When interest rates fall, which bonds are worth buying?

Now, as inflation declines and the U.S. central bank begins to cut interest rates to support the weakening economy, fixed-income experts say it’s a good time for investors to re-evaluate their bond portfolios. As interest rates fall, bond prices rise and vice versa.

“It’s easy to invest in cash and money market funds when they’re yielding 5%, but that wears off,” says Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments. “Investors should think about bonds not just from an income-producing perspective, but as a diversifier and an important component of a portfolio.”

Some investors, however, are likely still spooked by the bond market’s weak performance in 2022 as the Federal Reserve begins aggressive interest rate increases. The S&P 500 Index has seen a return of minus 18% this year, and bonds have not hedged portfolios against stock losses as they typically do, with the Bloomberg US Aggregate Bond Index returning minus 13%.

Since then, the aggregate bond index, which tracks investment-grade issues, has performed significantly better, up about 4.5% so far this year after posting a positive return of 5.5% in 2023.

So what bonds should investors be paying attention to now? Here are four to consider:

Treasures

Treasury yields fell – and prices rose – in the months leading up to the Fed’s September 18 announcement of an interest rate cut, pushing the benchmark federal funds rate to a range of 4.75% to 5%.

However, experts say there is still room for prices to rise as the Fed is expected to continue cutting interest rates in the coming year. Tannuzzo prefers Treasuries maturing in five or 10 years because their price is likely to rise as interest rates fall.

He is more cautious about long-term bonds, especially 30-year Treasuries, because he fears there could be an oversupply of Treasuries in the event of a large tax cut or infrastructure package under a new president. The additional supply can cause prices to fall, and long-term bonds are more sensitive to changes in government spending, interest rates and inflation than shorter-term securities.

Thirty-year Treasuries recently yielded 4.08%, about 0.35 percentage points above the benchmark 10-year bond’s recent yield of 3.74%.

Regardless of the Fed’s moves, Treasuries can also serve as a portfolio hedge against an economic slowdown or global geopolitical turmoil. Treasury securities are less volatile than stocks and other types of higher-yielding bonds, often serving as a haven for investors seeking greater stability due to a weakening economy, geopolitical unrest or other market shock.

“You could argue that (10-year Treasuries) look cheap,” says Priya Misra, portfolio manager at JP Morgan Asset Management. “If we are heading into a recession, the 10-year bond will fall below 3%. “

Corporate bonds

Investment-grade corporate bonds look attractive in many respects: They offer solid yields and a low default rate that isn’t expected to rise sharply even amid concerns about a weakening economy, and prices should continue to rise as the Fed cuts short-term rates. Market specialists favor issues with maturities between three and 10 years as a good place to take advantage of this momentum.

Anders Persson, chief investment officer and head of global fixed income at Nuveen, likes Class B corporate loans, which are at the lower end of the investment ladder. He says many companies in this category can withstand an economic downturn. According to S&P Global, only two investment-grade companies went bankrupt last year, and in 2024, there were none.

“Companies were preparing for an economic slowdown,” says Persson, adding that he does not expect a large increase in insolvencies. “So at this point it makes sense to focus on some of the triple-B investment grade space.”

David Rogal, portfolio manager in BlackRock’s core fixed income group, agrees that the corporate sector is in good shape, although he says “a lot of the good news is around the price” of these bonds. In other words, it looks expensive.

For example, according to Nuveen, triple-B bonds were trading about 1.1 percentage points above Treasuries as of Sept. 23, up from 1.41 a year ago. So investors don’t get as much extra profit as they did 12 months ago for the risk of holding corporate bonds.

Still, Rogal says “the fundamentals for investment-grade bonds are very strong.”

High yield bonds

Market specialists also say there are opportunities in the form of high-yield, or junk, bonds issued by companies with non-investment grade credit ratings. They have performed well recently, with the ICE BofA US High Yield Index up nearly 8% this year through Sept. 20, after rising 13% last year.

This part of the market also appears to be resilient. S&P Global forecast the 12-month junk bond default rate to be 3.75% in June 2025, down from an actual rate of 4.6% in June, citing solid corporate earnings and consumer spending, among other factors.

JP Morgan’s Misra says the high-yield market is fragmented by opportunity. He prefers higher-rated double B or single B bonds rather than even lower-rated distressed bonds. She believes there are many companies with good earnings and balance sheets that could be upgraded to investment grade.

Nuveen’s Persson takes a similar view, preferring higher-rated junk bonds. He doesn’t see much opportunity in lower-rated high-yield bonds such as triple-C bonds, which “will be more exposed as the economy slows.” “Given the continued corporate credit fundamentals, we believe I am “comfortable playing double Bs and better quality single Bs” with high yield, he says.

One strategy he likes is to reduce some of his exposure to floating-rate bonds, which reset regularly based on prevailing interest rates, and shift to higher-quality, high-yield issues. Holders of floating-rate bonds are exposed to the risk of reinvestment in conditions of falling interest rates, and especially lower yields.

Municipal authorities

While it is difficult to predict the impact of the winner of the presidential election on different parts of the bond market, munis could benefit in certain scenarios.

Dan Close, director of municipal government at Nuveen, cites the example of the top marginal federal tax rate, which will be 39.6% from the current 37% if former President Donald Trump’s Tax Cuts and Jobs Act expires at the end of 2025.

Given that municipal bond interest is exempt from federal taxes, Close argues that “for every taxpaying person, the exemption is worth more” if marginal tax rates increase.

He gives the example of a 5% muni earning a tax-equivalent yield of 7.9% at a marginal interest rate of 37%. If the tax returns to 39.6%, the tax-equivalent income will be even higher and will amount to approximately 8.25%.

“The higher tax bracket makes municipal exemption a lot more profitable,” says Close.

Close sees better opportunities in long-term investing, where “you get paid to take that risk,” he says.

The benchmark for a 14-year triple-A rated muni bond is 2.85%, compared with 2.3% for a two-year triple-A issue, according to FactSet.

Lawrence Strauss is a writer from Millburn, New Jersey. He can be reached at [email protected].