A Simple Way to Take Advantage of Higher Yields - Heard on the Street -- WSJ

By Telis Demos

Nobody likes to catch falling knives, as the old Wall Street saying goes. Except that with shorter-term bonds, at least you're wearing some protective gear.

Traders seem to be struggling to find the bottom for Treasurys. The past week saw yields on the 10-year note surge beyond previous high-water marks, first 5%, then 5.1% and even 5.2%. The move was also accompanied by a jump in bond volatility, which had still been subdued until the last few sessions. This is a sign that markets are becoming more jumpy.

However, unlike with stocks, bonds offer some cushion, even if investors get their market calls wrong. Investors get a coupon payment that helps offset the decline in value the bond might experience if market yields rise. In other words, even if a bond's price drops, it can still end up with a positive return.

Plus, if a bond is going to mature in less than a couple of years, that adds another layer of insulation. That is particularly the case for buyers who can be comfortable holding until maturity, rather than constantly checking on the price to see if it has risen or fallen.

Currently, 2-year Treasurys are yielding over 4.9%. That isn't much less than what the 10-year Treasury is paying at over 5.2%. Longer-term bonds have some additional yield built in for less quantifiable risks like long-term inflation or a surge in future issuance. Whether that is sufficient compensation can be very tough to think through.

Longer-term debts are more exposed to bigger concerns, such as the Fed's credibility or the U.S. deficit. Buying those bonds "requires investors to have more conviction given the more significant risk profile involved," says Gennadiy Goldberg, head of U.S. rates strategy at TD Securities.

For shorter-term bonds, though, it is a somewhat simpler equation. One way to think about a bond is whether it is a better buy over its lifespan versus just rolling over cash in very short-term bills, which is what a money-market fund would be doing.

That, in turn, is effectively asking what the Federal Reserve's rate target will be during the bond's life. And right now, the 2-year Treasury is pricing in the risk of a more-aggressive series of rate increases than what the Fed itself is currently contemplating.

Following the Fed's rate increase in September, the current target overnight rate is 3.75% to 4%. The Fed probably won't stop there, barring some surprisingly negative economic or inflation data. Fed officials themselves are currently forecasting only one additional hike this year.

Meanwhile, the interest-rate derivatives market is pricing in even more hikes in this cycle, expecting a so-called terminal 4.85% fed-funds rate by September 2027, according to TD's Goldberg. That is a bit below what the 2-year will pay you in yield right now.

Of course it is possible that the Fed could turn out to be even more hawkish than that. Markets weren't fully anticipating how aggressive the Fed's 2022 hiking cycle turned out to be. The AI-fueled economy might also just need that much of a jolt to slow it down.

The flip side, though, is that it might not take too many hikes to put the brakes on the non-AI sectors of the economy, such as the housing market, or the part of the corporate lending market that borrows at floating rates. And all of that is before considering the political dimensions for the Fed of sharply hiking rates under President Trump.

But investors don't have to be macro analysts. Either way, the relatively high yield on two-year notes and their shorter lifespan mean that it would take something quite extreme to generate overall losses for investors.

If two-year yields rose by an additional 1 percentage point over a one-year horizon, and the bonds lost value, they would still generate a total return of almost 4% in that time, according to estimates by TD Securities.

Longer-term bonds would be more exposed in such a scenario. Ten-year Treasurys would have a return of roughly negative 2%, and 30-year bonds would lose about 8%, according to TD's estimates. Conversely, they can also gain more if yields started falling sharply.

Some investors might be willing to bet on the direction of rates. Others may want to let the market set their rate with a short-term instrument like a money-market fund. The Crane 100 Money Fund index is at a roughly 3.7% yield.

Just remember, the bigger the knives you are juggling, the more likely you are to hurt yourself.

Write to Telis Demos at Telis.Demos@wsj.com

(END) Dow Jones Newswires

September 29, 2026 05:30 ET (09:30 GMT)