The bond market struggles as more investors sell off their holdings amid the high interest rate environment in the U.S.
Earlier this month, the 10-year U.S. Treasury note yield hit 4.81 percent, its highest in over 16 years. The shorter-term debt yields were even higher, presenting an investment challenge for fixed-income portfolio investors.
Most bonds have a fixed interest rate, which becomes more attractive to investors when interest rates fall, increasing their prices. In contrast, when interest rates rise, investors are less interested in the lower fixed interest rate that bonds offer. This leads to a decrease in demand and price.
This environment hit bondholders hard last year, with the Bloomberg U.S. Aggregate Bond Index showing a total return of -13.01 percent. Although bond yields are comparably higher in 2023, the year-to-date total return for the index stood at -1.21 percent through September.
There has also been an unusual yield curve shape for different bond maturities. Since late 2022, the yield curve between the two-year and 10-year notes has been inverted — seen as a potential indicator of an upcoming recession. Longer-term bonds typically have higher yields, creating an upward-sloping curve since investors expect higher returns for lending money over a more extended period.
Bond yields will likely remain high if the federal funds rate stays above five percent. Corporate bond yields will also increase.
This continuous hike in interest rates is also affecting the global economic environment. Barclays Plc believes that global bond prices will likely continue to drop unless a prolonged decrease in stock market performance makes fixed-income investments more attractive.
The sudden decrease in bond prices could be due to various factors, such as the belief that central banks in major economies would maintain higher interest rates to control inflation, the strong outlook of the U.S. economy and traders anticipating the ending of the bond market rally.
Nick Nelson, head of equity strategy at Absolute Strategy Research in London, said the U.S. economy would slow down next year as the Federal Reserve considered halting rate hikes.
"A lot of people bought into the idea that because the Federal Reserve was reaching the peak of rate hikes, it was time to buy government bonds, meaning that the majority of the market has been long," said Juan Valenzuela, the fixed-income portfolio manager of Artemis.
"People have been forced to reduce risk and that essentially means selling."
How higher interest rates affect public
Currently, the Fed uses short-term interest rate hikes to control borrowing costs, curb economic activity and lower inflation. Although inflation has decreased since mid-2022, it is still above the Fed's two percent target.
Analysts point out that the Fed's ongoing monetary tightening may trigger another crisis, such as the regional bank crisis in March. According to analysts, the banking crisis created a lasting effect on the economy, with banks tightening credit requirements.
Minneapolis Fed President Neel Kashkari also warned that if the economy remains in a "high-pressure state," the Fed may have to raise rates considerably to control inflation.
A higher interest rate has significant effects on policies, businesses and individuals. While higher rates benefit savers, many have been accustomed to meager borrowing costs over the last 15 years. Adapting to a prolonged period of higher rates could be challenging and lead to issues like struggling businesses and difficulty affording homes and cars.