As we kick off a new year, bond investors are faced with a puzzling state of affairs: despite the Federal Reserve lowering the Federal Funds Rate (FFR) by a full 1% over the last few months of 2024, longer-term bond yields have risen sharply. The 10Y treasury yield has risen from 3.65% prior to the Fed’s September cut to 4.61% as of January 16th.1
Longer dated yields typically fall following Fed cuts… but not this time
Change in 10Y treasury yield in the three months following the first Fed cut, 1984-2024
Just when history would suggest bonds should start doing well, performance went in the opposite direction: the Bloomberg Aggregate Bond Index lost 3.7% between Sept. 17, 2024 (the day prior to the Fed’s cut) and Jan. 16, 2025.2
Does this spike in yields create a buying opportunity? Or might this phenomenon last longer, demanding a reconsideration of what an “optimal” fixed income sleeve might look like?
The U.S. national debt stands at $36T to start 2025 – six times the $6T in 2000. The debt now represents a full 124% of GDP, and the Congressional Budget Office (CBO) is projecting the debt to increase over the next 10 years.3
That growing debt translates into a fiscal deficit, which now stands at 6.2% of GDP. Like the debt number, this figure is projected to increase: the CBO estimates it’ll grow to 6.9% by 2034.4
The U.S. fiscal deficit is projected to increase over the next 10 years
U.S. federal deficit as % of nominal GDP, with recessions shaded
Source: Bloomberg as of 1/14/25.
We’re now faced with a situation where the ongoing deficit is combined with a strong economy in which persistent inflation could keep the Fed from cutting the FFR much further. This leads us to believe we could be in for more volatility and limited appreciation potential from longer-term bonds.
The bond market itself has seen its duration increase significantly over the years. A full 42% of the US Aggregate Bond Index has a maturity profile of 10+ years, implicitly increasing the risk of the many core bond strategies that are benchmarked to it. We’ve seen this extension risk reflected in advisor portfolios as well: 42% of the average advisor’s bond sleeve also has 10+ years until maturity.5
The S&P 500 lost money in 14 of the 36 months between 2022 and 2024. While losing money is always painful, these months felt worse since the average core bond strategy also lost money in all 14 of those down months.
Bonds fell in tandem with stocks over the last three years
Average monthly return when the S&P 500 was negative, 2022-2024
Source: Morningstar as of 12/31/24. “Agg bond index” represented by the Bloomberg U.S. Agg Bond TR Index. “Average core bond fund” represented by the Morningstar US Fund Intermediate Core Bond category average. Past performance does not guarantee or indicate future results. Index performance is for illustrative purposes only. You cannot invest directly in the index.
In a world of negative stock/bond correlations, high bond volatility can work for you: zigs in the equity market can be offset by zags in the bond market. However, with stocks and bonds now more highly correlated – and projected to remain that way given the deficit and inflation outlook – higher bond volatility leads to more volatile multi-asset portfolios as that diversification recedes.
As such, investors may want to consider reducing their exposure to long duration bonds – a trade that doesn’t even cost you much in yield today. There’s still a reasonably low term premium for long-dated bonds. And there are many more opportunities to replace and enhance your bond portfolio’s risk/return profile with a diverse set of shorter duration bonds.
While most investors are familiar with the Bloomberg U.S. Aggregate Bond Index (it’s been the de facto benchmark for bonds for nearly 50 years, with $2.2T in assets benchmarked against it), they may not be as familiar with the growing universe of bonds that are excluded from it. We call these “plus sector” bonds, and they could have the ability to deliver higher risk-adjusted yields than their traditional “core” bond counterparts.
The bond market has evolved
Market capitalization weights of U.S. bond market sectors
Source: Bloomberg as of 9/30/24.
Consider floating rate treasuries, or AAA-rated collateralized loan obligations (CLOs). Strategies that aim to capture these parts of the market, such as the iShares Treasury Floating Rate Bond ETF (TFLO) and iShares AAA CLO Active ETF (CLOA) have yields of 4.32% and 5.72%, respectively (see below, as of 1/13/25), with standard deviations of just 0.22% and 0.93%. They have matched or beaten the Aggregate index but with far less volatility.
Excluded securities may offer attractive yields with less risk
Source: Bloomberg as of 1/13/25. Standard deviation uses daily returns from 1/12/23 (common inception)-1/13/25. Yield refers to yield to worst, which is a measure of the lowest possible yield that can be received on a bond with an early retirement provision. Standard deviation measures how dispersed returns are around the average. A higher standard deviation indicates that returns are spread out over a larger range of values and thus, more volatile. Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. For most recent month-end performance, standardized performance and to view a prospectus, click the following links: TFLO, CLOA.
While highly rated floating rate debt is the lowest hanging fruit, we see opportunity across many of the plus sectors.
As an example, some of our favorite sectors within the iShares Flexible Income Active ETF (BINC) also include international credit, U.S. high yield and securitized assets.
We believe that an active, diversified approach can monetize these higher-yielding opportunities in a risk-aware way.
BINC currently has a yield-to-worst of 6.23% – more than 100 bps higher than that of the Bloomberg U.S. Aggregate Bond Index – but a standard deviation of just 2.57% since its launch on May 19, 2023. Compare that to the Aggregate Bond Index’s standard deviation of 5.94% over that same period, and the potential benefits of such an approach to these plus sectors become even more clear.6
Volatile long bonds. Elevated stock/bond correlations. Investable “plus sector” opportunities.
The combination of all three leads to a bond portfolio that might look different today than it did in prior years. This portfolio might have a shorter duration, with higher yield/income and more plus sector exposure.
As an example, our Target Allocation models team currently splits its 0/100 Hybrid model roughly evenly between core bonds and plus sector bonds. The more you believe that the characteristics of today’s environment will carry forward, though, the more you may want to lean away from long duration and into plus sector exposures.
BlackRock continues to be at the forefront of fixed income investing and we look forward to being a partner of choice for advisors in building portfolios.
Ben Wallach and Faye Witherall contributed to this article.
Obtain exclusive insights, CE courses, events, model allocations and portfolio analytics powered by Aladdin® technology.