Higher yields could make bonds more attractive again

MacKenzie Kohler is an associate portfolio manager of fixed income at Northwestern Mutual Wealth Management Company.

Why higher bond yields may make fixed income more attractive

Fixed income is offering investors something it did not provide for much of the past decade: meaningful income from higher-quality bonds. With Treasury yields near multi-year highs and real rates—the return investors can potentially earn after accounting for inflation—back in positive territory, bonds may once again play a larger role in generating income, managing risk, and supporting long-term portfolio returns.

For almost a decade, investors became accustomed to a world where interest rates were low and high-quality bonds yielded almost nothing. Today, that environment has changed. Interest rates are considerably higher, but more importantly, real rates—the return investors can potentially earn after accounting for inflation—are positive. Investors can earn meaningful yields while taking substantially less credit risk. Bonds are once again an asset class capable of producing meaningful cash flow, real income. and attractive total returns.

What is a bond yield?

Before looking at today’s yields, it helps to start with the basics: A bond is essentially a loan. When investors buy a bond, they are lending money to a government or company in exchange for regular interest payments and the return of their principal when the bond matures. The yield is the return an investor expects to earn from that bond, and today’s yields are much higher than they were just a few years ago. For more information on how bond yields, coupons and prices work, this article offers a crash course on bond basics.

Why today’s interest rates matter for bond investors

The U.S. rate environment presents a compelling story for fixed income. The Treasury curve is positively sloped, with elevated yields across the curve. The 10-year Treasury yield is around 4.7 percent, and 30-year Treasurys are above 5 percent. In plain terms, the curve's upward slope signals that investors are demanding to be paid more to lend money for longer periods of time. That extra compensation reflects several factors, including interest rate risk, inflation uncertainty, and duration risk. For patient, income-oriented investors, this creates an attractive opportunity.

To understand why this matters, the tables below show how yields have changed over time. In 2021, an investor holding a 10-year Treasury was earning less than 1.5 percent per year. A $100,000 investment in a 10-year Treasury at a 1.44 percent yield in 2021 generated roughly $1,440 per year. The same investment at today’s 4.7 percent yield generates approximately $4,700 in interest per year. The income advantage in today’s rate environment is not so subtle.

The higher starting yield also provides investors with an income cushion. When yields are 1 to 2 percent, there is little income to offset the effects of rising rates and falling bond prices. If an investor purchases a bond yielding about 5 percent, they receive income while they wait, lock in an attractive income stream, and have a greater ability to reinvest coupons at those attractive rates.

When an investor buys a bond, they are not just buying a price on a screen; they are purchasing a stream of future cash flows. The yield investors receive when they purchase a bond is one of the most important determinants of future fixed income returns. Assuming they hold the bond to maturity, day-to-day fluctuations in market price become much less important.

For example, if an investor buys a 10-year Treasury bond at 4.7 percent today and holds it to maturity, they are essentially locking in that elevated yield every year for the next 10 years. Bond prices move inversely to yields. If rates fall, the bond price will appreciate because the 4.7 percent yield becomes more attractive relative to newly issued bonds offering lower yields. If rates rise, that existing bond becomes less attractive. Higher rates can therefore be painful to bondholders in the short run but can improve the opportunity set for new investors. As bonds mature and coupons are received, investors can reinvest that money at higher rates, creating a powerful compounding effect. The higher rates that hurt bond prices today create higher expected returns tomorrow.

The chart below illustrates just how dramatic the rate cycle has been. From near zero in 2021, the 10-year yield rose through the Fed’s aggressive hiking cycle and peaked in 2023. Investors sitting in cash or short-duration instruments in 2021 earned almost nothing. The 10-year has since re-established itself, and the same Treasury market offers a 10-year yield of about 4.7 percent—locked in for a decade.

The 10-year TIPS (Treasury Inflation-Protected Securities) real yield currently sits at 2.43 percent. That figure is important because it represents the return investors can earn above inflation over the next decade. The 10-year breakeven inflation rate is approximately 2.27 percent. Together, a 2.43 percent real yield and 2.27 percent expected inflation imply a nominal return of roughly 4.7 percent. That level of purchasing power and compensation was essentially unavailable for much of the 2010s and again from 2020 to 2022. For the first time in a long time, investors can earn a meaningful return above inflation from a U.S. government-backed asset without taking on credit risk.

