Fixed Income: Frequently Asked Questions

Increasing deficits and debt relative to the size of the economy likely will mean that long-term Treasury yields will be higher than otherwise would be the case. However, we don't anticipate a default by the Treasury.

On July 4th President Donald Trump signed the "One Big Beautiful Bill" into law. The bill is expected to expand the federal deficit over the course of the next decade and adds to the accumulated debt. The Congressional Budget Office (CBO) has estimated that the current bill will add about $3.4 trillion to the debt over the next 10 years.¹ With U.S. debt held by the public already at 120% of gross domestic product (GDP), the result is that interest payments on the debt may become one of the largest expenses for the government. The Treasury will need to issue larger amounts of debt instruments including Treasury bills, notes, and bonds to finance the government.

The trend suggests that yields for intermediate to long-term bonds likely will stay elevated even if inflation comes down. Investors likely will demand a larger risk premium to hold long-term debt versus holding a series of short-term T-bills or notes. This risk premium, or "term premium," already has been rising and could continue to move higher.

We do not see a risk of default for several reasons:

• The U.S. has the world's largest economy and is a very wealthy country. We have the capacity to pay the debt. It's just that there is an unwillingness to take the steps, such as tax hikes and spending cuts, needed to reduce the deficit. The unwillingness of U.S. politicians to address the deficit is the reason for Moody's downgrade of U.S. Treasuries.
• Even in the event that a standoff over the debt ceiling delays some payments, this would not be like a default in an emerging-market country, where the debt is restructured and creditors get less than full principal and interest.
• The U.S. has the world's reserve currency in the form of the U.S. dollar, which means that there is global demand for dollars which get invested into Treasuries. Roughly 80% of all global trade is transacted in U.S. dollars and about 58% of all reserve assets held by global central banks are held in U.S. dollars, a level that hasn't changed much in over a decade.

• The U.S. Treasury market is the largest and most liquid in the world by a large percentage. Foreign investors access the market for liquidity and safety. There isn't a logical substitute market to handle the volume of transactions or savings.

In sum, the rising U.S. deficits and debt levels are concerning and likely will mean that interest rates remain higher than they might otherwise be. Historically there hasn't been a relationship between U.S. debt and interest rates because Treasuries are considered risk-free assets. However, we do see the likelihood of the risk premium for long-term Treasuries to stay high or expand. We don't see a default on the horizon.

The likelihood of a debt-ceiling-induced default has declined as the tax-and-spending bill that was signed into law on July 4th increases the debt ceiling by $5 trillion. While the risk of a near-term default has declined, a brief explanation of the situation might help as the debt ceiling topic has come up frequently over the years.

When the debt ceiling is close to being hit, the government uses "extraordinary measures" to keep the government funded. Those measures are limited, however, and there is usually some sort of "X date" where those extraordinary measures would be exhausted. If the debt ceiling isn't raised or suspended by then, theoretically the government would be unable to pay its liabilities that were due at that time. This would include bonds and would be considered a default by the U.S. government.

A missed payment (default) by the Treasury would be different from a default by an emerging-market government. There wouldn't be lengthy restructuring process; rather, it would likely result in a delayed payment for those Treasuries that matured after the X date was hit. Bondholders holding Treasuries that mature around the X date, or the date that the Treasury's general account runs out of funds, should be aware of the potential for a delayed repayment should the debt ceiling not be raised.

A delay in receiving payment likely would result in a loss of investor confidence in the U.S., however. It would not be surprising if the value of the dollar dropped, longer-term interest rates rose, and riskier investments sold off. Additionally, the odds of a recession would likely increase.

The U.S. government has strong capacity to meet its liabilities even though the willingness may not be there. In the past, the U.S. has come dangerously close to not raising the debt ceiling but eventually did. In August 2011 and October 2013, the government came within days of reaching the X date but eventually a deal was struck. At the time, yields for bonds maturing right after the X date were higher than yields for bonds maturing right before to the X date because investors were concerned about when they would be paid.

There is some indication that foreigners are pulling back from investing in U.S. government bonds. Trade wars and concerns about U.S. policies appear to be leading to some decline in capital inflows to Treasury bonds. The data on foreign investment flows lags, so it is a few months old.

Foreign investors buy and sell U.S. securities every month, and usually there are more purchases than sales. That wasn't the case in April, where net purchases of U.S. long-term securities by foreign investors were negative $50.6 billion. Put differently, there were $50.6 billion in net sales of U.S. securities, as the chart below illustrates. That was largest monthly net sale since April 2020.

The chart above represents the net purchases of a number of long-term U.S. securities: Treasuries, agencies, corporate bonds, and equities. It also represents net purchases by both official foreign investors—generally central banks or foreign governments—and private foreign investors. The net purchases were negative in April for both private and official foreign investors.

