (the Agg is still down 1.6% over the last 5 years) with nearly half the volatility. Few areas of investing remain unchanged from 20 years ago, and fixed income is no exception. A new playbook is clearly emerging for this asset class.

At its core, every investment is a purchase of future cash flows – adjusted by discounting for relevant risk and volatility factors. When thinking about allocating globally, growth and inflation are major determinants for whether a country’s macro environment is more conducive to equity investing or lending. Diverging economic cycles across regions have created significant opportunities for those with the flexibility to go global.

The trajectory and stability of corporate cash flows—closely tied to GDP growth—provide a consistent framework for evaluating the appeal of global equity markets. The US is the clear front-runner here, with a steep trajectory and the lowest volatility of growth across major markets. Japan and India also stand out for their robust cash flow growth. Conversely, Europe and parts of Asia, characterized by slower growth, distinctive capital structures, and relatively predictable policy environments, are better suited for being a lender via fixed-income investments offering defined payment schedules.

But isn’t this in the price? Equity valuations in the US are near the top of their range, while markets like Europe look much more reasonable at face value. To understand why this isn’t a major cause for concern, or even something to be expected, we can look at a macro version of the Gordon growth model for equity valuation.

Price has a direct relationship to the cash flows and nominal GDP growth, and is inversely related to the cost of capital. Weighted average cost of capital (WACC) is similar across the U.S. and Europe, but corporate cash flows and the growth of these cash flows are markedly higher in the U.S. It follows that prices, and the valuation method behind those prices, can be a level above other developed markets after accounting for the sheer magnitude of free cash flow the largest U.S. companies are generating. The “Magnificent Seven” tech stocks have been the primary source of discomfort for valuations in the U.S. However, the context in which they have achieved these valuations is unlike anything we’ve ever seen before. These companies have oligopoly-like status with pricing power in areas of major growth, all while continuing to bring down costs and increasing productivity. Their special status looks much more justified when you consider that they have grown free cash flow (FCF) by an astonishing 70% over the last two years, S&P FCF as a whole has only grown 4.3%. Continued outperformance by these companies, and the U.S., should be the base case for some time to come.

What does this mean for investing in 2025?

Fixed income must now be approached with a fresh perspective, one that emphasizes optimizing for income rather than straightforward interest rate exposure. When deployed thoughtfully, debt securities can serve as a stabilizing force in portfolios, offering generous yields and low volatility. Traditional fixed income indexes such as the US Agg, however, predominantly focus on U.S. Treasuries, Agency MBS, and investment-grade credit. Their construction favors the largest issuers—the U.S. government and the most indebted corporations—without accounting for yield, beta, liquidity, diversification, or correlation. Ironically, the most attractive conditions for fixed income investing in decades are proving exceptionally challenging for these indexes. Fortunately, the global fixed income landscape is rich with sub-asset classes that provide unique return opportunities. Some of our top picks—such as European high yield, securitized assets, floating-rate instruments, and convex global credit—are offering generationally high yields without requiring excessive interest rate or credit risk. We believe proactive allocation in these areas has rarely had such a significant impact on portfolio outcomes.

A higher-rate, higher-volatility regime in treasuries appears to be the new norm. With real rates still moderate relative to GDP growth and the potential for further steepening driven by elevated issuance and term premium in the long end, we maintain a preference for shorter maturities. The return of an upward-sloping yield curve has made the carry dynamic at the front end far less punitive, making this part of the curve much more attractive than it was just months ago.

The credit landscape highlights the advantages of maintaining flexibility across the full fixed income opportunity set. Index-level investment-grade spreads are hovering near their lowest levels this century, with 87% of spread assets in the Agg offering sub-100 basis point (bps) spreads—leaving little margin for error. Expanding the scope to Europe, however, unlocks an additional 30 bps of spread among the highest-rated companies and almost 2% in additional carry from the FX hedge. Notably, the European high-yield market has seen no net growth in outstanding supply for a decade, with this scarcity acting as a powerful stabilizing force.

