Monetary Policy2025-11-10
Bond ETF Duration Strategy Amid Fed Rate Cut Expectations
As the possibility of additional Fed rate cuts gains traction, interest in bond ETFs is rising. Investors need to understand the characteristics of duration-based bond ETFs such as TLT, IEF, and AGG, and establish an optimal strategy based on interest rate scenarios.
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As of November 2025, the Fed has maintained its benchmark rate at 4.5%, but recent easing of inflation and stabilization of the labor market have raised the possibility of further rate cuts. The bond market is pricing in approximately a 25% probability of a 25bp cut by the first half of 2025, which has significant implications for bond ETF investment strategy. Long-duration TLT can generate substantial capital gains when rates fall but comes with high volatility, intermediate-duration IEF pursues balanced returns with moderate duration, and the broad-market AGG is suited for investors who prioritize stability. Use the asset allocation calculator to simulate returns under various interest rate scenarios, and the rebalancing calculator to optimize your duration allocation.
Fed Rate Outlook and Bond Market Response
The Fed began its rate-cutting cycle in September 2024 and has since lowered rates to 4.5%. Recent economic data shows CPI inflation easing to 2.4%, approaching the Fed's 2% target. The unemployment rate stands at 3.8%, consistent with full employment, though monthly job gains have slowed to around 150,000. GDP growth is running at 2.1% annually, near potential, with limited overheating concerns. Taken together, Fed commentary has been cautious — Chair Powell has indicated that additional cuts will be data-dependent, while some officials have argued that rates are already sufficiently restrictive and favor holding. Markets currently price in roughly a 25% probability of one additional cut by June 2025, and about 10% for two cuts. In terms of bond market response, the 10-year Treasury yield has fallen to 4.2%, down 0.3 percentage points over the past three months, while the 30-year yield has declined to 4.5%, down 0.4 percentage points. The yield curve has normalized, with the 2s10s spread moving from inversion to +0.3 percentage points. TLT has gained approximately 5% over the past three months, already pricing in rate cut expectations, while IEF rose 3% and AGG gained 2%.
Duration Comparison: TLT vs. IEF vs. AGG
Bond ETFs differ significantly in their interest rate sensitivity depending on duration. TLT holds US Treasuries with maturities of 20 years or more and carries a duration of approximately 17 years. A 1% decline in rates produces roughly a 17% price gain, while a 1% rise produces roughly a 17% loss. Its current yield is approximately 4.5% and annualized volatility is around 18% — making it suitable for directional rate bets but subject to significant short-term swings. IEF holds intermediate-term Treasuries maturing in 7 to 10 years and has a duration of roughly 8 years. A 1% rate move translates to approximately an 8% price change in either direction. Current yield is around 4.2% and annualized volatility is roughly 10%, offering a moderate risk-return profile that makes it a strong candidate for a core bond position. AGG holds a blend of Treasuries, mortgage-backed securities, and investment-grade corporate bonds, with a duration of approximately 6 years. A 1% rate move results in roughly a 6% price change. Current yield is approximately 4.0%, annualized volatility is around 7%, and the expense ratio is just 0.03%, making it an excellent choice for a stable, broadly diversified bond portfolio. As a general rule for duration selection: when rate cuts are expected, TLT maximizes capital gain potential; when the rate direction is uncertain, IEF provides a balanced approach; and when stability is the priority, AGG minimizes volatility.
Bond ETF Return Projections by Rate Scenario
It is essential to simulate bond ETF returns under different interest rate environments. Scenario 1 — an additional 50bp rate cut: TLT is expected to deliver approximately 8.5% in capital gains (17-year duration × 0.5%) plus 4.5% in income, for a total annual return of roughly 13%. IEF would generate approximately 4.0% in capital gains (8-year duration × 0.5%) plus 4.2% in income, for an annual return of roughly 8%. AGG would produce approximately 3.0% in capital gains (6-year duration × 0.5%) plus 4.0% in income, for an annual return of roughly 7%. Scenario 2 — rates held steady: TLT would return roughly 4.5% from income alone, IEF roughly 4.2%, and AGG roughly 4.0%, with no capital gain component. Scenario 3 — an additional 50bp rate hike: TLT would suffer approximately 8.5% in capital losses (17-year duration × -0.5%), partially offset by 4.5% in income, for a net annual return of roughly -4%. IEF would see roughly 4.0% in capital losses offset by 4.2% in income, for an approximately breakeven outcome. AGG would incur roughly 3.0% in capital losses but retain 4.0% in income, for a net annual return of approximately +1%. Use the asset allocation calculator to assign probabilities to each scenario and compute expected returns in order to determine the optimal duration target.
Bond ETF Rebalancing Strategy
A strategy for adjusting bond ETF allocations in line with the interest rate cycle is essential. In the early stages of rate cutting, consider a mix of TLT 30%, IEF 40%, and AGG 30% to benefit from rate declines while avoiding excessive concentration. Use the rebalancing calculator to track monthly allocation drift and make adjustments when any position deviates by more than 5%. In the later stages of rate cutting, reduce TLT to 20% and increase AGG to 40% to lock in capital gains and shift toward greater stability. Rebalance back toward IEF-heavy positioning at the first signs of a rate rebound. During a rising rate environment, shift to AGG 50%, IEF 30%, and short-duration bonds or cash at 20% to shorten overall duration; reduce TLT to 10% or eliminate it entirely. For a balanced stock-bond portfolio, in a 60% equity / 40% fixed income structure, the bond component might be constructed as AGG 50%, IEF 30%, and TLT 20% to pursue a blend of stability and return. Set a quarterly rebalancing cadence and shift to monthly monitoring during periods of significant rate volatility. Use the asset allocation calculator to compute the portfolio's overall duration and ensure it remains within the target range.
Currency Hedging and Bond ETF Returns
Because bond ETF yields are relatively modest, currency movements can have a significant impact on total returns. With an unhedged strategy, exchange rate appreciation adds to bond returns — for example, a 10% gain from TLT combined with an 8% rise in the USD/KRW rate would produce an 18% total return. However, there is a risk that currency depreciation offsets bond income: even a 5% return from AGG could result in a -3% loss if the dollar falls 8%. Over a long investment horizon, currency rates tend to mean-revert, making an unhedged approach more cost-effective. With a currency-hedged strategy, exchange rate risk is eliminated and the investor captures only the pure bond return: a 5% return from AGG, net of approximately 1.5% in hedging costs, yields around 3.5% in stable, predictable income — making this approach better suited for short-term holdings. As a general recommendation: for AGG, hedge at least 70% of currency exposure, since stability is the primary objective and exchange rate noise should be minimized. For TLT, a 50% hedge is appropriate — capturing capital gain potential from rate cuts while cutting currency risk in half. For IEF, a 60% hedge strikes a reasonable balance between duration and currency risk for an intermediate-duration instrument. Use the rebalancing calculator to evaluate the cost-benefit of hedging and determine the optimal hedge ratio.
Conclusion
As expectations for Fed rate cuts build, bond ETF investors should revisit their duration strategy. TLT is well-suited for a directional rate-cut trade, IEF serves as a balanced core holding, and AGG is the right choice for a stable, diversified bond portfolio. Use the asset allocation calculator to simulate returns under various rate scenarios, and the rebalancing calculator to fine-tune duration weighting and currency hedge ratios.
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