After years of aggressive rate hikes to combat inflation, the Federal Reserve began pivoting to rate cuts in late 2024, and these cuts are likely to continue well into 2025. Since interest rates fundamentally influence everything from bond yields to stock valuations, investors should be mindful of these changes and prepare their portfolio for a lower rate environment over the coming months.
In this article, we’ll examine how rate cuts affect different asset classes and outline strategic moves to help protect and grow your portfolio during this transition.
What to Expect in 2025
The Federal Reserve hiked interest rates to a high of 5.25% to 5.50% by July 26, 2023 before pausing as inflation began to come down. Then, on September 18, 2024, the central bank cut interest rates by 50 basis points to a 4.75% to 5.00% range. This ‘jumbo’ rate cut came as a surprise to many investors expecting a more conventional 25 basis point cut.
Since the September meeting, the Consumer Price Index—a measure of inflation—clocked its first gain in seven months, rising from 2.4% to 2.6% in October. These rates are still above the central bank’s target rate of 2%, but core inflation remained steady at 3.3% in October.
Target rate possibilities for December 2025’s meeting. Source: CME FedWatch
As of early December, CME FedWatch projects a 64% chance of a 25-basis point cut during its December 18th meeting. The market expects these rates to continue falling throughout 2025 with a roughly 70% chance they will be between 3.50% to 4.25%—and a nil chance they remain at current levels.
Impact on Stocks & Bonds
Falling interest rates impact different asset classes in different ways.
For bonds, the relationship is straightforward: as rates decline, existing bond prices rise because their high yields become more attractive to buyers. The longer a bond’s duration, the more dramatic this price increase becomes. But, at the same time, falling bond yields put pressure on investors counting on steady income from their bond portfolio.
Stocks often benefit from rate cuts through multiple channels. Lower rates reduce corporate borrowing costs, increasing profitability. They also make bonds less attractive compared to stocks, driving investors toward equities in search of returns. However, with stock valuations already elevated, the impact could be more muted compared to past rate-cutting periods.
Adjusting Your Bond Portfolio
Interest rate cuts present both opportunities and challenges for bond investors. While existing bondholders will see their holdings appreciate in value, reinvesting maturing bonds or new money will yield progressively lower returns. A bond yielding 5% today might only offer 3% after several rate cuts, significantly impacting your portfolio income.
There are several ways to adjust a bond portfolio to cope:
- Lock in high yields: Extend duration now to lock in high yields before interest rates fall lower. By doing so, you can capture both income and price appreciation as rates decline. However, you may want to keep some shorter-duration bonds for flexibility and liquidity needs, depending on your financial goals.
- Diversify across credit quality: Treasury yields will always fall with Fed rates, but corporate bonds may maintain higher yields due to credit spreads. Consider adding high-quality corporate bonds and even some carefully selected high-yield bonds to enhance your bond portfolio’s income as rates drop.
- Consider bond alternatives: Preferred stocks or dividend-focused ETFs can provide stable income streams that are less vulnerable to falling interest rates. These securities can help maintain portfolio yield without taking on excessive risks, as long as they’re part of a diversified basket.
You might also consider actively-managed bond portfolios where managers have the flexibility to make these kinds of adjustments. Rather than buying the largest or most liquid bonds, these funds may take a closer look at credit quality and factor in the impact of expected interest rate changes.
Popular Active Bond ETFs
These ETFs are sorted by their YTD total return, which ranges from 3.4% to 8.6%. They have AUM between $57M and $9.5B, with expenses running between 0.36% and 0.71%. They are currently yielding between 1.8% and 6%.
| Name | Ticker | Type | Actively Managed? | AUM | YTD Total Ret (%) | Yield | Expense |
|---|---|---|---|---|---|---|---|
| Hartford Strategic Income ETF | HSUN | ETF | Yes | $57.3M | 8.6% | 4.3% | 0.49% |
| JPMorgan Income ETF | JPIE | ETF | Yes | $1.07B | 6% | 6% | 0.4% |
| PIMCO Active Bond ETF | BOND | ETF | Yes | $4.32B | 4.5% | 5% | 0.71% |
| Fidelity Total Bond ETF | FBND | ETF | Yes | $9.45B | 3.9% | 1.84% | 0.36% |
| iShares Total Return Active ETF | BRTR | ETF | Yes | $80.8M | 3.4% | 4.8% | 0.41% |
Protecting Your Stock Portfolio
The stock market is already trading near its record highs, and the promise of deregulation next year could send it even higher in the short term. But, of course, every stock market rally comes to an end—usually in the form of an abrupt drop—which means prudent investors may want to take measures to safeguard their stock portfolio right now.
Some steps you can take include:
- Quality over growth: Rebalance your portfolio toward quality stocks with strong balance sheets and sustainable dividends. Companies with strong pricing power and low debt levels tend to weather market turbulence better. Focus on sectors like healthcare and consumer staples over high-growth sectors like pharma or tech.
- Consider hedging: Stock options offer a way to hedge against decline without selling stocks and moving into cash. And some ETFs, such as buffer ETFs, provide a built-in way to limit losses during a market drop. Depending on your risk tolerance and financial goals, these moves might make sense for your portfolio.
- Keep a cash reserve: Maintaining an adequate cash reserve provides dry powder for future opportunities while acting as a portfolio stabilizer. Consider gradually increasing cash positions as market valuations become more stretched, which you can then deploy when the market crashes and equities become cheaper.
You might also consider some active ETFs to help manage equity risks. With more flexibility than market cap-weighted index funds, they may be better positioned to limit losses during a sudden market drop or even capitalize on new opportunities.
Risk-Off Active Equity ETFs
These ETFs are sorted by their YTD total return, which ranges from 13% to 25%. They have AUM between $307M and $10.1B, with expenses running between 0.13% and 1.05%. They are currently yielding between 0% and 1.5%.
| Name | Ticker | Type | Actively Managed? | AUM | YTD Total Ret (%) | Yield | Expense |
|---|---|---|---|---|---|---|---|
| Avantis U.S. Large Cap Value ETF | AVLV | ETF | Yes | $3.16B | 24.8% | 1.5% | 0.15% |
| JPMorgan Active Value ETF | JAVA | ETF | Yes | $1.18B | 24.6% | 1.5% | 0.44% |
| Vanguard U.S. Quality Factor ETF | VFQY | ETF | Yes | $307M | 19.1% | 1.2% | 0.13% |
| Dimensional U.S. Targeted Value ETF | DFAT | ETF | Yes | $10.1B | 17% | 1.3% | 0.28% |
| FT Vest Laddered Deep Buffer ETF | BUFD | ETF | Yes | $879M | 13.1% | 0% | 1.05% |
The Bottom Line
Interest rates have a fundamental impact on stocks and bonds. So, investors should pay attention as the Federal Reserve moves to cut rates over the coming year. Fortunately, there are some steps you can take to reduce risk and keep your portfolio safe, from shifting to quality stocks to increasing bond durations. But, of course, any decisions should be made with your own goals in mind.
