U.S. Treasuries: Balancing strong income and diversification opportunities with fiscal risks

The U.S. Treasury market continues to reflect the interplay of Federal Reserve (Fed) policy expectations, inflation and growth trends, bond supply expectations and policy uncertainty. “Treasuries offer an important source of reliable income, while continuing to represent a key ingredient in diversified portfolios,” says Bill Merz, head of capital markets research with U.S. Bank Asset Management Group. Treasury yields sufficiently compensate for Fed policy expectations, inflation, and recent bond issuance trends. However, there is risk that investors may demand additional compensation via higher yields in response to ongoing deficit spending and its translation to higher bond issuance and supply.

For now, valuation considerations don’t outweigh long-run benefits of Treasuries in diversified portfolios

10-year U.S. Treasury yields in the 4-5% range contribute to higher consumer and business borrowing costs and a sluggish housing market. Investors can take advantage of these Treasury yields, which provide a strong basis for high quality, steady income, and portfolio diversification. Treasuries still pose risks to their owners. The recent downgrade of U.S. debt by Moody’s, a rating agency, highlighted a common investor concern - that elevated deficit spending is unsustainable and eventually may influence bond yields. “We do not see strong evidence of the U.S. fiscal situation heavily influencing bond yields yet, but we must monitor government, economic and market data for signs of change,” says Merz.

“Our proprietary fair value model indicates current Treasury prices fairly compensate investors for risks, including Fed policy expectations, inflation and growth considerations, bond supply dynamics and the portfolio diversification benefits of Treasuries.” Fed policy rate expectations comprise three-quarters of the fair value yield and represent the most important driver of long-term Treasury yields over time. Other primary factors exerting influence over Treasury yields include inflation, supply of new bond issuance (which funds deficit spending), diversification qualities versus stocks, among other unique factors.

Treasury bond supply dynamics and the relationship with fiscal policy

Deficit spending ¹ in the United States, which necessitates additional Treasury issuance over time, held steady near 2-4% of GDP for most periods between 1975 and the 2008 financial crisis. Notably, efforts in 1993 via higher taxes and in 1997 by way of bipartisan balanced budget legislation contributed to budget surpluses for a brief time. However, the long run pattern of deficit spending built up debt levels over the years, which jumped after the Great Financial Crisis (GFC) of 2008, and again post-Covid, as U.S. pandemic-related fiscal stimulus spending in the U.S. far exceeded tax revenues. Deficits are in the spotlight once again as budget watchdogs forecast deficit spending as a percentage of GDP will grow. “Current deficit spending of 7% of GDP already represents higher levels than any period in U.S. history besides post-GFC responses and the post-Covid period,” according to Merz.

Figure 1. U.S. deficit spending as a percent of GDP

Congressional debate around new tax and spending legislation represents additional uncertainty, with some concerned plans may exacerbate fiscal imbalances. The Congressional Budget Office (CBO) projects deficit spending will continue to grow but will issue updated guidance once more details of new legislation emerge.

Treasury bond supply dynamics and the relationship with fiscal policy

Investor demand for Treasuries has not meaningfully shifted, despite many headlines on the topic. Foreign holders continue to represent an important share of new issuance demand. “We note a slight downshift in domestic demand though Treasury auction results are near-normal,” says Merz. “Occasionally, a weak auction will send bond yields somewhat higher, but the tendency has been for yields to normalize in the days that follow.” Furthermore, potential regulatory changes could unlock additional capacity for financial institutions to hold more Treasuries. While these factors could change, and investor sentiment can be volatile, there appears to be foundational support for the Treasury market currently.

Moody’s, a rating agency, recently downgraded U.S. debt from the highest rating possible, citing debt levels and deficit spending. While this captured headlines, it had only minor impacts on capital markets. Standard & Poor’s downgraded U.S. debt in 2011 and Fitch followed suit in 2023, both with minimal market impact. “We have observed many media accounts over recent weeks attributing the rise in bond yields to fiscal concerns,” Merz notes. “However, sovereign bond yields across the developed world have risen, often more than U.S. yields.” It appears the optimism some investors had that the new administration would trim deficit spending was overly ambitious. However, it is difficult to attribute the rise in yields to new legislation alone.

Figure 2. Change in 10-year sovereign bond yields

Foreign demand for U.S. Treasuries has also captured headlines, with some concern foreign investors could “go on strike”, forgoing U.S. Treasury purchases and potentially spiking Treasury yields. “There is yet no evidence in the yield data,” says Merz, “but we note foreign buyers have in fact increased holdings more than domestic buyers since the November presidential election through March 31, 2025, the most recent data available.”

Figure 3. Treasury ownership breakdown

Figure 4. Treasury ownership and recent changes

Recent Treasury auctions indicate reasonable overall demand, albeit slightly weaker than long-run averages. Intermediate-term bonds evidence normal auction demand with respect to incremental yield of auction prices versus the prior day’s closing levels (referred to as auction “tails”), and a historically normal number of bids relative to the bonds offered (referred to as “bid-to-cover” ratios). Longer-term bond auctions are slightly weaker but still orderly, with higher tails in recent years but normal bid-to-cover ratios. Auctions, like other market data such as bid/ask spreads (the difference between a seller’s “ask” price and a buyer’s “bid” price) indicates normal functioning of the bond market.

Strategic implications

We continue to view U.S. Treasuries as an important holding for many diversified portfolios. The market has, to date, adapted to higher issuance by way of broader participation and potential regulatory support. Treasuries offer an important source of diversification, income and liquidity. We remain vigilant in our monitoring of risk factors such as new legislation, ongoing deficit spending and investors’ response.