Meanwhile, 2024 set a record for ABS issuance, with AAA tranches offering a 50-70 basis points (bps) premium to Investment Grade (IG) bonds of the same maturity. Similarly, leveraged loans are trading at a 150 bps premium to U.S. high-yield bonds—without the accompanying duration risk. We’ve argued in prior commentaries that the highest-quality issuers in today’s market are closer to being risk-free than Treasuries. In this vein, we favor gaining duration exposure through long-dated IG bonds, many of which trade at sub-$60 prices for companies with near-zero net leverage. This market has contracted by $460 billion since 2021, even as demand for yield from liability-matching investors has surged. For those willing to look beyond the traditional tools, the opportunities to source efficient and differentiated income have rarely been more compelling.

Turning to equities, cash flow is king. The outlook for large, predominantly U.S.-based companies with technological advantages continues to be exceptionally strong. In an environment of 4.5–5.0% nominal GDP growth, corporate earnings typically expand by 10 -15%. This suggests that even with some degree of multiple contraction, equities are well-positioned for another year of solid returns.

Of course, we recently learned that Chinese firm Deepseek has produced a step forward in the efficiency of AI by proving that more complex models can be run with significantly less resources than previously understood. This advancement suggests that less semiconductors, power, and other inputs will be required for the “buildout phase” of AI in the near-term, which has understandably resulted in a repricing of expected earnings and share prices for the producers of these inputs. This episode is a good reminder that in the short-term, future cash flow expectations are always susceptible to change – and high valuations make prices vulnerable to drawdowns. However, we see this evolution as a positive step for the global advancement and adoption of AI and we expect that there will be net benefits of more efficient AI production – including the expansion of AI accessibility and utilization. While producers of inputs may see a short-term adjustment of expected cash flows, any increased adoption on the back of more affordable AI could be a tailwind in the future. Furthermore, users of AI are huge net beneficiaries of more affordable, efficient technology.

So, while we are careful around the affected names here in the near-term, we do maintain a preference for sectors generating the most robust cash flows – generally tech and data oriented. While these companies have often been labeled “expensive” over the past decade, they have consistently outpaced their lofty valuations. For example, buying Amazon in 2014 at a seemingly high 80x P/E multiple would have resulted in owning it today at a much lower 3.2x multiple, along with a remarkable 1,308% gain. High forward multiples only become problematic when earnings fail to grow—something these companies have demonstrated a consistent ability to achieve, even amid disruptions on the scale of a global pandemic. Looking ahead, these innovators are likely to be among the primary beneficiaries of an AI-driven productivity boom. Concerns about the effect of higher costs of financing don’t apply here as they predominantly have negative net debt. They are benefitting from rates being higher by making a substantial return on their billions in cash. Investing in companies operating in an ecosystem with public-sector support, with deep competitive moats and proven growth potential should remain central to equity portfolios for the foreseeable future.

After a turbulent year in markets, it’s worth noting that gold outperformed the S&P last year—and has done so in three of the past five years. In an increasingly uncertain world, holding scarce stores of value has gained importance, especially given the established precedent of expanding the money supply during periods of financial distress. The inflation-hedging properties of assets like precious metals, Bitcoin, real estate, and even equities present a compelling argument for maintaining a permanent allocation to these instruments in diversified portfolios.

There’s no denying the world has changed. Just as it would be unthinkable to rely on a Commodore 64 for modern portfolio analysis, it no longer makes sense to use stocks and bonds in the same roles they traditionally played. The opportunities and tools in Fixed Income are completely different. Being cognizant of the environment we are in and going beyond the traditional expressions to create high-quality income with minimal volatility is the best way to take advantage of this renaissance in debt investing. The flexibility this affords can be used to support a growth-oriented equity allocation that compounds cash flow unlike any other asset. When there is scope for it, adding stores of value can create comfort against the unknowns. Bringing these together in the appropriate sizes, with a tactical approach to changes in the environment, creates a modern portfolio fit for 2025 that optimizes for returns, risk, and balance.

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To view standardized performance for BINC and BSIIX and MALOX, click on the fund cards above.

The performance quoted represents past performance and does not guarantee future results. Investment returns and principal values may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. All returns assume reinvestment of all dividend and capital gain distributions.

Refer to www.blackrock.com or www.ishares.com to obtain performance data current to the most recent month-end.

The Morningstar Rating for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure (excluding any applicable sales charges) that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.

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