The Bond ETF Market is Down in 2025 Ahead of Highly Anticipated U.S. Inflation Data

The U.S. bond market has faced challenges in 2025, with funds tied to fixed-income assets experiencing declines due to a rapid rise in Treasury yields since September. This trend has weighed heavily on investors, particularly in longer-term bond funds.

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Data from FactSet shows that the iShares Core U.S. Aggregate Bond ETF (AGG) and Vanguard Total Bond Market ETF (BND) have each dropped around 1% year-to-date through Tuesday. Longer-term bond funds have been hit harder, with the Vanguard Long-Term Treasury ETF (VGLT) and iShares 20+ Year Treasury Bond ETF (TLT) both slumping more than 2% in 2025.

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The climb in Treasury yields, particularly the 10-year Treasury yield nearing 5%, has disrupted the U.S. stock market and hurt fixed-income prices. A range of investor concerns has driven this surge, including strong economic growth expectations and worries over the U.S. fiscal deficit.

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Vishal Khanduja, head of the broad markets fixed-income team at Morgan Stanley Investment Management, highlighted the recent uptick in volatility. According to him, a significant portion of the 10-year yield’s rise is tied to higher “real yields,” reflecting optimism about robust economic growth without inflationary pressures. However, the market also appears concerned about the trajectory of the U.S. deficit, with investors demanding higher premiums for holding long-term government debt.

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The fiscal policies of the incoming White House administration are under scrutiny, as investors remain cautious about their potential economic impact. Khanduja noted that policymakers would need to carefully navigate market expectations when implementing new measures.

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Bond market volatility has intensified over the past month, with traders largely expecting the Federal Reserve to pause its interest rate cuts at its upcoming monetary policy meeting in late January. This meeting is scheduled shortly after the inauguration of President-elect Donald Trump on January 20.

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Amid an expanding U.S. economy, investors are contending with potential inflationary pressures stemming from policies related to tariffs and immigration. Additionally, there is heightened focus on how the U.S. plans to fund its deficit, particularly as technical indicators in the Treasury market show signs of weakening.

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On Tuesday, the yield on the 10-year Treasury fell slightly to 4.787%, after reaching its highest level since October 31, 2023, on Monday. Meanwhile, the 30-year Treasury yield edged closer to 5%, and the 20-year Treasury yield exceeded that threshold, according to FactSet data. Since bond prices and yields move inversely, the sharp rise in long-term yields this year has had a particularly negative impact on funds with longer durations.

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Khanduja warned that financial conditions could become challenging for the economy if the 10-year Treasury yield surpasses 5%, as refinancing would become more difficult for borrowers. Despite these concerns, the bond market is not signaling a significant rise in inflation, based on the 10-year breakeven inflation rate.

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However, investors remain wary that inflation could remain stuck above the Federal Reserve’s 2% target, even though it has eased significantly from its 2022 peak. A key focus is Wednesday’s consumer price index (CPI) report, which is expected to provide fresh insights into inflation trends.

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During the pandemic, surging inflation resulted in steep losses for the bond market as the Federal Reserve responded with aggressive rate hikes. While these hikes caused short-term pain, they have left investors with higher starting yields, which now offer more attractive income streams.

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Khanduja expressed optimism about certain areas of the bond market, describing current starting yields as “pretty compelling.” He noted that the U.S. economy is performing well, with strong balance sheets for both companies and consumers. He particularly favors bonds with maturities on the front end of the yield curve, up to five years, which are primarily influenced by the Federal Reserve’s monetary policy.

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Exchange-traded funds targeting fixed-income assets with shorter durations have fared better than the broader U.S. bond market so far this year. The iShares 3-7 Year Treasury Bond ETF (IEI) has declined 0.8% year-to-date, while the iShares 1-3 Year Treasury Bond ETF (SHY) has slipped just 0.1% over the same period, according to TradeAlgo.

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In 2024, the iShares 1-3 Year Treasury Bond ETF delivered a total return of 3.9%, outperforming the iShares Core U.S. Aggregate Bond ETF, which gained 1.3%.

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Louis Navellier, chief investment officer at Navellier, expressed hope that Treasury yields might ease if the CPI report comes in better than expected. In comments made during a podcast, he suggested that such a development could provide some relief to the bond market.

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While challenges persist, the bond market's higher starting yields and the potential for easing inflation could offer opportunities for investors willing to navigate the current environment carefully.

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