Key takeaways

  • The yield on the benchmark 10-year Treasury note continues to hover around 4%.

  • Yet an “inverted yield curve” persists, meaning certain shorter-term securities offer higher yields than some longer-term instruments.

  • Investors should carefully assess how best to position fixed income assets for the long term in today’s higher interest rate environment.

A notable milestone was reached in the summer of 2023 when the yield on the benchmark 10-year U.S. Treasury note consistently exceeded 4% for the first time since 2007.1 At the same time, shorter-term debt securities generated even higher yields, contributing to an unusual investment environment and raising questions for investors about how best to position assets in fixed income portfolios.

Bond yields are responding to a series of dramatic interest rate hikes by the Federal Reserve (Fed), which raised its target federal funds rate by 5.25% to 5.50% over the course of the past 18 months. The Fed’s actions were intended to address a rapid resurgence of inflation, which peaked at 9.1% for the 12 months ending in June 2022, but had dropped to 3.7% by August 2023.2

In the weeks leading up to the Fed’s first rate hike in March 2022, 10-year Treasuries yielded just 1.5%, reflecting a longstanding lower interest rate environment. Yields rose in 2022, then fluctuated within a range of 3.30% and 4.25% before recently breaking through to a new high of 4.37% as of September 19, 2023.

chart depicts weekly closing yields on the 10-year U.S. Treasury from December 2021 through September 20, 2021.

Yields across the bond market remain elevated despite more favorable inflation trends. Economic growth, which slowed in 2022 in response to the Fed’s policy decisions aimed at reducing inflation, appears to have stabilized. The recent upturn in 10-year Treasury rates may reflect that investors anticipate inflation could be a persistent issue, according to Rob Haworth, senior investment strategy director at U.S. Bank. “Inflation expectations are being pushed to the longer-end of the market, and as a result, it’s putting more pressure on long-term interest rates.” What could the Fed’s future monetary policy mean for the bond market and how should fixed-income investors consider positioning their portfolios?


Changing bond market

“Bond yields rose primarily because the Fed pivoted to a much more hawkish position, as investors anticipated aggressive interest rate hikes to rein in inflation,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.

“It makes sense to consider spreading fixed income investments across the maturity spectrum, with a focus on higher credit quality,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management.

Rising bond prices are a challenge for existing bondholders because of the inverse relationship between bond yields and bond prices. When yields rise, prices of current bond issues fall. This is a function of supply and demand. When demand for bonds declines, issuers of new bonds must offer higher yields to attract buyers, reducing the value of lower-yielding bonds already on the market. This environment hit bondholders particularly hard in 2022, with the Bloomberg U.S. Aggregate Bond Index generating a total return of -13.01%.3 While bondholders have had the opportunity to earn higher income due to elevated bond yields in 2023, total returns for the year, as of mid-September, are nearly flat.


Fed’s influence on interest rates

The Fed uses interest rate hikes on the short-term federal funds rate it controls as a tool to raise borrowing costs to slow economic activity and reduce inflation. The Fed pursued an aggressive rate-hiking policy, and between March 2022 and July 2023 the fed funds rate rose by 5.25%, a significant turn of events. The Fed left the door open for an additional rate hike in 2023 as it continues to scrutinize inflation data going forward. It also indicated the fed funds rate will remain elevated for some time into 2024.

“The Fed remains firmly focused on bringing inflation down,” says Eric Freedman, chief investment officer, U.S. Bank Wealth Management. “2% is the Fed’s inflation target, and despite some progress – from June 2022’s peak to the 3.7% rate in August 2023 – it is still a far cry from the 2% the Fed wants to maintain.”


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 circumstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve. It logically reflects the thinking that investors should earn a return premium for the greater uncertainty inherent in lending money over a longer time period. The current environment is unusual, as yields along the maturity spectrum now reflect an inverted curve.


U.S. Treasury Yield Curve Comparison
Dec. 31, 2021 and September 20, 20231

graph depicts a normal yield curve at the end of 2021 (represented by the blue line) as compared to the inverted yield curve (represented by the red line) that exists as of September 20, 2023. The graph plots the relative yields of 3-month, 2-year, 5-year, 10-year and 30-year U.S. Treasury securities.