Looking at Treasury flows alone paints a more nuanced picture. Foreign official investors still were net purchasers of U.S. Treasuries in April. That makes sense because foreign governments and central banks still generally have a need to hold high-quality, dollar-denominated assets.

Foreign private investors, however, were net sellers of U.S. Treasuries in April to the tune of $46.8 billion. Considering that the net purchases of all long-term U.S. securities in April was -$50.6 billion, the net selling of Treasuries by foreign private investors was the main culprit.

For U.S. investors, the impact of any decline in demand for U.S. Treasuries is likely to be limited. Treasury yields are largely a function of Federal Reserve policy, inflation expectations and economic growth. Purchases or sales by foreign investors tend to have less influence. On the margin, a drop in foreign investment would mean somewhat lower bond prices and higher yields but is not likely to have a major impact on the market.

Bond yields generally have risen lately in most major developed markets due to rising debt levels, expanding fiscal policies, and, in some cases, central banks loosening their grips on controlling yields. The trend has been led by Japan's bond market. The Bank of Japan, which owns about half of all the country's bonds, has been reducing its purchases and allowing long-term yields to rise in response to the economy's exit from deflation. Since Japan is one of the largest foreign investors in foreign bonds—including U.S. Treasuries—the trend has contributed to higher yields globally.

We think the trend can continue for a while, but there are already signs of slowing growth and easing inflation pressures in some markets. The European Central Bank (ECB) has lowered short-term rates this year in response to easing inflation. Consequently, yields may be near or at the peak in Europe.

In terms of investing, international developed-market bonds have been the strongest-performing sub-asset class in the fixed income universe year to date. Most of the performance is attributable to the drop in the dollar versus other major currencies, however. Through July 4th, the year-to-date currency return of the Bloomberg Global Aggregate ex-USD Bond Index was 9.4%, representing most of the overall index return of 10.2%. U.S. bond yields currently are higher than yields in most other major countries, but that interest rate difference has been offset by a weaker currency. Since we anticipate further weakness in the U.S. dollar, international developed market bonds will likely continue to gain relative to U.S. Treasuries.

Emerging-market bonds have also benefited from a weaker dollar. Typically, emerging-market (EM) bonds outperform when the dollar is falling because it usually reflects easier monetary policy in the U.S. that benefits growth elsewhere. While we see scope for EM bonds to deliver positive returns in the second half of the year due to a weaker dollar, it is a volatile asset class. Ongoing trade conflicts could be a negative for those that rely on export for economic growth. Investors should be cautious if allocating to EM bonds.

Broadly speaking, we don't expect the tax bill to have a major impact on the muni market but it could impact certain sectors. The bill that was signed into law fully extended the 2017 Tax Cuts and Jobs Act (TCJA) and left the income tax rates unchanged. It also kept in place the municipal bond tax exemption. Prior to the bill, there was some speculation among market participants that Congress might have curbed the muni tax exemption to help pay for the bill, but that didn't happen. The bottom line is that because the muni tax exemption and the current tax rates were left unchanged, we don't believe the bill decreases the attractiveness of munis for higher income earners.

Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) have made headlines lately given discussions about the potential end of their conservatorships and subsequent privatization. As government sponsored enterprises, Fannie Mae and Freddie Mac are major issuers of mortgage-backed securities, and they issue traditional bonds as well.

Trump has mentioned this idea himself, saying in late May that he was working on taking both companies public again. The prices of the common and preferred stocks have risen sharply in anticipation of that potential outcome, but it remains to be seen what the endgame would actually be, as the government still holds senior claims through preferred stock as well large shares of the common stock outstanding. What ultimately happens with their common or preferred stock is still very much unknown, but the potential for privatization is likely what drove their prices up so much lately.

For bond investors, the implied backing of the U.S. government still appears to be in place. In fact, Trump posted on Truth Social on May 27th, 2025 that "…I want to be clear, the U.S. Government will keep its implicit GUARANTEES…" It is good to hear that reassurance, and the markets generally agree. Spreads on agency-backed mortgage-backed securities (MBS), those backed by Fannie Mae and Freddie Mac, are still in line with their five-year averages, while spreads on agency bonds remain low. If the implied backing were to go away, spreads probably would rise to reflect the greater risks.

Agency mortgage-backed securities (which include those issued by Ginnie Mae and are fully backed by the full faith and credit of the U.S. government) can make sense for investors with their average yields near 5%. There are some key characteristics and risks to be aware of, however. Unlike traditional bonds  that repay the principal amount at maturity, the monthly payments from mortgage-backed securities generally include both interest and principal, and those monthly payments can fluctuate depending on how quickly homeowners pay down the underlying mortgages. The level of interest rates can impact the speed at which the principal is repaid—falling interest rates usually result in quicker repayments of principal, while rising interest rates generally result in slower repayments. Likewise, agency bonds (often callable) can allow investors to earn slightly higher yields than Treasuries but with very little extra credit risk.