Bond funds sector review – is there a change of stance from the Federal Reserve?

The US Federal Reserve (Fed) is set to start buying bonds again. The US and UK find themselves in similar scenarios of conflicting data whereas in Europe the path looks clearer. And there’s a wave of fresh economic data.

We look at what this means for bond markets as investors consider central banks’ next moves.

This article isn’t personal advice. If you’re not sure whether an investment is right for you, ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest. Yields are variable and not a reliable indicator of future income. Past performance also isn’t a guide to the future.

The US

The Fed is set to end quantitative tightening next year as they look to start buying US Treasuries again. The Fed have been reducing their balance sheet by letting bonds they own mature but not buying more bonds with the proceeds.

It’s expected that they’ll begin to use money from maturing bonds to buy more treasuries to stop their balance sheet from shrinking further in early 2026. The Fed coming back to the market as a buyer increases demand for US Treasuries and should help keep prices higher.

This in turn should keep yields lower than they otherwise would have been. Note though that the extent of the buying is expected to be lower than during periods of full quantitative easing, where the Fed was buying a much larger amount of US Treasuries.

This change in stance sets the US apart from the UK and Europe, with the Bank of England (BoE) and European Central Bank (ECB) still shrinking their balance sheets and neither are buying any bonds at the moment.

Inflation and interest rate expectations continue to dominate moves in bond market yields. Long-term inflation expectations in the US are still mixed. Inflation’s already back on the rise and reached 3% in September extending the current upwards trend. At the same time, the jobs market is potentially slowing, which isn’t good for the economy.

The Fed expects inflation to remain elevated over the next 12 months, and therefore faces a balancing act of trying to stimulate the economy and the jobs market, while keeping a reign on inflation.

The Fed cut interest rates by another 0.25% in October to 4%. This is just the second cut this year. Expectations were that there would be two cuts in the final quarter of 2025 one in October and another in December.

However, the Fed have come out more hawkish than many investors had been expecting, highlighting that a December cut was not a ‘forgone conclusion’.

This caused the 10-year Treasury yield, which briefly fell below 4% for the first time since ‘liberation day’ in April, to rise again. The overall trend for Treasury yields though is still downwards as the market expects the Fed to continue cutting interest rates in 2026.

The UK

Whilst the yield in the US has mostly been on a downward trend for the last 12 months, the UK has been more volatile. However, since the start of October there was a sharp decline in the 10-year gilt yield as we approached the budget, before spiking back up due to a U-turn on income tax changes.

UK unemployment jumped to 5% at the end of September – this is a red flag for the BoE. With the labour market showing weakness the expectations are that the BoE will have to cut interest rates to try and stimulate the economy. This has also helped lower yields more recently. But inflation remains sticky at 3.6% as at the end of October and it’s set to be the highest among the G7 by the end of the year.

The BoE find themselves in a similar predicament to the US of trying to balance a slowing labour market whilst keeping inflation in check.

Bond yields will also be reacting to the UK budget as the government attempts to lower the fiscal deficit. It is estimated that the current UK deficit is close to £30bn.

When governments run a large deficit their bond yields are typically higher due to the increased risk that the government won’t be able to repay all their debts.

Rachel Reeves has pledged to try and lower the deficit – boosting investor confidence that a more financially responsible approach to the UK deficit will lower the risk of the government getting into trouble later down the line. This has helped push gilt yields lower.

Europe

In Europe, government bond yields have been relatively stable compared to the UK and US.

The biggest reason for this is that inflation seems to be tamed. Inflation in October was 2.1%, marginally above the ECB 2% target. This means that the ECB have been able to hold interest rates at 2.15% since June this year. The ECB have suggested that they’re at or very near the end of the rate cutting cycle.

The labour market has also remained in relatively good shape. The current job vacancy rate for Q2 of 2025 was just 2.2%, the lowest it has been since the beginning of 2021. It peaked at 3.3% in Q2 of 2022.

With inflation hovering around the ECB’s target and the job market’s showing resilience, the ECB has no obvious reason to change rates anytime soon. Bond yields have therefore remained relatively stable.

What could change this is of course global politics and trade tensions. With US President Donald Trump constantly targeting European imports with tariffs. The more pressure Trump puts on Europe the more volatile bond yields could be.

How have bonds performed over the last 12 months?

Performance has been different for different parts of the bond market over the last 12 months.

Higher-risk bonds within the high yield category have provided the highest returns, while UK government bonds have provided the lowest. This is largely because of the yields those bonds offer.

Companies with a higher risk of defaulting on their bond payments have to offer higher returns to investors to take that risk, especially compared to the UK government.

While returns varied within the different sectors, corporate bonds have tended to provide the highest returns. UK government bonds have also given investors positive returns, but to a lesser extent over the last 12 months.

The table above highlights how different the returns can be from different parts of the bond market.

The IA £ Strategic Bond sector returns have been consistently in the middle of the range over time, as you’d expect given funds in that sector can invest in all types of bonds.

This highlights the potential benefits of investing in those indices. While the overall returns might not have been the highest available, the journey hasn’t been as bumpy.

How have our fixed income Wealth Shortlist funds performed?

Our Wealth Shortlist bond funds have delivered mixed performance over the past year. Some have outperformed their peer group, while others have underperformed.

We wouldn’t expect them all to perform the same though. If all your funds in a sector are performing well at the same time, they're probably investing in similar areas.

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a long-term diversified portfolio.

For more details on each fund and its risks including charges, see the links to their factsheets and key investor information below.

Artemis High Income

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