How high interest rates affect borrowers and bond investors

High rates can also be tough on consumers because the burden falls on borrowers. Consumers face higher mortgage rates, businesses face higher financing costs, and governments pay more to finance their debt. The 30-year fixed mortgage rate currently stands at 6.77 percent, nearly double the 3 percent rate in 2021. That significantly reduces purchasing power and increases the cost of borrowing. However, while higher borrowing costs are a headwind for consumers, they can be a tailwind for bond investors: The borrower pays the coupon, and the bondholder receives it.

How higher Treasury yields change the credit risk trade-off

Higher Treasury yields also change the trade-off between income and credit risk. Investment-grade corporate bonds are currently yielding approximately 5.38 percent, while high-yield bonds yield around 7.24 percent. Investment-grade companies generally have stronger balance sheets and a greater ability to service their debt. High-yield issuers, on the other hand, carry greater default and financial risk.

Investors do not need to move aggressively to lower-quality credit to generate attractive income. When Treasurys yield 1 to 2 percent, investors may feel they need to seek additional yield, but when Treasurys yield 4 to 5 percent, meaningful income can be generated while maintaining a relatively high level of credit quality.

Should investors wait for the Fed to cut rates?

So, when is the right time to invest?

A common misconception is that investors should wait for the Fed to cut rates, wait for yields to peak, or simply wait for the “right time.” The problem is that the market does not wait for investors. Bond prices are constantly adjusting to expectations for economic growth, fiscal policy, and investor demand. By the time a decision is announced or a headline is published, it is often already reflected in bond prices.

The bond market considers a variety of competing forces. The Federal Reserve controls the Fed funds rate, a very short-term interest rate, and has maintained its target range at 3.5 to 3.75 percent. Today, inflation continues to hover above the Fed’s 2 percent objective. The market is pricing a 50/50 probability of a hike at the September meeting, with additional tightening priced into year-end. But the important point is that investors do not need to correctly predict the Fed to benefit from today’s yields.

If the Fed cuts rates and longer-term yields decline, bonds benefit from both their income and potential price appreciation. In that scenario, duration can work in investors’ favor. If the Fed keeps rates elevated, investors continue to collect attractive income and reinvest at higher yields. Either way, investors begin with a meaningful starting yield.

The Bottom Line

For years, fixed income investors faced a difficult choice: Accept low real yields, take substantial duration risk, or move down the credit spectrum to generate income. Today, that trade-off is far less severe. Investors can now earn approximately 4 to 5 percent on risk-free U.S. Treasurys across the curve. Investment-grade corporate bonds offer additional income for taking measured credit risk, and real yields are positive, allowing investors to potentially earn a return above inflation. After years of near-zero rates, investors have the opportunity to build portfolios around meaningful income, positive real yields, and the potential for attractive total returns from high-quality fixed income.

Frequently Asked Questions

Why are higher bond yields important for investors?

Higher bond yields can give investors more income potential from fixed income investments. They may also provide a larger income cushion if bond prices fluctuate.

What does a positive real yield mean?

A positive real yield means investors may earn a return above inflation. In the article’s example, the 10-year TIPS real yield is 2.43 percent, which reflects the potential return above expected inflation.

Should investors wait for the Fed to cut rates before buying bonds?

Not necessarily. Bond prices constantly adjust to expectations for growth, inflation, fiscal policy, and investor demand. Because today’s yields already offer meaningful income, investors do not need to perfectly time Fed decisions to potentially benefit from fixed income.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Indices are unmanaged and cannot be invested directly. Any views on the relative attractiveness of different asset classes are made in the context of a well-diversified portfolio, not in isolation. All investments carry some level of risk, including loss of principal invested. An investment strategy cannot assure a profit and does not protect against loss in declining markets. Returns represent past performance and are not a guarantee of future performance and are not indicative of any specific investment.

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