How Changing Interest Rates Affect Bonds | U.S. Bank (2024)


Spring 2024 Investment Outlook – April 10

Capitalizing on today’s market opportunities to meet your financial goals.

How Changing Interest Rates Affect Bonds | U.S. Bank (1)

Key takeaways

  • U.S. Treasury yields appear modestly rangebound so far this year.

  • Yields on the benchmark 10-year U.S. Treasury moved higher at the start of 2024 but are mostly holding between 4.20% and 4.30% now, well below earlier peaks of nearly 5%.

  • Bonds in the current environment appear to offer investors more attractive long-term opportunities.

Interest rates generally trended higher in the opening weeks of 2024, as investors assess economic data and pending monetary policy decisions from the Federal Reserve (Fed).

“Publicly released economic data is sending investors mixed signals,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “Economic growth remains solid, which might indicate interest rates need to remain elevated for some time. Yet inflation has slowed a bit, which is a sign that rates might come down.”

The yield on the benchmark 10-year U.S. Treasury note started the year at 3.88%, but moved to as high as 4.33% in February before backing off by month’s end. Over the first two months of the year, the 10-year Treasury yield generally ranged between 3.90% and 4.30%. By comparison, the 10-year Treasury yield peaked at nearly 5% in October 2023.1

How Changing Interest Rates Affect Bonds | U.S. Bank (2)

The bond market in 2024 continues to exhibit topsy-turvy dynamics, with yields on short-term bonds exceeding those of longer-term bonds. For example, as of the end of February 2024, 3-month Treasury bills yielded 5.45% and 2-year Treasury yields were 4.64%, while the yield on 10-year Treasury notes was even lower, at 4.25%.1 However, investors are anticipating a change in the interest rate environment in 2024.

The current rate structure emerged after the Federal Reserve (Fed) began raising the short-term interest rate it controls – the federal funds rate – in early 2022. Between March 2022 and July 2023, the Fed raised rates eleven times, from near 0% to an upper range of 5.50%. Since then, the Fed has held the line on further rate hikes and made clear that it will begin cutting rates in 2024, reversing its previous policy.

The Fed's intended policy change is likely to reverberate across the broader bond market. “If the Fed cuts short-term interest rates, yields on shorter-term debt issues are likely to decline,” says Haworth.

The major question for the market is the Fed’s interest rate-lowering timeline. “Markets got well ahead of expectations for 2024 rate cuts,” says Haworth. At the December meeting of the policy-making Federal Open Market Committee (FOMC), the indication was that three cuts would occur in 2024. “The markets, however, appeared to anticipate many more 2024 rate cuts, and long-term bond yields began to drop as a result.” says Haworth. “By early 2024, the reality set in that for now, the Fed is maintaining higher rates for longer than the markets initially anticipated.” As a result, bond markets backtracked, and rates trended higher in recent months.

How might the bond market perform this year and what does that say about how to incorporate or adjust strategies for fixed-income investors?

Changing bond market

Despite the recent decline in bond yields, they remain significantly higher than was the case at the start of 2022. “Three key factors drove the jump in bond yields,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “First is the Fed’s policy response to inflation. Second is the strength of the U.S. economy. Finally, there is an increasing supply of U.S. Treasury securities coming to the market.”

“Money sitting in cash loses purchasing power every day that inflation rates stay above zero. Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.

“New Treasury bond issuance is growing due to a combination of federal government deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Merz. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz.

Haworth believes the Fed may need to reconsider its policy of reducing its balance sheet of Treasury debt given the federal government’s need to expand Treasury issuance to cover budget shortfalls and other funding priorities. “It may need to hit the brakes on its balance sheet reduction at some point in the future,” says Haworth.

Inverted yield curve persists

The yield curve, representing different bond maturities, has persistently remained inverted since late 2022. Under normal circ*mstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve (as in the line on the chart representing the yield curve on 12/31/21). It logically reflects that investors normally demand a return premium (reflected in higher yields) for the greater uncertainty inherent in lending money over a longer time. Many yield curve pairs using various maturities have been inverted since late 2022. This is due in large part to the Fed’s rate hikes, which have the greatest direct impact on short-term bond yields.

How Changing Interest Rates Affect Bonds | U.S. Bank (3)

Haworth notes that in recent months, the inverted curve has flattened a bit. “Yields are still higher on one-month to two-year Treasuries, but the curve is following a more normal slope from the five-year level on up.” Haworth says a normal upward slope will gradually occur as the Fed begins reducing short-term rates, but the timing of that change will depend on the pace of Fed rate cuts.

Keeping an eye on the Fed

The Fed’s rate hikes were designed to slow the economy as a way to reduce inflation, which peaked at 9.1% for the 12 months ending June 2022, but dropped to 3.1% by January 2024.2

The Fed remains focused on fighting inflation but is expected at some point in 2024 to begin cutting interest rates. “When the Fed decides to do so, its focus will be less on stimulating the economy than on gradually loosening its monetary policy to return to a more neutral position,” says Haworth. “But we will need to see a number of rate cuts to reach a “neutral” fed funds rate, which the Fed indicates is 2.5%.” This compares to the current fed funds target rate range of 5.25% to 5.50%.

Finding opportunity in the bond market

How should investors approach fixed income markets today? “Money sitting in cash loses purchasing power every day that inflation rates stay above zero. Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities,” says Merz.

