Higher bond yields: Opportunities and tradeoffs

• The post-COVID yield curve normalization has hampered bond returns in 2026
• Higher rates can impact business investment, mortgage origination, and variable-rate credit instruments while savers are more highly compensated, and bonds can once again provide diversification
• Investors might benefit from diversifying their duration exposure and adding inflation protection inside portfolios

One of the most impactful market trends in recent years has been the continued normalization of the yield curve. For much of the period following the Global Financial Crisis, investors became accustomed to unusually low interest rates. That environment changed in 2022 with the end of a 40-year bull market in bonds. Treasury yields have repriced substantially higher, including another move upward in 2026 (Chart 1).

CHART 1: 10-YEAR TREASURY YIELD

Bonds saw further repricing through the first three quarters of 2026, with rates rising across all tenors of the yield curve (Chart 2).

CHART 2: US TREASURY YIELD CURVE

While the immediate impact of rising rates has been lower total returns from bonds, that impact has been felt differently depending on if your bond exposure is shorter-term or longer-term. Longer-term bonds, which carry more interest rate risk, have underperformed shorter-term bonds by 40.7% cumulatively since 2022, and 3.8% year-to-date (Table 1).

TABLE 1

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Why is this happening?

The Federal Reserve sets the federal funds rate, which directly influences the front end of the yield curve. This monetary policy tool allows the central bank to manage its dual mandate of price stability and maximum employment by easing or tightening access to money. The Federal Reserve aggressively tightened (increasing federal funds rate) in 2022 post-COVID as they aimed to control inflation (Chart 3).

CHART 3: FEDERAL FUNDS RATE

The longer end of the yield curve is driven by market participants’ expectation for inflation and growth, future short-term rates, Treasury issuance, fiscal deficits, investor demand, and the additional “term premium” required to hold longer bonds. As mentioned earlier, market participants' concern about unchecked inflation stemming from a combination of the Iran conflict and US government debt load has bid up the middle-to-long end of the yield curve.

Should you care?

Yes! Higher rates have economic trade-offs that ripple through the economy while also creating potential opportunities for fixed income investors. The tradeoff is two-sided. All else equal, higher borrowing costs force the US government to pay more in interest, impact corporations’ willingness and ability to invest due to a higher cost of capital, make residential and commercial real estate mortgage rates move higher, and weigh heavily on households that rely on variable-rate borrowing. These are significant concerns, and if rates rise too high, too fast, we could see an economic pullback.

On the positive side of the ledger is the ability for investors to achieve higher income and potentially better diversification. Treasuries are paying a higher yield than earlier in the year, and certainly more than in the post-GFC period. Today’s higher starting yields provide investors with substantially more income and a larger potential cushion against inflation than was available during much of the post-GFC period. Further, with rates moving higher, there is the potential for Treasuries to buffer stocks in the event of an economic shock. This diversification was absent in 2022 when stocks and bonds sold off together (Table 2).

TABLE 2

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What steps should investors contemplate inside their portfolios?

Rising yields have created plenty of concern for risky assets inside portfolios, but they have also improved the prospective return and diversification value of bonds. Investors should selectively consider opportunities to rebalance and/or reallocate within the fixed income portion of their portfolio.

1. Put excess cash and short-term bonds to work thoughtfully: As absolute rates have increased across the yield curve, intermediate- and long-term bonds provide additional yield. In the event of an economic downturn, their higher duration may provide additional portfolio ballast if interest rates decline. However, with a modest term premium, investors should consider diversifying duration exposure rather than making an explicit rate call.
2. Review asset allocation mix: With bonds offering more competitive yields, they may improve the risk-adjusted return prospects of portfolios pursuing a total return objective.
3. Consider inflation protection: Markets are not currently pricing in a dramatic acceleration in inflation. Investors may consider TIPS or other inflation hedges in their portfolio to protect purchasing power in the event that higher than expected inflation materializes.

Years of low rates and robust returns on riskier assets have led many investors to ignore the fixed income portion of their portfolio. However, as Treasury yields have reached their highest levels in nearly two decades, bonds may be a more compelling portfolio diversifier than they have been in years. As times change, it is important that investors position their portfolios for the future, not the past.