How Changing Interest Rates Affect Bonds | U.S. Bank (2024)

After bond yields rose sharply in late summer and early fall 2023, yields fell in the closing weeks of October and continued that general trend into December. The change in direction for the bond market reflects growing confidence among investors that the Federal Reserve (Fed) is finished with short-term interest rate hikes and will likely begin cutting rates in 2024.

The yield on the benchmark 10-year U.S. Treasury note neared 5% at its peak in early October 2023, only to fall below 4% in December. The October peak represented the highest yield for 10-year Treasuries since 2007.¹ At the same time, yields on shorter-term debt securities were even higher. It’s created the best opportunity in years for investors to utilize bonds to generate meaningful income streams.

Source: U.S. Bank Asset Management Group, Bloomberg as of December 8, 2023.

Most recent changes in the broader interest rate environment can be attributed to the Federal Reserve’s (Fed) actions. The Fed raised its target federal funds rate by over 5% from March 2022 to July 2023. The Fed sought to slow the economy as a way to reduce inflation, which peaked at 9.1% for the 12 months ending June 2022, but dropped to less than 3.1% by November 2023.²

What should investors expect from the bond market in 2024 and what does that say about how to incorporate or adjust strategies for fixed-income portfolios?

Changing bond market

Despite the recent decline in bond yields, they remain significantly higher than was the case at the start of 2022. “Three key factors drove the jump in bond yields,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “First is the Fed’s policy response to inflation. Second is the strength of the U.S. economy. Finally, there is an increasing supply of U.S. Treasury securities coming to the market.”

The Treasury stepped up bond issuance in recent months due to a growing federal government budget deficit. “New Treasury bond issuance is growing due to a combination of deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Merz. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz. He notes that in some cases, Treasury bonds have become less attractive for foreign investors after accounting for currency hedging costs. These factors contributed to the bump up in Treasury yields that continued into October. However, the yield on the 10-year Treasury backed off its recent highs as investors grew increasingly confident that the Fed was finished raising interest rates for the current cycle. Expectations now are for the Fed to cut the fed funds target rate several times in 2024.

A notable consideration for fixed income investors is the inverse relationship between bond yields and prices. When bond yields rise, prices of existing bonds fall. This phenomenon hit bondholders particularly hard in 2022, with the Bloomberg U.S. Aggregate Bond Index generating a total return of -13.0%. Bondholders have had the opportunity to earn higher income due to elevated bond yields in 2023. Even after the recent yield decline, year-to-date total returns reflect a gain of 4.2% according to the Bloomberg U.S. Aggregate Bond Index through mid-December 2023.³

Inverted yield curve persists

A phenomenon that developed in 2022 and continues in 2023 is the unusual shape of the yield curve representing different bond maturities. Under normal circ*mstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve. It logically reflects that investors normally demand a return premium (reflected in higher yields) for the greater uncertainty inherent in lending money over a longer time. Many yield curve pairs using various maturities have been inverted since late 2022.

U.S. Treasury Yield Curve Comparison
Dec. 31, 2021 and Dec. 14, 2023¹

Source: U.S. Bank Asset Management Group, U.S. Department of the Treasury.

While many cite inverted curves as a harbinger of recessions, our analysis shows this relationship is not always evident. There can be inconsistent lag times before tighter policy and inverted curves result in a slowing economy. In fact, the economy generated solid growth as measured by Gross Domestic Product (GDP) and surprised many forecasters by expanding at an annualized rate of 5.2% in the third quarter of 2023.⁴

Keeping an eye on the Fed

The Fed remains focused on fighting inflation but may be about to modify its interest rate policy. While inflation has declined, it remains above the Fed’s target inflation rate of 2% annually.⁵ After the December meeting of the policy making Federal Open Markert Committee, Fed Chairman Jerome Powell indicated that additional rate hikes may be off the table and that several rate cuts could occur in 2024.⁶

Finding opportunity in the bond market

How should investors approach fixed income investing today? “Money sitting in cash loses purchasing power every day that inflation rates stay above zero. Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities,” says Merz.

Despite the appeal of short-term bonds paying high yields, Merz says investors with a long-term time horizon want to build a diversified portfolio designed to generate competitive returns over time. “It’s time to take money that was shifted away from appropriate bond allocations during the period of historically low interest rates to gradually move money into longer-term bonds. Even after the recent decline in longer-term bond yields, they remain far more compelling today than they have been in years.” Merz says for conservative investors, “It’s possible to generate reasonably attractive returns in a mix of bonds without extending their risk budget.”

Additional opportunities exist depending on investors’ risk tolerance and tax situation. For example, investors in high tax brackets may benefit from an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Certain taxable investors may benefit from diversifying into non-government agency issued residential mortgage-backed securities. And insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors for certain eligible investors.

Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.