What the Fed’s Rate Cut Means for Bond Investors

With the Federal Reserve beginning a long-awaited shift to cutting rates with a decisive half-percentage-point move, changes are in store for bond investors.

Investors may want to tilt their portfolios differently in the days ahead: With the Fed in motion, yields on cash and shorter-maturity products will drop rapidly. Strategists say investors can now benefit from taking on a little more interest-rate risk in the form of bonds with longer maturities rather than cash.

Meanwhile, a stronger-than-expected economy could push longer-term bond yields higher and pose a risk to investors in those assets.

With the Fed in easing mode, corporate credit and other securitized products have the potential to outperform safe-haven Treasuries.

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

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

With a Soft Landing Priced In, Where Are Bond Yields Headed?

Longer-term bond yields, which tend to reflect future expectations about the strength of the economy, began a steady descent downward in the middle of May 2024 as steadier inflation prints solidified the Fed’s case for an eventual rate cut.

After peaking at 4.70% early that month, the yield on the 10-year Treasury note fell more than 100 basis points over the course of five months to land at 3.62% ahead of September’s Fed meeting. The overall bond market as measured by the Morningstar US Core Bond Index climbed roughly 7.5% during that period. Yields tend to move in the opposite direction of prices.

Analysts say forecasts for a strong economy mean that yields aren’t likely to fall further, even if it’s widely agreed among investors and analysts that more rate cuts are coming through the end of the year and into 2025. Much of the impact of rate cuts has already been priced into the market, they say, and it wouldn’t be surprising to see yields rise as a result. They’ve already ticked up a hair in the aftermath of the Fed’s cut.

“Our view is that rates, particularly long-term rates, should not come down significantly from here,” says David Rogal, a portfolio manager in BlackRock’s Fundamental Fixed Income Group. Barring any changes to the forecast for strong economic growth, he expects yields on the 10-year note to remain in a range between 3.75% and 4.25%, and potentially 4.50% on the higher end.

Carol Schleif, chief investment officer of the BMO Family Office, also sees room for yields to rise given expectations for a robust economy in the months ahead. “Our house call is that the 10-year ought to be at 4.25% to 4.50%,” she says.

Uninverted Yield Curve Brings Opportunities to Add Duration …

The new rate regime has also brought with it the normalization of the bond market’s most closely watched signal: the yield curve, which charts the differences in the yield investors receive on bonds of different maturities. Historically, yields on longer-maturity bonds tend to be higher than yields on shorter-maturity bonds, reflecting the extra compensation investors demand in exchange for the extra risk of holding the asset for a longer period.

The yield curve inverted in 2022 as the Fed hiked rates and shorter-maturity bonds outearned longer-maturity bonds, but in recent days it has returned to a more typical shape. That’s changing the dynamics for bond investors.

“As the curve steepens out, people are going to be moving into intermediate fixed income” rather than staying in cash or other shorter-dated products, BlackRock’s Rogal says. He says he’s already seeing that demand reflected higher valuations.

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

Duration is a measure of interest-rate sensitivity and is often used when discussing bond maturities. Longer-term bonds have greater duration than shorter-term bonds and tend to carry more risk than shorter-duration bonds (with the notable exception of the last year or so, when the yield curve was inverted), but they also tend to carry higher yields.

With the yield curve uninverted, Pappalardo explains, investors don’t need to give up income to extend into longer-duration bonds. At the same time, higher longer-term bond yields mean that longer-duration bonds are again effective portfolio hedges.

Analysts expect the curve to continue to steepen as the Fed continues its easing cycle and shorter-term rates fall.

… but Be Wary of Too Much Duration

While higher yields can now be found along the yield curve, some strategists caution investors against too much exposure to long-dated bonds—especially given forecasts of robust economic growth in the months ahead. They recommend investors find a comfortable spot in the middle of the curve.

“If we do get stronger growth than is expected, there’s some risk in being too far out on the duration curve,” BMO’s Schleif says, because long-term economic expectations tend to affect long-term rates more than shorter ones. “It’s the proverbial bullwhip effect,” she says. To avoid that volatility but retain high yields, she says investors can look to bonds with two-, three-, and five-year maturities.

Mary Ellen Stanek and Warren Pierson, co-chief investment officers at Baird Asset Management, also point to intermediate-maturity bonds as a safer bet. “The main concern is that you could see long-term yields go up,” Pierson says. If an investor extends duration significantly only for yields to keep rising, “that could be painful.”

Where to Look for Yield in a Risk-On World

In a new world of more accommodative policy, Morningstar’s Pappalardo says risk assets should once again look attractive to investors. In the bond market, that means corporate credit rather than government debt like Treasury bonds. Lower rates mean lower borrowing costs for businesses, which means better profitability, better credit conditions, and less refinancing risk, he explains.

This is a big change from the major bond rout in 2022 when unexpectedly sticky inflation turned investors bearish on bonds as they braced for higher rates for longer. In an environment like that, Treasuries looked safer than riskier asset classes like corporate bonds.

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

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

Within investment-grade credit, Alwine says the shorter end of the yield curve—bonds with maturities of between one and five years—looks most attractive.

Bottom Line for Investors

Overall, strategists say the fundamental story of fixed income hasn’t changed all that much compared with earlier this year when yields were at their peak for 2024.

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

For investors reconsidering their bond holdings, Baird’s Stanek recommends going back to basics—yield, risk, and cost. “Take a look at the vehicle you’re using,” she says. “Is that the best way to provide a diversified portfolio that gives you the overall interest-rate exposure that you want? What about opportunities to add additional yield via the sectors? What’s your expense ratio? Pay attention to those details.”

Adds Pierson: “Take advantage of the value in the bond market, we think there’s a fair amount of it. But don’t go crazy taking excessive risk.”