Key takeaways
Beginning in October 2024, an established trend of declining long-term interest rates reversed course.
In a matter of weeks, yields on the benchmark 10-year U.S. Treasury note, which dropped to around 3.6% in September 2024, neared 4.8% by January 2025.
Investors may want to reexamine the role bonds play in their diversified portfolios considering current market dynamics.
Interest rates remain elevated, with the yield on the benchmark 10-year Treasury lingering close to 1% higher than its September 2024 low. At January’s close, yields settled in the 4.5% range, down from mid-January’s 4.79% peak, but still considered high by recent standards.1
“Long-term bond yields appear to be range-bound, which is a good sign,” says Rob Haworth, senior investment strategy director with U.S. Bank Asset Management. “The market’s current yields are pricing in better economic growth, but we’re not seeing higher inflation expectations, which is often what triggers an interest rate upturn.”
10-year Treasury yields began heading higher in September 2024, just after the Federal Reserve (Fed) instituted its first federal funds target rate cut in more than four years. While the fed funds target rate has a more direct impact on short-term bond yields, other market forces, such as how market demand keeps up with supply, have greater influence on 10-year Treasury yields.
2024 proved to be a challenging year for bond investors. Through the first nine months of the year, interest rates trended lower, but reversed course as 2024 ended. In the year’s closing months, with rates rising, bond prices fell. As a result, bond total returns flattened out. At year’s end, the Bloomberg Aggregate Bond Index generated a total return of just 1.18%.2
In December 2024, to the Fed signaled its plan to pull back on 2025 interest rate cuts. After cutting the fed funds target rate by 1.00% between September and December 2024, Fed officials now project that in the coming months, they’ll trim rates by only an additional 0.50%.3 The Fed’s more cautious approach centers on the need to see inflation decline further before more rate cuts can be considered.
“Long-term bond yields appear to be range-bound, which is a good sign,” says Rob Haworth, senior investment strategy director with U.S. Bank Asset Management. “The market’s current yields are pricing in better economic growth, but we’re not seeing higher inflation expectations, which is often what triggers an interest rate upturn.”
The economy remains on a positive trajectory. Gross Domestic Product (GDP) growth was 2.3% in the fourth quarter, down from second and third quarter readings of 3.0% and 3.1% respectively.4 In the meantime, inflation, as measured by the Consumer Price Index, trended higher, from its 2024 low of 2.4% to 2.9% by year’s end.5 “On average, most households remain resilient, supported by a healthy jobs market,” says Beth Ann Bovino, chief economist, U.S. Bank. “It signals that the economy can withstand fewer Fed rate cuts without falling into recession.”
Higher government deficits, occurring in conjunction with elevated interest rates, require the U.S. Treasury to increase debt supply to fund federal government spending. In early 2025, Treasury officials noted that it was utilizing extraordinary measures to avoid a debt default. “In the short-term, that means the Treasury will need to release liquidity into the system, which could temporarily lower interest rates,” says Haworth. “However, growing government deficits, over the long term, risk putting upward pressure on rates.”
For more than two years, an unusual environment persisted. The yield curve, reflecting yields across the Treasury security maturity spectrum, is typically upward sloping (see the line in the chart below representing the yield curve as of Dec. 31, 2021). In a normal environment, the shortest-term securities offer the lowest yields, and those with the longest maturities pay the highest yields. However, in 2022, the yield curve inverted as short-term rates rose dramatically, exceeding long-term yields (see the line on the chart showing the yield curve on June 30, 2023). In recent months, the market began shifting. Now the yield curve is again mostly upward-sloping, though relatively flat (see the line on the chart showing the yield curve on Jan. 30, 2025).6 “A normal upward sloping yield curve might require continued strong economic growth, which would likely keep long-term yields higher.” Haworth says such a trend would need to be combined with modest enough inflation to allow the Fed to continue cutting short-term rates, which would be reflected on the shorter end of the yield curve.
How should investors approach fixed income markets today? Investors may wish to modestly underweight their fixed income position within portfolios that mix stocks, bonds and real assets. “This indicates our expectations that continued earnings growth, boosting equity prices, offers better opportunity than bond coupon payments, even at today’s higher rates,” says Haworth.
Nevertheless, Haworth says that within their bond portfolios, investors should explore the potential of more complex credits. For example, investors in high tax brackets may benefit by extending durations slightly longer and including an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Some non-taxable investors should consider diversifying into structured credits, non-government agency issued residential mortgage-backed securities, commercial mortgage-backed securities and collateralized loan obligations. “These types out-of-the-mainstream credits all offer solid fundamentals and an opportunity to pick up extra yield,” says Haworth. For certain eligible investors, insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors.
Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.
The bond market is often reflective of other key factors that affect the economy. If the economy grows rapidly and inflation is rising, bond yields tend to follow suit. Bond yields also tend to rise if the Federal Reserve, the nation’s central bank, raises the short-term interest rate it controls, the federal funds target rate. Inflation in the U.S. began surging in 2021, and by early 2022, the Federal Reserve began raising rates. As a result, yields across the bond market also rose. In contrast, if the economy is slowing or maintaining modest growth with low inflation, bond yields tend to decline or remain low. This was the situation for an extended period prior to 2022. In mid-2024, bond yields began to decline again, and, in September 2024, the Fed began what was expected to be a series of rate cuts. Since the Fed’s initial rate cut, long-term bond yields moved higher, likely reflecting the market’s recognition of the strong U.S. economy.
Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond’s price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates. Bondholders will generally be repaid the face value of a bond if it is held to maturity, regardless of the interest rate environment.
There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels. However, even when interest rates are low, bonds can still be appropriate for inclusion in a well-diversified portfolio.
As interest rates change, learn what the ripple effects across capital markets may mean for investors.
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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