Interest rates soared to multi-decade highs between 2020 and 2024 thanks to rampant inflation. While the Federal Reserve began cutting rates in Q3 2024, investors shouldn’t expect interest rates to return to their pre-2016 levels—at least not for some time. And that means rethinking how bonds could play a role in your portfolio.
In this article, we’ll explore where interest rates are headed long term, what that means for bond allocations, and some funds to help position your portfolio.
Will Interest Rates Remain High?
Many economists look toward the neutral rate—also known as R-star—when trying to understand interest rates. While the Federal Reserve sets an absolute interest rate based on temporary shocks and cyclical pressures, the neutral rate reflects a theoretical rate that would keep the economy in perfect balance—with full employment and stable inflation.
Policymakers estimate the neutral rate to be below 1%, but others argue that it could be upwards of 1.5%. While the former point to weak productivity growth and an aging population as catalysts for lower rates, the latter argue that structural U.S. deficits could contribute to higher-than-expected rates over a prolonged period.1
The case for higher interest rates is further bolstered by the fact that the U.S. appears to have avoided a severe recession when raising rates. In addition to supporting the higher neutral rate narrative, steadying economic growth could lead to fewer rate cuts than initially anticipated, leaving long-term interest rates higher for longer.
High Quality vs. High Yield Bonds
The good news for fixed income investors is that higher interest rates translate to higher long-term income. But while long-term rates could remain elevated, the market expects the Federal Reserve to cut rates to 425 to 450 basis points by year end. And by the end of 2025, those rates could settle into a 275 to 300 basis point range.
In today’s market, these expectations make bonds quite attractive. You can lock in today’s higher yields before they move lower while benefiting from price appreciation over the coming two years (bond prices move inversely to bond yields). In the end, you’re left with more income and some capital gains on top.
The million-dollar question is: Should you take maximum advantage of these dynamics with high-yield bonds or stick to higher quality issuers?
Source: Longtermtrends
Interestingly, credit spreads have been compressing over the past few years. Currently, the yield spread between Aaa and Baa corporate bonds continues to hover around 1%—lows last seen in 2006/2007 and in the 2000s. As a result, investors aren’t getting as well-compensated for risk as they were previously.
How to Position Your Portfolio
A simple solution is to pursue short duration high-yield bonds. That way, you can lock in higher yields without taking a lot of risk. For example, the PGIM Short Duration High Yield ETF (PSH) offers a 6.59% SEC yield with short maturities. Similarly, the RiverPark Short Term High Yield Retail Fund (RPHYX) offers a 5.39% TTM yield with little duration.
Another option is sticking to investment-grade issuers while selectively pursuing higher yield opportunities as a secondary focus.
For example, the Dodge & Cox Income Fund (DODIX) focuses on diversification and opportunistic high-yield investments. The fund offers a still-compelling 4.03% yield and has beaten the Bloomberg U.S. Aggregate Index over 1-, 3-, 5-, 10-, and 20-year periods, making it a great long-term choice for investors.
For more high-yield exposure, the Fidelity Strategic Income Fund (FADMX) offers a slightly higher 4.36% yield by holding about 45% of its portfolio in high-yield bonds. And like DODIX, it has outperformed its Morningstar category average in 1-, 3-, 5-, and 10-year timeframes, making it a compelling option.
Funds to Balance Quality & Yield
These funds are sorted by their YTD total return, which ranges from 3.8% to 6.3%. They have AUM between $25M and $73B, while they have expenses between 0.41% and 1.19%. They are currently yielding between 3.9% and 8.3%.
| Name | Ticker | Type | Actively Managed? | AUM | YTD Total Ret (%) | Yield | Expense |
|---|---|---|---|---|---|---|---|
| Fidelity Advisor Strategic Income Fund | FADMX | Mutual Fund | Yes | $13.3B | 6.3% | 3.9% | 0.66% |
| Dodge & Cox Income Fund | DODIX | Mutual Fund | Yes | $73.1B | 6.1% | 3.9% | 0.41% |
| PGIM Short Duration HIgh Yield ETF | PSH | ETF | No | $25.1M | 6.1% | 8.3% | 0.45% |
| RiverPark Short Term High Yield Fund | RPHYX | Mutual Fund | Yes | $787M | 3.8% | 4.4% | 1.19% |
The Bottom Line
Interest rates are likely to remain elevated over the long term, meaning bonds could play a more important role in investor portfolios than they did between 2008 and 2016. That said, investors shouldn’t necessarily go out and purchase the highest yield bonds—quality remains an important consideration given compressed credit spreads.
The bonds we’ve covered provide a balance between yield and quality, enabling you to capitalize on the near-term drop in interest rates while avoiding problems if the economy suddenly turns south or other risks arise.
1 Federal Reserve Bank of Minneapolis (February 2024). Are higher interest rates here to stay?