The curve is generally downward sloping today, compared to the normal upward sloping curve (such as the lower curve shown on the chart, reflecting bond yields at the end of 2021). Most notable is the inversion between 3-month and 10-year Treasury yields, with a spread of 1.3% in favor of the shorter-term security as of mid-September. A common view of many analysts is that a yield curve inversion signals increased odds of a recession in the future. “The reality is that there is limited historical data related to yield inversions and economic trends,” says Haworth. He notes that significant COVID-19-related government financial aid and Fed monetary stimulus has had a lingering effect on the economy, despite interest rate trends. “It appears a lot of stimulus needs to be pulled out of the system before the economy might dip into a recession,” says Haworth.


Keeping an eye on the Fed

While inflation trended lower after its mid-2022 peak, it remains above the Fed’s target inflation rate of 2% annually.4 Investors are closely watching the Fed’s actions to see where it takes interest rates in the months to come, but it appears steadfast in its ongoing commitment to higher rates given that inflation remains persistently above the Fed’s target.

External events can also impact inflation trends. Fallout from Russia’s invasion of Ukraine is a prime example. Russia is a major energy producer, particularly for Europe, while both countries are significant agricultural exporters. The conflict affects the flow of oil, natural gas and food products. More recently, Saudi Arabia and Russia cut oil production to drive prices higher. “Developments like these are outside the control of central banks,” says Merz. “Interest rate hikes by the Fed, the European Central Bank and others are meant to slow demand, but they don’t improve supply.”

An economic slowdown could also alter the general upward trend of interest rates. “The Fed’s statements after its September meeting acknowledge that the economy is stronger than they expected it to be,” says Freedman. That is likely to temper expectations of the Fed cutting rates quickly or to any significant extent even in 2024. If the fed funds rate stays above 5%, yields across the bond market are more likely to remain elevated as a result.

Corporate bond yields are higher as well, but not significantly more attractive than Treasury yields. “The shape of the economy will have a large bearing on the corporate bond market going forward,” says Haworth. “Will investors become more concerned about the risks inherent in corporate debt if an economic slowdown materializes?” To this point, the economy appears to still be moving in a positive direction, which should bolster the corporate bond market.


Finding opportunity in the bond market

What are the best options for bond investors in today’s market? Opportunities are clearly more attractive given today’s higher yields. “Investors who have money sitting in cash can earn much more competitive rates owning bonds with relatively short holding periods of three months to two years,” says Haworth. For an existing bond portfolio, Haworth says investors should consider reaching out further on the maturity spectrum, where reasonable yields can be locked in for a longer term. “The fact is that even though shorter-term securities pay higher yields, longer-term bonds generated comparable total returns in the first half of 2023.”

Freedman points out that owning long-term bonds requires an investor to accept more interest rate risk (if bond yields rise, the value of existing bonds declines). “Our view is over time, interest rates have more room to fall than to rise,” says Freedman. Falling interest rates help boost total returns for existing bondholders. “It makes sense to consider spreading fixed income investments across the maturity spectrum, with a focus on higher credit quality,” says Freedman.

Within a fixed income portfolio, investors may want to consider specific tactical opportunities based on the current environment. For example, high tax-bracket investors may benefit from an allocation to high-yield municipal bonds. Certain taxable investors should focus on longer maturity U.S. Treasury bonds and consider non-government agency issued residential mortgage-backed securities. Insurance-linked securities or catastrophe bonds may offer a way to capture differentiated cash flow with low correlation to other portfolio factors, for investors in a position to gain exposure to such opportunities.

There can be broader diversification benefits for those wishing to concentrate more of their bond positions in high-quality segments of the fixed income market. “It is a way to add diversification to help manage risks in a portfolio that includes equities, which tend to have more short-term volatility,” says Merz. While a rarity occurred in 2022 as both stocks and bonds suffered negative total returns, Merz says that over the long run, holding high-quality bonds will typically help smooth volatility in an investor’s diversified portfolio.

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

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  1. Source: U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates.

  2. Source: U.S. Bureau of Labor Statistics.

  3., “Tracking Bond Benchmarks” Dec. 30, 2023.

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