What the Fed’s interest rate cut means for bond investors

With the Federal Reserve beginning its long-awaited shift toward lower interest rates with a decisive half-percentage-point move, bond investors can expect a change.

Investors may want to refocus their portfolios in the coming days: With the Fed in motion, yields on cash and shorter-dated products will fall sharply. Strategists say investors can now benefit from taking on a bit more interest-rate risk in the form of longer-dated bonds than cash.

Meanwhile, a stronger-than-expected economy could push up long-term bond yields and expose investors to risks in those assets.

If the Federal Reserve begins to ease monetary policy, corporate loans and other securitized products have the potential to outperform safe-haven Treasuries.

At a higher level, strategists also agree that the fundamental story for fixed income hasn’t changed all that much since yields peaked earlier this year. With inflation-adjusted interest rates now firmly in the positive territory, they say bonds remain a good choice for both income and portfolio diversification.

Here’s everything investors need to know about the bond market as interest rates fall.

With a soft landing now priced in, where will bond yields head?

Long-term bond yields, which reflect expectations about the health of the economy, began to decline steadily in mid-May 2024 as more stable inflation strengthened the Fed’s case for a possible interest rate cut.

After peaking at 4.70% earlier this month, the yield on the 10-year Treasury note has fallen more than 100 basis points in five months, reaching 3.62% ahead of the Fed’s September meeting. The overall bond market, as measured by the Morningstar US Core Bond Index, is up about 7.5% during that period. Yields tend to move in the opposite direction of prices.

Analysts say the outlook for a strong economy means yields are unlikely to fall further, even though investors and analysts agree that the next rate cuts will come later this year and in 2025. Most of the impact of the rate cuts has already been priced into market prices, they say, and it wouldn’t be surprising if yields rose as a result. They already rose a bit after the Fed cut.

“We don’t think interest rates, particularly long-term rates, are going to fall much from here,” says David Rogal, a portfolio manager in BlackRock’s Fundamental Fixed Income Group. Barring any changes to the strong growth outlook, he expects the 10-year Treasury yield to remain in a range of 3.75% to 4.25%, with a potential high of 4.50%.

Carol Schleif, chief investment officer at BMO Family Office, also sees room for yields to rise, given expectations of a strong economy in the coming months. “Our house view is that 10-year bonds should be between 4.25% and 4.50%,” she says.

An inverted yield curve creates opportunities to extend the duration of…

The new interest-rate regime has also normalized the bond market’s most closely watched signal: the yield curve, which shows the differences in yields investors receive on bonds of different maturities. Historically, yields on longer-dated bonds tend to be higher than those on shorter-dated bonds, reflecting the extra compensation investors demand for the extra risk of holding assets for a longer period.

The yield curve inverted in 2022 as the Fed raised rates and shorter-dated bonds outperformed longer-dated bonds, but in recent days it has returned to a more typical shape. That changes the dynamic for bond investors.

“As the curve steepens, people will move into intermediate fixed income” rather than sticking to cash or other shorter-dated products, says BlackRock’s Rogal. He says he’s already seeing demand reflect higher valuations.

Dominic Pappalardo, chief multi-asset strategist at Morningstar Investment Management, says there are significant benefits to “extending duration” in portfolios now that the yield curve has returned to normal.

Duration is a measure of interest rate sensitivity and is often used when discussing bond maturities. Longer-dated bonds have a longer maturity than shorter-dated bonds and tend to be riskier than shorter-dated bonds (with the notable exception of the last year or so when the yield curve inverted), but they also tend to have higher yields.

With an inverted yield curve, Pappalardo explains, investors don’t have to give up income to expand their investments into longer-dated bonds. At the same time, higher yields on longer-dated bonds mean that longer-dated bonds are once again effective portfolio hedges.

Analysts expect the curve to continue to steepen as the Fed continues its easing cycle and short-term interest rates decline.

…but be careful about the duration being too long

While higher yields can now be found along the yield curve, some strategists caution investors against too many exposure to long-term bonds — especially given the outlook for strong economic growth in the coming months. They recommend investors find a comfortable middle ground on the curve.

“If we do get stronger growth than expected, there’s some risk of deviating too much from the duration curve,” says BMO’s Schleif, because long-term economic expectations tend to have a bigger impact on long-term interest rates than short-term ones. “It’s the proverbial whip effect,” he says. To avoid that volatility but keep yields high, he says investors can look to bonds with maturities of two, three and five years.

Mary Ellen Stanek and Warren Pierson, co-chief investment officers at Baird Asset Management, also point to intermediate-term bonds as a safer option. “The main concern is that you could see longer-term yields rising,” Pierson says. If an investor significantly increases the duration, only to see yields continue to rise, “that could be painful.”

Where to Find Profit in a Risk-Oriented World

In the new world of more accommodative policy, Morningstar’s Pappalardo says risk assets should once again seem attractive to investors. In the bond market, that means corporate credit, not government debt like Treasuries. Lower rates mean lower borrowing costs for companies, which means better profitability, better credit terms and lower refinancing risk, he explains.

That’s a big change from the major bond selloff in 2022, when unexpectedly stiff inflation made investors bearish on bonds as they braced for higher interest rates for longer. In that environment, Treasuries seemed safer than risky asset classes like corporate bonds.

Chris Alwine, global head of credit in Vanguard’s fixed-income group, points out two themes for investors in the risky fixed-income landscape. For high-net-worth individuals, tax-advantaged municipal bond yields look very attractive. On the tax side, Alwine favors higher-quality investment-grade credit over lower-quality high-yield credit, and he favors corporate bonds and structured products over government bonds. “We think in a world where the economy continues to grow and the Fed is easing, you still want to be exposed to sectors.”

Quality bias is especially important now, Alwine says, because with compressed valuations, “the extra return you get from high-yield versus investment-grade is low.” While an unexpected recession isn’t the most likely outcome, according to Vanguard, it would mean high-yield bonds would significantly underperform their higher-quality counterparts.

For investment-grade loans, Alwine says the most attractive option is the shorter end of the yield curve — bonds with maturities of one to five years.

Investor Summary

Strategists say the overall fixed-income market hasn’t changed all that much from earlier this year, when yields for 2024 were peaking.

“Bonds have redemption today,” Alwine says, citing attractive inflation-adjusted yields as well as portfolio diversification benefits. That’s a big change for investors who remember the brutal bond rout of 2022 and years of negative yields before the pandemic. And while rates have come off their peak, Pappalardo adds, bonds still serve “a very useful purpose in a diversified portfolio.”

For investors reconsidering their bond holdings, Baird’s Stanek recommends going back to the basics—yield, risk and costs. “Look at the vehicle you’re in,” he says. “Is this the best way to provide a diversified portfolio that will give you the overall interest-rate exposure you want? What about the opportunities to add additional yield through sectors? What’s your expense ratio? Pay attention to those details.”

Pierson adds: “Take advantage of the value in the bond market, which we think is there. But don’t go crazy and take on too much risk.”