While the world watches Donald Trump’s inauguration on Monday, investors will be watching bonds. The reason: The once-boring bond market is causing angst as the 10-year Treasury flirts with 5% and fixed-income volatility spikes.
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What Is A Bond? A Beginner’s Guide To This Key Financial Asset
When the Federal Reserve started cutting its key interest rate last September, Wall Street was hoping long-term rates would follow suit and trend lower. Instead, rates have started an upward march yet again. The 10-year Treasury ticked up to a 52-week high of 4.817% this week. The 10-year note last flirted with 5% in October in 2023, when it hit 4.987%.
Some investors are calling for rates to hit the 5% big round number.
“We expect the 10-year Treasury to breach the 5% threshold in the first quarter as both fundamental and technical factors suggest the ‘higher for longer’ interest-rate dynamic will continue for the foreseeable future,” said Chris Brigati, chief investment officer at investment firm SWBC.
What The Market For Bonds Is Saying
Bonds, of course, are meant to provide ballast and diversification to an investment portfolio. They also can pay much-needed income for retirees. But with bonds there’s a double-edged sword: As bond prices fall, yields rise. That means a bond investment’s principal declines and bond investors lose money. But at the same time, bond investors benefit from higher yields, which lead to higher income.
There is a combination of factors driving yields higher, says Anders Persson, chief investment officer for global fixed income at Nuveen. The main culprits are a stronger economic backdrop, a resilient jobs market and still-sticky inflation. You can add in incoming President Trump’s proposed fiscal policies, such as tax cuts and levying tariffs on U.S. trading partners.
Trump’s pro-growth policy pledges could put upward pressure on inflation — and bond yields. On Wednesday, the government reported a 0.4% rise in inflation in December and a year-over-year gain of 2.9%. Wall Street took the latest CPI data in stride, with stocks rising and bond yields retreating. Still, inflation’s reluctance to get back to the Fed’s preferred 2% level poses a challenge to the incoming Trump economic team.
“It’s the stronger-than-expected economy and the uncertainty around what the new administration’s economic policies will look like going forward,” said Persson.
Due to the economy’s resilience, the Fed has dialed back its interest-rate-cut forecast to two quarter-point cuts this year, down from four reductions. But Wall Street is now pricing in one rate cut, and places just 29.4% odds on the Fed cutting twice, according to CME Group.
So, what’s an investor or a retiree to do?
Don’t Panic About Bonds
Now’s not the time to don’t dump your bonds just because they’re falling in price, says Persson.
The 10-year Treasury yield is close to 5%. And other parts of the fixed-income market, such as bank senior loans and municipal bonds, offer even higher yields. Retirees, for example, who once winced when rates were at 0% should welcome higher yields. And going forward, investors with diversified portfolios can count on bonds providing the downside protection and diversification they’re known for.
“The income generation is really quite powerful,” said Persson. “There’s still very attractive income opportunities from investing in fixed income.”
Stephen Hooker, manager of Virtus Newfleet Core Plus Bond fund, notes the importance of high yields as a predictor of future returns. “One of the best barometers for forward-looking returns is the starting point of yields,” said Hooker. “You’re supposed to be adding to fixed-income allocations as yields tick higher.”
The higher the starting yield, the more protection you have against future rate increases, adds Hooker.
Benefit From Bonds’ Cushion Effect
Another plus of higher yields, says Persson, is that they function as a line of defense in the event of a stock market correction. Stocks aren’t cheap. The price-to-earnings ratio of the S&P 500 at the end of 2024 was 25.21, above the five-year average of 22.76 and the 10-year average of 21.29, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.
Don’t get lulled into a false sense of security and figure stocks can only go up.
“Equities have been up nearly 25% for two years in a row; can that continue?” says Persson. “Bonds are becoming more relevant in a portfolio again. If we have a sell-off in stocks, we expect bonds to provide a little bit more cushion and become more of a true diversifier going forward.”
Invest In Short- Or Intermediate-Term Bonds
With the long end of the yield curve more volatile and susceptible to economic factors and government fiscal policies, Persson advises sticking with bonds with shorter durations. He likes bonds with durations of three to five years.
“The front end of the curve is going to be anchored around the Fed continuing to cut rates,” said Persson. “Further out on the curve still has a fair amount of volatility. At the front end of the curve, most of that noise won’t be quite as prevalent. But you’re still getting a decent yield.”
Jim Elios, founder, CEO and wealth advisor at Elios Financial Group, recommends going out a tad farther on the yield curve.
“To position a bond portfolio for elevated interest rates, we prefer an intermediate duration of five to seven years,” said Elios. “We also prefer high-yield bank loans, which offer good yield and a good spread to Treasuries.”
For those who can stomach some volatility, now’s a good time to move to longer duration, adds Elios. “That would allow investors to lock in these elevated yields for the long term,” he said. If forecasts call for modest economic growth, that will support further rate cuts and lower rates, which is better for longer-term bonds, Elios says.
Buy Individual Bonds
For investors who don’t mind holding bonds to maturity, buying individual bonds at these high yields makes a lot of sense, says Hooker. And investors buying bonds in the secondary market now will be buying fixed-income assets at a discount.
“If investors and their financial advisors do a good job selecting individual bonds, they’ll not only get decent income but price appreciation potential as well,” said Hooker.
Consider A 40/60 Portfolio
The traditional balanced portfolio is 60% stocks and 40% bonds. But in early January, Vanguard released a report calling for a 40% stock and 60% bond asset allocation.
“It’s a potentially attractive portfolio in the current economic environment,” according to Vanguard. “This perspective is driven by elevated interest rates and high starting equity valuations.”
Vanguard expects the 40/60 portfolio to have slightly higher returns than a traditional 60/40 portfolio, and with lower volatility.
Vanguard says it is overweight U.S. credit and U.S. long-term bonds. The reason? “(It) reflects our belief that higher starting yields in fixed income can provide a cushion against modest yield increases, making fixed income an attractive component of the portfolio,” Vanguard noted in its report.
Benefit From Lower-Risk Strategies
Retirees should cheer higher rates, says Hooker. For one, higher yields mean investors will need to take less risk to meet the return hurdles needed to fund their lifestyle with distributions from their portfolio.
“They can embrace less risky strategies and still earn a decent return,” says Hooker. And they’re also earning a higher return than inflation.
The key now is to lock in higher yields for longer, says Hooker. Bonds he likes now include those further out on the yield curve to lock in higher rates. He likes investment-grade corporate bonds, mortgage-backed securities and asset-backed securitized such as auto loans. All have yields around 5% or more.
