What Higher Bond Yields Mean for Markets in 2025
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Welcome to investing insights. I'm your host. They are handsome, and i'm filling in for i've in a handsome today. The november election triggered a steep sell off in longer term bonds, with yields on the ten year treasury note climbing as high as four point four five percent. Fixed income markets have been stabilized, but yields remain significantly higher than their september laws.

We have morningstar investment management chief multi assets strategist dominic pilar's to help us unpack what's going on and what might be ahead in twenty twenty five. Here's our conversation, right? So welcome down. Thanks so much for being here. Thanks.

sir. Gond be here with you.

So can you tell us first, maybe lets start with the news, um why did bond als ride so much in the week of the election?

Last share said the two main issues investors were worried about, but the first was potential for inflation to resurface. Boll, from A A supply side perspective and demand side perspective, the supply side would be from potential tariff s that trump has talked about a tariff s by definition, rage Prices, which could lead to inflation.

The second the mahdi is from decrease tax rates both for uh weijden NER as well as business owners, which will impact the demand side. Certainly, both of those could potentially push yields. Re, uh.

the second factor is more structural.

which is a potentially higher borrowing rates for the U. S government as they have to issue more debt to fund those tax rates that I mention. At some point, bond investors will demand more yield or more compensation for risk if the government has to continue to issue issue more and more debt, um they're still very unlikely default. But at some point, investors will want more compensation as that levels continue to increase.

right? So IT sounds like some investors have a certain state of mind when bond als are rising. And what does that thinking look like? And what does that tell you or tell us about what they expect in the future?

Yeah, the higher bony els really focused on the linger and concerns of inflation, in my view, and these concerns have definitely escalates post election. Others no doubt that trump continues to discuss their fs things of that nature. It's also quite likely that policy does get contacted because I really only requires White house support for that to happen.

So I think that's the main driving force um behind the post election run up a in bonier ds. Additionally, from a macroeconomic view, the higher yields do suggest some believe that will avoid recession. If you go back to twenty twenty two, in part to twenty twenty three, there is a growing narrative that we are likely to see an economic downturn that really never materialized. And as such, interest strates have been able to move up or at least remain higher if we were to start to see weaker economic that I would expect bags to come down accordingly. A on the heels of that news.

So interestingly, that actually happened a little bit right in the week of you know the last couple weeks. So as of today, we're on wednesday, december report um the yield on the ten year treasury is about four point two percent. Give you take a little bit um what is so is what you just described, ed, happening? Um what does that say about the market?

I think IT might mean that the initial reaction was a bit overdone to the election. This comes back to morning starts, ilo, sophy, where it's really important investors to look past the short term week to week or month to month market moves and focus really on long term investment strategy. Higher bang yells are really can be positive for investors using diversify portfolios.

Bonds are now a place where they offered benefits in multiple ways. Firstly, they now offer a positive real yield, which means that the income they generate is higher than the inflation rate. So even after inflation, investors are technically making money by investing in bonds that can not be the case for for twenty twenty two and twenty twenty three.

Um that's true in the U S. But it's even more uh there's even bigger examples globally and for investors that could consider moving into emerging market debt from countries like brazil and mexico where there local bony's are over thirteen percent and over ten percent against the local inflation, there are about four percent. There's really opportunity to to increase value and and fixed income portfolios.

And obviously, those emerging markets come with more risk than U. S. treasuries. But again, in a diversified structure could have a place um .

and so you know you mentioned the long term view um which is something that morning star is is very big on um what about what about history? More broadly, there's been a lot of talk about how yields are rising, rising, rising um but where we situated over you know the span of decades rather than know the span of months.

sure. It's it's a really great points are and I think recently, current investors views have been artificially biased to where rates have been for the last two decades. We've been historical low.

Today's rates are are basically on top of long term averages, maybe even a touch below on depending what part of the eal curve you look at. So I think the the public perception is that rates have gone up sustentation ally. But if you look back more than twenty years, you could see we're right around long term averages.

And what is different today is the shape of the eel curve. So traditionally, as investors by longer digger bonds, they receive more yield to compensate them for the longer time to maturity. Right now, the yield on the two year, ten year, thirty year treasuries are all roughly the same, about four point two before point four percent.

So there really is no incremental yield advantage to extending your maturity profile. Um that's even different than where we were in twenty two and three where the ulcer was actually inverted. Making short term yields were higher than long term yields are highly unusual situation. And uh, the result of that was many investors had begun hurting cash because cash yids were higher than longer term treasury yields. And we really think now is a good time to move out of cash, add some longer term, uh, fixed income exposure to your portfolios.

You know, you know so we're not inverted. We're not on a super build curve right now. We're flat.

Um this this is a good time to talk about the future. Twenty five, do you expect a steep curve? What are you what are you looking ahead to over the .

next couple of quarters? Yeah, it's unusual for the curve to be as flag as IT is and stay here for a new length of time. Flat yo curves are generally inflection point for interest rate policy changing our economic shifts.

So we think going into T Y twenty five, short term rates will continue to fall based on additional fed cuts, which should cost deepening at the eel curve that could be compounded by the inflation or concerns we talked about earlier, where long term interest strates would be most impacted if the market starts to be fearful of of inflation again. So we don't think it'll stay here. We think it's likely .

steeping in their future, kay and steepening again means that long term rates like ten year and out are gonna rising in twenty twenty five.

sure rising. Or you could give the opposite where they stay the same. And short term yields come down, but the difference between long term and short term will increase.

And I thought to talk about kind of the relationship between fixing markets and the bonuses were talking about in the stock market. What we we seen big changes in the bond market over the last couple of months. And what does that mean for equity is isn't for equity investors?

