Old-Fashioned Bond Math for a New-Fashioned Fed

Every so often, markets present an opportunity to reset the muscle memory of a generation of investors. The arrival of a new U.S. Federal Reserve chair – one who has heralded a genuine changing of the guard – is one such moment.

Kevin Warsh's early signals have been clear: Expect less forward policy guidance, lighter use of the Fed’s balance sheet, more debate among officials, and a greater willingness to act aggressively – and even to be wrong – in both directions. Expect the Fed to be less reliant on interest-rate projections and less inclined to act as a risk manager for financial markets.

This change is significant. For the better part of two decades, the Fed's implicit job description has included suppressing market volatility, telegraphing intentions, and smoothing the path for risk assets. Investors were rewarded for moving as a herd in accordance with the Fed’s “dot plot” forecasts rather than doing their own analysis.

See more: Fed Policymaker Comments Raise the Stakes for Inflation Data

A Warsh Fed appears prepared to let markets stand more on their own, with less explicit guidance or implicit backstop. That stands to increase volatility, dispersion, and two-way risk. Those happen to be the raw materials for active investment managers to pursue enhanced returns. And those raw materials are especially beneficial at a time when basic bond math is already working in investors' favor again.

Exorcising the ghosts of 2022

Amid an era of relentless stock market gains, the renewed case for fixed income has been overshadowed, especially after the Fed’s post-COVID policy path produced some rough patches for bonds. In 2022, fixed income faltered as the Fed hiked rates sharply to combat an inflation spike. Bonds have endured a repricing of the front end of the yield curve, a selloff at the long end, a testing of the "duration diversifies" narrative, and a steady drift of financial advisers toward equity risk.

And yet, bonds have quietly gone back to work. This year, even with the 10-year Treasury yield above where it began 2026, high-quality bonds have done their job – posting positive total returns and outperforming cash across most segments of the curve.

Meanwhile, disinflationary forces appear to be reasserting themselves after the energy-price shock triggered by the conflict in Iran. Inflation data released in July showed a broad-based cooling in price pressures, with both headline and core inflation surprising to the downside as energy prices retraced and services inflation moderated.

Real (inflation-adjusted) yields sit near multi-decade highs that not only reward investors but also give policymakers ample room to move in either direction as the data dictate. The Fed’s institutional independence and credibility on inflation are no longer in doubt.

Still, the muscle memory of recent years has kept many allocators from noticing the merits of fixed income. Now, it’s time to revisit those merits.

The math

The 10-year Treasury note today yields about 4.55% – roughly four percentage points above the all-time lows seen in 2020. Historically, starting yields have been highly correlated with five-year forward returns. That suggests a solid baseline for returns in a steady-state economy.

Now imagine the next genuine growth scare, credit event, or geopolitical shock. In that scenario, our baseline view is that central banks would cut rates significantly. If that happened, the total return on that 10-year Treasury could be 10% or more over the following year. In a severe recession scenario, the total return could approach 20%.

That means that in the adverse economic scenario – the case where equity investors most need help – a high-quality bond position could plausibly deliver a double-digit offset. And investors are being paid a starting yield of about 4.55% simply to wait for that optionality to matter.

Our baseline view is that the Fed will hold its policy rate steady through the rest of 2026 amid gradually easing price pressures, and recent inflation data reinforce that view. Importantly, investors do not need an aggressive easing cycle for bonds to generate attractive returns from current yield levels. Indeed, the beauty of bonds today is that performance isn’t predicated on a single macro outcome.

Across a range of growth and inflation outcomes – soft landing, no landing, recession, and stagflation – high-quality bonds could deliver positive total returns, including meaningful upside in the scenario that matters most to a balanced portfolio. Even if rates were to rise, today’s yields offer a significant income cushion to offset price losses.

This is convexity in plain English: A truncated downside and a meaningful upside.

The case for bonds, not the case against equities

Equity valuations remain historically elevated, a concern we hear in client conversations. But valuations have been stretched for a while and stocks have kept climbing. Rather than trying to forecast an equity downturn, the more useful observation is that you don't need a bearish view on stocks to justify owning bonds.

Instead, the case for fixed income rests on standalone bond math: starting yields that compound, convexity that protects, attractive global yields that diversify (for more, see our 24 June publication, Global Bond Diversification: Higher Yields and New Opportunities for Alpha), and a more laissez-faire Fed.

Bonds also look increasingly compelling on a relative basis as diversification has grown scarce elsewhere in portfolios. In equities, the top 10 issuers account for roughly 37% of the S&P 500, concentrating exposure in a handful of mega-cap names (see Figure 1). In private direct lending, the fastest-growing corner of many portfolios, roughly 31% of business development company (BDC) exposure sits in software and technology.

Figure 1: Avoid the illusion of diversification in equity and private corporate credit

A high-quality fixed income allocation, by contrast, sources from a genuinely diversified mix of rate, credit spread, and currency exposures across sectors and regions.

The Warsh dividend

A generation ago, the Fed reshaped itself in the aftermath of the global financial crisis, laying the groundwork for the investor muscle memory that endures today. Large-scale asset purchases flattened the yield curve, while calendar-driven forward guidance sedated the front end. Dot plots and press conferences trained markets to expect the Fed to telegraph its every move. Passive investing flourished as active decisions migrated to Washington, and bond yields marched toward all-time lows.

In a Warsh regime, that machinery is set to recede (for more, see our 24 June Macro Signposts, “Will Greater Monetary Policy Uncertainty Lead to Tighter Financial Conditions?”). Volatility will be absorbed by markets rather than managed away, and a Fed that telegraphs less certainty is a Fed that reinvigorates opportunities for active managers — including curve analysis, directional views, currency positioning, and relative value trades.

The result is a doubly supportive backdrop, in our view. Higher starting yields have brought old-fashioned bond math back in investors' favor, and a Warsh Fed stands to enable active investors to build on that already attractive baseline for returns.

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References, either general or specific, to securities and/or issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Bond investments may be worth more or less than the original cost when redeemed. Equity investments may decline in value due to both real and perceived general market, economic and industry conditions. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Private credit involves an investment in non-publicly traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. An investment in a BDC is subject to credit and investment risk, leverage risk, market and valuation risk, price volatility, liquidity risk, interest rate risk, structural and regulatory risk. Diversification does not ensure against loss.The current regulatory climate is uncertain and rapidly evolving, and future developments could adversely affect any particular market sector or investment strategy.

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