How to Position Your Bond Portfolio as Short-Term Yields Fall

There’s been a major change in one of the bond market’s favorite indicators: the yield curve. After roughly two years of “inversion,” yields are now behaving like they do most of the time, with longer-term bonds yielding more than short-term ones.

This may seem like inside baseball, but it has real implications for bond investors. Against this backdrop, strategists are encouraging investors to look beyond cash and ultra-short-term bonds to bonds with intermediate maturities—those with terms between three and seven years—in order to capture attractive yields and take advantage of the diversification benefit that fixed income can offer. They also warn investors against taking too much risk in bonds with very long maturities, since changes in the economic outlook could lead to volatility in those assets.

With the Federal Reserve embarking on a rate-cutting cycle and a soft landing coming into view, investors expect short-term interest rates to fall rapidly. On Friday, after the Personal Consumption Expenditures Price Index showed inflation at 2.2% in August—within striking distance of the Fed’s 2% target—bond futures markets began pricing in another dramatic half-percentage-point rate cut for November. That would follow an easing of the same magnitude by the Fed in September.

Here’s everything investors need to know about the rapidly changing landscape in the bond market.

What Is the Yield Curve?

The yield curve is a graphical representation of government-bond yields across different maturities, most commonly from two-year Treasury notes to 10-year Treasury bonds.

For the most part, bonds with longer maturities yield more than bonds with shorter maturities. That’s because investors expect extra compensation for the risks—like inflation and economic uncertainty—of locking their money up with the government for longer. The result is a curve that slopes upward.

In rarer circumstances, short-term yields climb higher than long-term yields, resulting in an “inverted” curve that slopes downward. This happens when investors anticipate slower economic growth in the future, and thereby lower interest rates, down the line. It’s often interpreted as a signal of a recession.

The yield curve inverted in 2022 and remained that way until very recently, when longer-term yields inched above their short-term counterparts.

“We were meaningfully inverted for a significant period of time,” explains Dominic Pappalardo, chief multi-asset strategist at Morningstar Investment Management.

This created some unusual dynamics in the bond market, he notes. Because investors didn’t need to take the additional risk associated with longer-dated bonds to capture higher yields, he says, “you probably ended up with this artificial overweight from investors in the short end of the yield curve, because that was where the most yielded income was available.”

Why Did the Yield Curve Normalize?

As it became clear to investors late this summer that the Fed was poised to cut interest rates, yields on shorter-dated bonds—which closely track the central bank’s target interest rate—began to fall.

Yields on longer-dated bonds—which track expectations about the state of the economy and the path of fiscal policy way down the line—ticked lower, too, but not nearly as dramatically. When the two-year bond yield fell below the 10-year in early September, the yield curve officially un-inverted.

While there’s been extended debate about whether the yield curve’s inversion—or its un-inversion—are harbingers of recession, there’s a simpler message investors can take from the shift.

Matt Diczok, head of fixed-income strategy for the chief investment office at Merrill and Bank of America Private Bank, explains: “The yield curve normalizing tells you what we already know: The Fed is ready, willing, and able to provide more monetary policy accommodation, provide more liquidity, and provide lower rates to keep economy on better footing.”

He adds that recession or not, this message means that the yield curve is still a useful indicator for investors. “It told you the economy was going to slow down dramatically, and it has.”

Cash No Longer a Free Lunch

Falling short-term yields mean that the cushy returns investors have enjoyed on cash and ultra-short-dated products like money market accounts will fall, too. As that happens, strategists expect that the crowd of investors at the short end of the curve will begin to thin.

“The fact that the curve isn’t inverted anymore means that you’re not earning more yield in cash than you are further out on the curve,” says Patrick Klein, a portfolio manager for Franklin Templeton’s multi-sector and quantitative fixed-income strategies.

Bank of America’s Diczok says he’s been reminding clients that a normalizing yield curve is a good time to consider adding longer-dated bonds into a portfolio and moving away from cash.

“If you buy cash when it’s super high yielding, that’s usually right before the Fed cuts and your future returns are quite poor,” he says, which is why it makes sense to build a portfolio with longer-dated bonds to protect against macroeconomic risk and lock in reliable yields. “Cash isn’t fixed income, it’s variable income,” Diczok says.

“Fixed-income investors in general will be moving out the curve as the front end goes down,” Klein adds.

Yield Curve Expected to Steepen

As of Sept. 26., the 10-year Treasury bond was yielding 3.79% while the two-year yielded 3.60%—a gap of 0.19 percentage points.

Strategists expect the spread between the two bonds to continue widening as the Fed cuts rates, which will push yields on the short end of the curve lower until the central bank reaches its “terminal” rate—the end of the easing cycle. With a soft landing priced into the economy, they say yields on the longer end of the curve aren’t likely to fall much further from current levels, if at all.

This is what bond traders refer to as a “bull steepening”—when yields at the short end of the curve drop faster than yields at the long end. Meanwhile, prices for both assets are rising. (Bond yields and prices tend to move in opposite directions.)

A bear steepening, on the other hand, happens when longer yields rise faster than their shorter counterparts. That’s a rarer scenario and it generally means investors are wondering if the Fed is behind the curve, Diczok explains. “Inflation might be accelerating …[it’s] definitely a more worrying and unusual occurrence.”

Risks for Investors

It’s a nuanced concept, but the type of steepening “makes a big difference,” for investors, and especially for those looking further out on the curve, Franklin Templeton’s Klein says. A bull steepening is driven by a rally in shorter-dated bonds, which means that yields are falling while prices rise. But if those declines are being driven by concerns about growth, Klein says, investors could see riskier holdings like stocks fall.

Strategists say that a bear steepening—a future selloff in longer-dated bonds as shorter-term bonds remain more predictable—is also possible. A soft landing is not guaranteed, and “there’s room for the long end to go up,” Klein says. “We actually think that the market’s a little bit too sanguine in terms of soft landing probabilities.”

Long-term rates may also climb higher as the government deficit increases, especially since the economy has shown that it can withstand higher interest rates across the board, and strategists also say longer-term bonds could see some volatility in the months ahead.

“With government spending unlikely to slow regardless of the election’s outcome and US debt already breaching new highs each month, there’s precedent for rapid rate fluctuations in the long end of the curve—an unfavorable risk/reward profile,” strategists from BlackRock wrote in their most recent outlook.

And as rates go lower across the board, Diczok warns investors against reaching for income anywhere they can find it. On the corporate side, he prefers investment-grade credit over riskier high-yield offerings.

Bottom Line for Bondholders

As the yield curve continues to normalize, Klein says the best place for investors to be “really depends on what you’re trying to achieve with that fixed-income allocation.”

While strategists are encouraging investors—especially those with extra cash—to look further out on the yield curve with their portfolios, the perfect spot will vary according to an individual’s goals and risk tolerance.

As a starting point, Diczok recommends sticking with the crowd. The average duration—a measure of interest-rate risk that’s related to a bond’s maturity—in the fixed-income market clocks in at about six years, and he says that’s a good place to start. “If you don’t have a very good reason not to be around six, you should be around six,” he says.