Ah that's a it's a difficult question to answer with a blanket statement IT IT tends to be more focused by sectors or industries within the stock market. So for example, banks could benefit from higher rates, more specifically that steeper yell curve we talked about and the function of banks is to borrow capital at short term rates and lending out to customers at higher at longer term rates.

So as that differential increases that flows through to their profit march. And so there are an example where they could benefit from from higher interest rates. Um other sectors such as uh, real estate or utilities have the opposite effect where their subject to the additional borrowing cost of higher interest strates and therefore could their armies could suffer if interest rates continue to rise. Uh additionally, thinking about different components of the equity market, small caps tend to have an outside negative impact from higher interest strates, mostly because their borrowing is done generally through banks and flooring rate um in flogged rate vehicles, whether large caps can issue fixed great debt in public markets and lock in rates when they're low or or more attractive. So as such, we think small caps in a position to perform um as such, we think small caps will under performing in a higher interest and environment as opposed to longer turn to large caps based on their borrowing structures.

So IT seems like that interest state sensitivity is kind of a two way street. Is there is there any danger to the broader market um if rates stay high for a long time, like is there worries about how long the market can would stand that kind of environment?

sure. At some point, higher borrowing cost has a negative impact across corporation. Is is is a general statement.

However, if each to remain high, there's a good chance that the autonomy is also doing well. So perhaps some of those companies could offset the higher borrowing ing. Cost by sales are potentially Price increases to to their customers. So um there are ways for them to mitigate. But but yes, if if rates stay abNormally high for some length of time, corporation ies would be negatively impacted by that.

Um and then what about um you know other areas of the economy? So higher yields, not only effective income investors, equity investors, but they also kind of interestingly turkle out other to other places and other you know other unexpected areas. I'm like mortgages is when we've seen recently. Can you talk a little about that relationship and what what weird thing happening?

Yeah there is no doubt that consumer barring rates are impacted by bond market rates. Ah you're ability correct mortgages in your example generally follow the ten year treasury rate. So there are more suspect ble to long term rate volatility and is opposed to the short term movements that the fed is dictated.

Um that could be bad depending on on what happens to the shape of the deal curve. Fortunately for current homework, ers rates were really low for a long party of time. So many of them were able to refinance and lock in loans that historically attractive rates at three percent or less.

A conversely, today's home buyers don't have that luxury and they're paying between six and half and seven and a half percent on average to borrow a money for home purchases. So a substantial difference when you come on that over and fifteen year or thirty year time period for a mortgage. Other rates like car loans, for example, that affect consumers are are more tied to those short term rates and perhaps don't necessarily feel the impact as much as as mortgage blowers do. And with things like car loans, the manufacturer can offer in sanities and and perhaps buy down those rates and still make IT appealing for the customers, ensure that there is formed as possible can, regardless of the interest .

in environment, right? So those those shorter term rates follow of that closely? Yeah, right. Where's the longer term rates are a little less connected.

That's fair. Typical market edge is that the fed controls interest strates two years and in and the court and quote market, how are you wanted to find that controls rates ten years and longer?

okay. So so looking no big picture. no. What's what's most important for investors to remember when where environment where yields are may be higher than they've been or they're rising on the back of, you know, political loser? Anything like that, what people keep in mind .

we discuss earlier together, al environment offers some real benefits when thinking about overall portfolio construction. I think that's the major take away for investors today. That being said, it's important not to just always chase the highest fielding investments that are out there. Different asset classes across high yelled their value in different ways.

Most of our commentary today focused on us treasury markets and in treasury rates, but other asset classes within fixed income by cragged, auth investment, greg, in high yield mortgage back securities, foreign bonds, uh, all can have a place and revival options of an diversified portfolio. However, we believe the current valuations in some of those other other classes really suggest investors should be cautious looking at high yield. For example, a cragged spreads are a very rich.

And what I mean by cragged spreads, referring to the incremental yell that investor earns over above government bonds and the compensation they're receiving tig for that additional credit risk is very, very low. historically. Current yield spreads are roughly in the fifth percent tile historically ally.

So they've only been lower than this five percent of time over history, which is definitely not appealing. Um they're currently about two point six percent over treasury bonds for high yield of corporate bonds, which again is is not something that we think is adequate to justify the additional cradd risk that comes along with IT. So I I think I would just reinforce the the idea that diversified portfolio construction offers many ways to take advantage of the higher yield environment we're in today. Uh, we're back to a point where traditional government bonds or high quality bonds can offer that hedge value, uh, in a diversified portfolio, meaning that if we do enter a period of economic downturn, equity allocation suffer. Treasury bonds do actually have a chance for yields to come down and deliver some incremental Price appreciation that way, which has not been the case for most of the last two decades.

So IT IT sounds like rising yields are not always bad news. But maybe um maybe IT makes sense to take a closer look rather than you know painting with a super broad brush.

absolutely in a log of ways. Rising sing yields are a short term pain that do provide longer term benefits from investor perspective.

And um any any final comments on twenty twenty five the year ahead will have a new administration will have you know some changes in the economy and sure what is what's the take away their investors?

Totally, totally fair question, but difficult to answer. Uh, a couple themes we've been focusing on. One is really the move out of cash into longer term fixed income for many of the reasons we've discussed today that, that appears to be approving trade for investors to make. Secondly is just to be prepared for some level of volatility. Certainly with the political regime changing, uh, the fed shifting gears and moving towards a uh cutting regime, um a lag of unknown factors right now, oh is very likely we do see some surprises in twenty twenty five and would just encourage investors to to nap panic in in be expecting some of that over the short term here.

Well, thank you so much for chatting some light on this for us and for chatting on the past.

Thanks, sir. It's going to .

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