By Daren Fonda

The bond market is battling the Federal Reserve in a knife fight over yields.

The next few months will be rocky, though there are ways to stay out of the fray and earn an attractive yield.

While the central bank has been cutting rates since September, long-term bond yields have been going in the opposite direction, rising sharply. Bond yields and prices move inversely, and the dynamic has hit long-term Treasury funds hard.

The yield on the 10-year Treasury was 4.61% on Thursday, up 2.2 basis points, or two-hundredths of a percentage point. It's now up around 100 basis points since this year's closing low of 3.62% on Sept. 16. Other long-term yields have spiked, too, reaching 4.86% on the 20-year Treasury and 4.77% on the 30-year Treasury.

What happens next depends on several things, including the Fed's next moves, the U.S. fiscal situation, inflation expectations, and the policies of President-elect Donald Trump. Fed Chair Jerome Powell has already taken a more hawkish tone, priming the market for just two more quarter-point cuts in 2025.

The market may now be sensing that even two cuts looks optimistic given the economy's strength and lack of progress on inflation.

"The bond market is saying the Fed has the wrong policy," observes Jim Bianco, president of Bianco Research.

Monetary easing isn't necessary given the strength of the economy and the coming "Trump Stimulus," he added in a LinkedIn post on Christmas Day. "Fed easing is raising inflation expectations and driving yields higher."

The technicals suggest rough waters ahead.

"We wake up this morning to see new high yields in Treasuries in the long end as BEAR STEEPENING TAKES HOLD," said Andrew Brenner, head of international fixed income at National Alliance Securities, in a note on Thursday.

A bear steepener occurs when long-term yields rise faster than short-term -- and it's a bad sign. If the 5-year Treasury yield breaks 4.5%, the next stop could be 4.61%, Brenner writes. The 10-year Treasury has support around 4.62%, but if that breaks, the next stop may be 4.71%.

"We don't sense that anyone is craziest enough to put on new positions given the liquidity," he added, though without much breadth in the market "anything can happen."

Some of the largest bond ETFs are slumping, heading into the year-end on a losing note.

The Vanguard Long-Term Treasury ETF and iShares 20+ Year Treasury Bond ETF were both down 0.2% on Thursday. The Vanguard fund has lost 6.3% this year, including interest, while the iShares fund is off 7.5%.

The broader market is holding up better: the iShares Core U.S. Aggregate Bond ETF is up 0.9% for the year. The fund isn't as rate sensitive as long-term Treasury ETFs, including about 30% of its holdings in corporate issuances.

Indeed, there's a silver lining to the market's renewed bearishness: Yields are back above 5% in corporate debt, and you don't have to delve into "junk" territory to capture them.

Vanguard Intermediate-Term Corporate Bond ETF, the largest of the investment-grade bunch with $48 billion in assets, has a 30-day SEC yield of 5.2%; it's ahead 3% this year on a total return basis.

Funds holding other types of debt are faring even better. Janus Henderson AAA CLO ETF, for instance, yields 6% and is ahead 7.3% on a total return this year. Janus Henderson B-BBB CLO ETF, which owns lower-rated securities, yields 7.9% and has gained 10.9%.

Junk bonds and preferred securities are also doing well, propped up by higher yields and expectations that the economy won't tank, keeping default rates low. The SPDR Bloomberg High Yield Bond ETF yields 7%, for instance. The iShares Preferred & Income Securities ETF yields 5.8%.

Granted, there isn't much value in corporate debt with "spreads," or the extra yield over Treasuries, in a relatively tight range. Still, a 6%-to-7% yield provides ample cushion against losses, especially if you stick with shorter-duration funds that are less rate-sensitive.

As long as the economy holds up, corporate debt should be a better bet than Treasuries and investors should be able to pocket yields of at least 5%. If inflation stays below 3% that should deliver a 2% "real return."

Let's just hope inflation cooperates and the Fed isn't forced to reverse course and start hiking again.

Write to Daren Fonda at daren.fonda@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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December 26, 2024 14:02 ET (19:02 GMT)

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