How rising interest rates impact the bond market

Investors continue to adjust to a bond market environment that is drastically altered from what existed less than two years ago. Yields on the benchmark 10-year U.S. Treasury note neared 5% by early October, only to fall back near 4.5% in early November. The fluctuations in interest rates across broad swaths of the bond market appeared to reflect a confluence of events that may give investors a new perspective on how to structure their portfolios for the long term.

Near the end of October 2023, the yield on the benchmark 10-year U.S. Treasury note briefly topped 5% in intra-day trading, and ended the month just shy of 4.9%, before falling to about 4.5% in early November. 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 has created the best opportunity in years for investors to utilize bonds to generate meaningful income streams.

Source: U.S. Bank Asset Management Group, Bloomberg. For time period 1/3/2003 - 11/3/2023.

The altered interest rate environment is attributed in large part to the Federal Reserve (Fed) raising its target federal funds rate by over 5% since early 2022. The Fed’s actions are aimed at slowing the economy to reduce inflation, which peaked at 9.1% for the 12 months ending June 2022, but dropped to less than 4% by September 2023.²

What do 2023’s interest rate trends mean for the bond market and how should fixed-income investors consider positioning their portfolios?

Changing bond market

Yields across the bond market remain elevated despite more favorable inflation trends. “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 so far in 2023. Finally, there is an increasing supply of U.S. Treasury securities coming to the market.”

Merz notes that consumers, supported by a strong job market, have maintained higher spending levels, fueling continued economic and corporate earnings growth. “This may be an indication the Fed will need to keep rates elevated for longer to pull back demand for goods and services, which could help reduce inflation to their 2% target. Those expectations can flow through to higher bond yields,” says Merz.

The Treasury has stepped up bond issuance in recent months due to a growing federal government budget deficit. “New Treasury bond issuance must grow 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, and to do so, they have demanded higher yields,” says Merz. “Rising rates could be attributed in part to the imbalance between an expanding supply of bonds and a shrinking pool of bond buyers, with the Fed now absent from the market.” Merz says in some cases, Treasury bonds have become less attractive for foreign investors after accounting for currency hedging costs. This relationship can change quickly but may have contributed to lower demand from certain countries. Although these factors could result in higher Treasury yields on new issues, the yield on the 10-year Treasury backed off its recent highs in the opening days of November 2023 as many interpreted comments from the Fed to indicate they may be finished hiking rates.

A notable consideration for investors is that 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%.³ While bondholders have had the opportunity to earn higher income due to elevated bond yields in 2023, it’s worth noting that the total return for the Bloomberg Aggregate Index was -2.77% year-to-date through October 31.³

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 circumstances, 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 October 31, 2023¹

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

Our analysis indicates lengthy periods of inverted yield curves can precede a rise in the unemployment rate and lower than average stock returns, however, certain historical periods have not adhered to the average tendencies. While many cite inverted curves as a harbinger of recessions, our analysis remains inconclusive, with inconsistent lag times before tighter policy and inverted curves result in a slowing economy. So far in 2023, the economy has generated solid growth as measured by Gross Domestic Product (GDP), expanding at an annualized rate of 4.9% in the third quarter.⁴

Keeping an eye on the Fed

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 with the hope of reducing inflation. While inflation trended lower after its mid-2022 peak, it remains well above the Fed’s target inflation rate of 2% annually.⁵ Fed Chairman Jerome Powell has indicated that additional rate hikes could occur, and despite the hope of some investors that the Fed would reverse course and begin cutting rates, that’s not likely to happen soon.⁶ “The Fed keeps reminding people that if inflation remains elevated, it will need to keep interest rates high,” says Merz. “That’s a key risk facing the markets today, even if the odds of additional rate hikes have fallen.”

Corporate bonds offer higher yields than Treasury bonds. “The incremental yield above Treasuries remains near historical norms, reflecting corporate credit health near historical averages,” says Merz.

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 maturities between three months and two years,” 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. Yields on longer bonds are 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.