Show Notes

Why Higher Interest Rates Can Be Good for Bond Investors

Fixed income returns are negative on the year and we are only a few years removed from the worst year for bonds in history. For an asset class that’s supposed to feel safe, it’s been a frustrating stretch.

That said, bond yields are now at multi-decade highs, which drastically improves the outlook for future returns, so it’s important to understand what’s happening.

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Why Are Interest Rates Higher?

One of the biggest themes of the presentation is higher interest rates.

Why interest rates are higher is particularly interesting to me because it highlights the interconnectedness of markets and economies.

There isn’t one explanation, and some of the reasons are actually encouraging.

For starters, a strong economy encourages investment. When businesses see opportunities to expand, they’re willing to commit money to projects they expect to be profitable.

Think about all the spending on artificial intelligence and data centers. Building those facilities takes an enormous amount of capital, and companies are financing some of that investment by issuing bonds.

But those companies aren’t the only ones looking to borrow money. Governments are also borrowing to finance their deficits. They’re competing for capital in the same global markets.

When businesses and governments are looking to borrow more, they may have to offer higher interest rates to attract investors.

So, again, part of the upward pressure on interest rates comes from businesses seeing opportunities worth investing in.

But stronger growth isn’t the whole explanation. Persistent inflation is part of the story, too.

When you lend money by buying a bond, you care about what those future payments will actually buy. If investors become more concerned that inflation will remain elevated, they may demand higher interest rates to compensate for that loss of purchasing power.

Persistent inflation also affects what investors expect the Fed to do. If inflation proves harder to bring down, investors may expect short-term interest rates to stay higher for longer. Those expectations influence longer-term bond yields.

Lastly, investors may want additional compensation for the uncertainty of holding a bond for ten or twenty years.

And while today’s rates may feel high, it’s worth remembering that the very low interest rates following the financial crisis weren’t the historical norm.

What Do Higher Interest Rates Mean for Bond Returns?

Back in 2022, interest rates rose substantially, and starting yields were so low that income from bonds wasn’t enough to offset the price declines.

So far in 2026, higher starting yields have offered some cushion against price declines, but the Bloomberg U.S. Aggregate Bond Index’s total return is still −2.91% as of September 30.

The rise in interest rates has hurt bond prices, but those higher yields also improve the outlook for returns from here.

Real yields, which are inflation-adjusted yields, help illustrate how much the opportunity has changed. At the end of September, the real yield on ten-year treasuries was 2.93%—that’s a yield of nearly 3% above inflation.

The reset in yields has materially improved the competitive position of fixed income as an asset class.

When high-quality bonds offered very little return, investors depended more heavily on stocks or took additional risks elsewhere to pursue the returns they needed. With bonds now contributing more, you may have less need to stretch for return by taking more stock risk, lending to weaker borrowers, or accepting investments that are difficult to sell.

That doesn’t automatically mean your allocation should change. 

The reset in yields also makes this a good time to revisit how your fixed income assets are invested, especially if you’re still using an approach you settled on when interest rates were near zero.

Two bond portfolios can offer similar yields while having very different costs and risks. You can pay more than necessary, take interest-rate risk you didn’t intend to take, or give up diversification without realizing it.

Those choices have consequences. You can be earning more than you used to and still be leaving returns on the table or taking risks that don’t fit the purpose of your bond allocation.

As we’ve covered in past episodes, bonds are an area with a lot of misconceptions. Some of the choices that seem straightforward involve tradeoffs that are easy to overlook.

• Bond Funds vs Individual Bonds: What’s Best For Your Portfolio?
• The Problem With Investing in Bond Index Funds
• Why Your Bond Questions Are Really About Cash

Individual Bonds vs. Bond Funds: What Actually Changes?

Individual corporate and municipal bond portfolios can be more expensive and less diversified than comparable bond funds, which has implications for returns as well as risk.

You may pay less attention to the price fluctuations of individual bonds, but those fluctuations still happen. If that is your primary reason for owning them over bond funds, it’s worth taking a closer look at what you actually gain from that approach.

And if you really boil down what a bond ladder is doing when you continually reinvest the proceeds from maturing bonds, the basic structure is similar to a bond fund, but often with far fewer holdings.

That’s different from owning bonds that mature when you need the money for specific expenses. Individual bonds can serve that purpose well.

Are Bond Index Funds Always the Best Choice?

For those using bond funds, bond index funds aren’t automatically the ideal option. The case for indexing your stock portfolio doesn’t automatically carry over to your bond portfolio.

In a stock index fund, companies with the largest market values generally get the biggest weights. In a traditional bond index fund, issuers with more eligible debt outstanding generally receive larger weights. That doesn’t necessarily produce the mix of bonds you would choose for your own portfolio.

Meanwhile, did you know that PIMCO estimates more than half of the bond market consists of institutions whose primary objectives extend beyond maximizing investment returns?

Central banks buy bonds to implement monetary policy. Banks and insurance companies also buy bonds to meet regulatory requirements and manage liabilities. They care about returns, but those other priorities influence what they buy and what they’re willing to pay.

This major quirk in the bond market creates structural opportunities that differ from those in the stock market.

That’s why I prefer a low-cost, systematic approach that evaluates what you’re being paid to take interest-rate and credit risk. Of course, any alternative to an index fund still needs to justify its costs and the risks it takes.

Are Your Bond Questions Really About Cash?

Lastly, I think many of the mistakes with bonds happen because people think of some bucket of their portfolio or some portion of their fixed income as cash needed to fund the next however many years of their life.

Setting aside money for future spending makes sense. The mistake is expecting your entire bond allocation to behave like cash simply because you plan to spend some of that money in the coming years.

Money needed soon and money intended to provide long-term portfolio stability can require different investments.

What to Review in Your Bond Portfolio

I get that fixed income seems confusing, but I’ve said it several times recently and I’ll say it again: You owe it to yourself to learn more about fixed income.

Fixed income implementation has always mattered. Now that yields are higher, it’s worth taking a fresh look at this part of your portfolio.

Start by understanding what you own, what it costs, and how much interest-rate and credit risk you’re taking. Then ask whether those choices fit the role bonds are supposed to play in your portfolio.

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