Bond Investors Lose Faith After Another Bad Year

Over the past two years, Wall Street investors began with high hopes for U.S. Treasurys and other high-quality debt instruments, only to face disappointment. This year, their outlook is far more cautious. Recently, many money managers have been selling Treasurys, while savers are withdrawing from longer-term bond funds.

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This wave of selling activity has pushed Treasury yields to the higher end of their two-year range. However, concerns persist that the bond market's challenging environment could deteriorate further, particularly if President-elect Donald Trump introduces inflationary policies, such as new tariffs. As a result, some investors are weighing the merits of shifting to short-term Treasury bills, which may offer a safer option.

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"Cash is yielding over 4%," remarked Ed Al-Hussainy, global interest-rate strategist at Columbia Threadneedle Investments. "That’s a pretty tough benchmark to beat."

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This cautious sentiment marks a significant change in Wall Street's perspective. Only a few years ago, bonds enjoyed a prolonged bull market, and fears of rising interest rates were minimal. Investors largely believed that rates couldn’t climb significantly without triggering a recession.

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When the Federal Reserve aggressively increased interest rates in 2022, many viewed it as a temporary measure. Throughout 2023, the prevailing assumption was that rates would soon reverse course, dropping faster and more sharply than the Fed projected. Now, however, a growing number of investors accept that the economy can withstand higher rates and recognize inflation as an ongoing risk.

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By November, market participants were already predicting that the Federal Reserve would only cut rates twice in 2024, contrasting with the four cuts Fed officials had indicated in September. When Fed officials revised their projections in December to suggest only two rate cuts, traders quickly adjusted their positions, with many betting on just one cut or none at all.

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These shifting expectations have impacted bond returns. As of December 26, an ICE BofA index tracking U.S. Treasurys was on track to underperform Treasury bills for the fourth consecutive year.

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The index delivered a modest return of 0.4%, compared to the 5.2% return from T-bills. Similarly, the Bloomberg U.S. Aggregate Index—covering investment-grade corporate bonds, mortgage-backed securities, and Treasurys—posted a return of 1.1%, after narrowly beating T-bills in 2023 but underperforming in the prior two years.

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Traditionally, bonds often follow a poor year with a strong one, but that pattern has not held recently. This has led to what Brian Nick, head of portfolio strategy at NewEdge Wealth, describes as "reluctance to deal with the asset class."

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Investor sentiment is evident in fund flows. BlackRock's iShares 20+ Year Treasury Bond ETF experienced $5.3 billion in outflows this December, according to FactSet data. If the trend holds through the month’s end, it will mark the largest monthly outflow in the fund's 22-year history.

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Declining bond prices have driven the yield on the benchmark 10-year U.S. Treasury note to 4.619% as of the last Friday, up from 4.192% at November's end and 3.860% at the close of 2023.

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Despite the cautious mood, not everyone is pessimistic. Economists at Goldman Sachs anticipate inflation will resume its downward trend next year, which could enable the Federal Reserve to implement three rate cuts. The bank’s rate strategists also forecast that 10-year Treasurys will outperform short-term Treasury bills by 2025, arguing that current market prices already account for strong U.S. economic growth and substantial federal budget deficits.

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This divergence in outlook underscores the challenges facing bond investors as they navigate an uncertain environment shaped by inflation risks, Federal Reserve policy, and broader economic dynamics. Whether the coming year will bring relief to the bond market or prolong its struggles remains a key question for Wall Street.

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