Why Higher Bond Yields Can Be ‘a Great Thing’

Key Takeaways

• Global bond markets have sold off sharply in recent weeks, sending yields soaring to multi-decade highs.
• For bond investors, higher yields mean more income and a bigger cushion to help insulate portfolios.
• With inflation elevated and the fiscal deficit rising, analysts expect yields to remain high in the coming months.

A global bond selloff continues to rattle Wall Street, with the yield on the 10-year Treasury climbing to 4.93%—its highest level in years—as markets react to another spike in oil prices and traders raise their expectations of a rate hike from the Federal Reserve next week. Falling bond prices go hand in hand with rising bond yields, meaning the market demands more compensation to offset the risks of lending money over the long term.

That shift certainly has downsides. Higher yields make borrowing more expensive, which can weigh on economic growth and dampen stock returns. But rising yields can also be “a great thing,” according to Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research. Higher yields mean more income from coupon payments for investors, and they can provide a bigger cushion against price declines in portfolios.

“Yields are very much in the value zone,” says George Bory, chief investment strategist for fixed income at Allspring Global Investments. That means they’re high enough to beat inflation, which is “the ultimate value metric for a bond investor.” That’s true even with high price volatility, and it hasn’t always been the case. When bonds sold off sharply in 2022, for instance, yields were too low to compensate for inflation or insulate investors against price depreciation.

In a recent paper, Pimco multi-asset credit strategist Lotfi Karoui put it like this: “The case for owning bonds today isn’t that they’ll outperform equities. It’s that they can once again deliver meaningful income potential and real downside mitigation—two functions low yields had stripped away for over a decade.”

Why Are Bond Yields Climbing?

A wide range of factors are pushing up yields, including investor anxiety about ballooning government debt, a massive surge in corporate borrowing to fund artificial intelligence projects, and the threat of higher inflation stemming from the Iran War’s impact on oil prices. Their impact is most pronounced on longer-term bonds, which tend to be more sensitive to changes in interest rates and inflation expectations. The yield on the 30-year US Treasury note has climbed from 5.03% to 5.33% over the past month alone.

“Inflation concerns are a major factor pushing yields higher,” says Dominic Pappalardo, chief multi-asset strategist for Morningstar Wealth. “The further out you go in time, the more the compounding impact of inflation devalues future cash flows.”

It’s a similar story overseas. “You would not have been insulated [from the selloff] by holding international bonds,” Pappalardo adds. That’s because bond yields in developed countries like the United Kingdom, Germany, Italy, Japan, and Australia have largely followed the trajectory of yields in the United States. “It’s very much been a global phenomenon.”

How Can Higher Yields Benefit Bond Investors?

Even against macroeconomic headwinds, investors can benefit from higher yields in the bond market.

First and foremost, higher yields mean larger coupons (Wall Street lingo for bonds’ annual interest payments). Coupon payments tend to be predictable over the long term, unlike the gains or losses bond portfolios may see from price changes, which are the other component of a bond’s total return. When yields are high, investors don’t need to depend on price appreciation or rate cuts for a dependable income stream.

Second, higher yields make it more likely that bond investors will beat inflation. As of last month, the Federal Reserve Bank of Cleveland estimated the 10-year real interest rate, which is adjusted for inflation, at 2.20%. That metric was negative as recently as 2022, meaning investors who held 10-year Treasury bonds to maturity at those rates would have lost money over the bonds’ terms, thanks to erosion from inflation.

“You can buy bonds today on the assumption that your purchasing power should expand over a medium-term time horizon,” says Allspring’s Bory. “That’s the good news.” The bad news is that the same forces putting upward pressure on yields also create market volatility, which has Wall Street wringing its hands.

Additionally, higher yields can cushion against portfolio losses when bond prices fall. Unlike in 2022—a bond selloff when yields started much lower— fixed-income investors at today’s higher yields can potentially capture a positive return, or a much smaller negative return, even if bonds sell off. “Those higher income payments can help offset some of those price declines,” Schwab’s Martin explains.

Bond Managers Can Capture Higher Yields Quickly

While investors who buy and hold individual bonds to maturity are largely unaffected by day-to-day and week-to-week yield and price fluctuations, fund holders will see the impact of higher yields in their portfolios much more quickly.

Cash flows into bond funds tend to be consistent and predictable, since those funds comprise many individual bonds that are constantly maturing and paying interest. That income can be reinvested in the market at current yields, which means fund managers are “recapturing the higher yields much, much more quickly,” explains Morningstar’s Pappalardo.

In active bond funds, managers are constantly weighing new investments against their goals, risk profiles, and benchmarks. “Not all yields are created equal,” Allspring’s Bory says. “We need to pick our spots.” One area he likes is the municipal market. Yields on munis are rising alongside Treasury yields, but the impact of macroeconomic factors like inflation and the US fiscal deficit is more muted. Municipal bonds are also more insulated from the boom-bust fluctuations that accompany major capital expenditure cycles, like today’s data center buildouts.

Expect Yields to Remain Elevated

Against today’s macroeconomic backdrop, analysts don’t expect bond yields to slide back down anytime soon. “I fail to see the catalyst to have them reverse course lower,” says Morningstar’s Pappalardo. “Inflation doesn’t turn on a dime,” and neither do government spending policies.

Schwab’s Martin doesn’t expect yields to move materially higher from here, and he says they’re more likely to rise than fall. While slower economic growth or a recession could pull yields back down, he doesn’t foresee either scenario.

“If investors have been waiting for attractive entry points in the bond market, we think they’re here,” Martin says. Overall, he advises investors to avoid taking too much risk on longer-term bonds, which are much more sensitive to yield fluctuations. At the same time, he cautions against sitting in cash or other ultra-short-term products. Even before the Fed hikes interest rates, higher yields mean investors can outearn cash by a significant margin without taking too much extra risk.