Despite the appeal of short-term bonds paying high yields, Merz says investors with a long-term time horizon want to build a diversified portfolio designed to generate competitive returns over time. “It’s time to take money that was shifted away from appropriate bond allocations during the period of historically low interest rates to gradually move money into longer-term bonds. Even after the recent decline in longer-term bond yields, they remain far more compelling today than they have been in years.” Merz says for conservative investors, “It’s possible to generate reasonably attractive returns in a mix of bonds without extending their risk budget.”

Additional opportunities exist depending on investors’ risk tolerance and tax situation. For example, investors in high tax brackets may benefit from extending durations slightly longer and including an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Certain non-taxable investors may benefit from diversifying into non-government agency issued residential mortgage-backed securities. They can also incorporate long-maturity U.S. Treasury securities to manage total portfolio duration. And insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors for certain eligible investors.

Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.

Frequently asked questions

The bond market is often reflective of other key factors that affect the economy. If the economy grows rapidly and inflation is rising, bond yields tend to follow suit. Bond yields also tend to rise if the Federal Reserve, the nation’s central bank, raises the short-term interest rate it controls, the federal funds rate. Inflation in the U.S. began surging in 2021, and by early 2022, the Federal Reserve began raising rates. As a result, yields across the bond market began rising. In contrast, if the economy is slowing or maintaining modest growth with low inflation, bond yields tend to decline or remain low. This was the situation for an extended period prior to 2022.

Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond’s price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates. Bondholders will generally be repaid the face value of a bond if it is held to maturity, regardless of the interest rate environment.

There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels. However, even when interest rates are low, bonds can still be appropriate for inclusion in a well-diversified portfolio.


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How Changing Interest Rates Affect Bonds | U.S. Bank (2024)


How Changing Interest Rates Affect Bonds | U.S. Bank? ›

Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

How interest rates change affect bonds? ›

This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up. Alternatively, if prevailing interest rates are increasing, older bonds become less valuable because their coupon payments are now lower than those of new bonds being offered in the market.

Why do banks lose money on bonds when interest rates rise? ›

Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond. Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.

What happens to interest rates when the central bank buys bonds? ›

When the Federal Reserve buys bonds, bond prices go up, which in turn reduces interest rates. Open market purchases increase the money supply, which makes money less valuable and reduces the interest rate in the money market. OMOs involve the purchase or sale of securities, typically government bonds.

How do interest rates affect investment in the economy? ›

A higher interest rate environment can present challenges for the economy, which may slow business activity. This could potentially result in lower revenues and earnings for a corporation, which could be reflected in a lower stock price.

What happens when interest rates rise? ›

When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.

How does inflation affect bonds? ›

Inflation's effect on bonds

Inflation can affect fixed-income investments more than other asset classes because, with higher prices for the consumer, fixed payments have less purchasing power. So, if a bond yields 2%, but inflation is 3%, the bond's total return decreases.

What banks are most at risk right now? ›

These Banks Are the Most Vulnerable
  • First Republic Bank (FRC) . Above average liquidity risk and high capital risk.
  • Huntington Bancshares (HBAN) . Above average capital risk.
  • KeyCorp (KEY) . Above average capital risk.
  • Comerica (CMA) . ...
  • Truist Financial (TFC) . ...
  • Cullen/Frost Bankers (CFR) . ...
  • Zions Bancorporation (ZION) .
Mar 16, 2023

Should you sell bonds when interest rates rise? ›

Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.

What are the disadvantages of increasing interest rates? ›

Higher interest rates typically slow down the economy since it costs more for consumers and businesses to borrow money. But while higher interest rates can make it more expensive to borrow and could hamper overall economic growth, there are also some benefits.

Can you lose money on bonds if held to maturity? ›

If interest rates rise the bond will lose value on the open market. But as the bond approaches maturity the market value of the bond will rise. On the day the bond reaches maturity it will be redeemed for face value. So in that sense you can not lose money.

What happens to money supply when you sell bonds? ›

If the Fed buys bonds in the open market, it increases the money supply in the economy by swapping out bonds in exchange for cash to the general public. Conversely, if the Fed sells bonds, it decreases the money supply by removing cash from the economy in exchange for bonds.

Why have bonds performed so poorly? ›

How bad is the sell-off? In 2022, the bond market suffered its worst year on record, as the Federal Reserve started raising interest rates aggressively to fight high inflation. This year, the picture hasn't improved much.

Do banks make more money when interest rates rise? ›

A rise in interest rates automatically boosts a bank's earnings. It increases the amount of money that the bank earns by lending out its cash on hand at short-term interest rates.

How does rising interest rates affect banks? ›

Besides loans, banks also invest in bonds and other debt securities, which lose value when interest rates rise. Banks may be forced to sell these at a loss if faced with sudden deposit withdrawals or other funding pressures. The failure of Silicon Valley Bank was a dramatic example of this bond-loss channel.

Who benefits from high interest rates? ›

Higher interest rates have gotten a bad rap, but over the long term, they may provide more income for savers and help investors allocate capital more efficiently. In a higher-rate environment, equity investors can seek opportunities in value-oriented and defensive sectors as well as international stocks.

Should I buy bonds now or wait? ›

Waiting for the Fed to cut rates before considering longer term bonds isn't our preferred approach. The bond market is forward-looking and long-term Treasury yields typically decline once investors believe that rate cuts are coming.

Will bond funds recover in 2024? ›

As for fixed income, we expect a strong bounce-back year to play out over the course of 2024. When bond yields are high, the income earned is often enough to offset most price fluctuations. In fact, for the 10-year Treasury to deliver a negative return in 2024, the yield would have to rise to 5.3 percent.

What makes bond prices go up? ›

Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon payments relative to broader interest rates. If prevailing interest rates increase above the bond's coupon rate, the bond becomes less attractive.


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