With interest rates falling, which bonds should you buy?

The past five years have been a roller coaster for bond investors. First, interest rates were cut to near zero during the early days of the pandemic—only to then rapidly rise above 5% to combat the highest inflation in a generation.

Now, with inflation waning and the U.S. central bank starting to cut interest rates to shore up a halting economy, fixed-income experts say it is a good time for investors to reassess their bond portfolios. As interest rates fall, bond prices increase, and vice versa.

“It’s so easy to sit in cash and money-market funds when they yield 5%, but that’s going away,” says Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments. “Investors should think not just about bonds from an income standpoint, but as a diversifier and as an important portfolio ingredient.”

Some investors, however, are probably still skittish from the bond market’s poor performance in 2022 when the Federal Reserve began its aggressive rate increases. The S&P 500 notched a return of minus 18% that year, and bonds failed to hedge portfolios against stock losses as they typically do, with the Bloomberg U.S. Aggregate Bond Index returning minus 13%.

The aggregate bond index, which tracks investment-grade issues, has done much better since then—up about 4.5% so far this year after notching a 5.5% positive return in 2023.

So, which bonds should investors be looking at now? Here are four to consider:

Treasurys

Treasury yields moved lower—and prices higher—in the months ahead of the Fed’s rate-cut announcement on Sept. 18, which brought the benchmark federal-funds rate to a range between 4.75% and 5%.

But, the experts say, there is still room for prices to go higher, since the Fed is expected to continue cutting rates over the coming year. Tannuzzo favors Treasury notes that mature in five or 10 years, because they are most likely to rise in price as interest rates go lower.

He is more cautious about longer-term bonds, notably 30-year Treasurys, because he is worried there could be a glut of Treasury-bond supply coming if there is a big tax cut or infrastructure package under the next president. Extra supply could pull down prices, and longer-term bonds are more sensitive to changes in government spending, interest rates and inflation than shorter-term securities.

Thirty-year Treasurys recently yielded 4.08%, some 0.35 percentage point above the benchmark 10-year note’s recent yield of 3.74%.

The Fed’s moves notwithstanding, Treasurys also could work as a portfolio hedge against an economic slowdown or global geopolitical tumult. Treasurys are less volatile than stocks and other types of higher-yielding bonds, often serving as a haven when investors seek more stability due to a weakening economy, geopolitical unrest or some other shock to the markets.

“You could argue that [the 10-year Treasury note] looks cheap,” says Priya Misra, a portfolio manager at J.P. Morgan Asset Management. “If we’re heading into a recession, the 10-year is going below 3%.”

Corporate bonds

Investment-grade corporate bonds look attractive on a number of fronts: They offer solid yields and have low default rates that shouldn’t spike even amid concerns about a weakening economy, and prices should continue to appreciate as the Fed cuts short-term rates. Market pros favor issues with maturities of three to 10 years as a good place to capitalize on these dynamics.

Anders Persson, chief investment officer and head of global fixed income at Nuveen, likes triple-B corporate credits, at the lower end of the investment-grade ladder. He says many companies in that category can withstand an economic downturn. Only two investment-grade companies defaulted last year, according to S&P Global, and there have been none so far in 2024.

“Companies have been preparing for an economic slowdown,” Persson says, adding that he isn’t expecting a big uptick in defaults. “So going down to that triple-B part of investment-grade space makes sense at this point.”

David Rogal, a portfolio manager in the fundamental fixed-income group at BlackRock, agrees that the corporate sector is in good shape, though he figures that “a lot of good news is in the price” of those bonds. In other words, they look expensive to him.

As of Sept. 23, for example, triple-B bonds traded at about 1.1 percentage points above Treasurys, down from 1.41 a year ago, according to Nuveen. So investors aren’t getting as much extra yield as they did 12 months ago for the risk of holding corporate bonds.

Still, Rogal says, “the fundamentals in investment-grade [bonds] are very strong.”

High-yield bonds

Market pros also say there are opportunities in high-yield, or junk, bonds issued by companies with non-investment-grade credit ratings. They have performed well recently, with the ICE BofA US High Yield Index climbing nearly 8% this year through Sept. 20 after a 13% gain last year.

This part of the market also seems resilient. S&P Global is projecting a trailing 12-month junk-bond default rate of 3.75% in June of 2025, down from an actual rate of 4.6% in June, citing solid corporate earnings and consumer spending, among other reasons.

J.P. Morgan’s Misra says she believes the high-yield market is bifurcated in terms of opportunities. She prefers higher-rated double-B or single-B bonds—not distressed bonds with even lower ratings. There are plenty of companies with strong earnings and balance sheets that could get upgraded to investment grade, she says.

Nuveen’s Persson has a similar view, preferring higher-rated junk bonds. He doesn’t see as many opportunities in lower-rated high-yield bonds such as triple-C’s, which “are going to be more exposed as the economy slows down.”“Given that the corporate credit fundamentals are holding up, we’re comfortable playing double-B’s and the better quality single-B’s” in high yield, he says.

One strategy he likes involves cutting some exposure to floating-rate bonds, which reset regularly based on prevailing interest rates, and moving to higher-quality high-yield issues. Holders of floating-rate bonds face reinvestment risk in a falling rate environment, specifically lower yields.

Municipals

Although it is hard to predict the impact of the presidential election’s winner on different parts of the bond market, munis stand to benefit under certain scenarios.

Dan Close, head of municipals at Nuveen, offers an example of the top marginal federal tax rate going to 39.6% from 37% currently if the former President Donald Trump’s Tax Cut and Jobs Act is allowed to expire at the end of 2025.

Given that municipal-bond interest is exempt from federal taxes, Close says that “for any individual who is paying taxes, the exemption is worth more” if marginal tax rates increase.

He uses an example of a muni yielding 5%, which has a tax-equivalent yield of 7.9% under the 37% marginal rate. If the tax reverts to 39.6%, the tax-equivalent yield would be even higher at around 8.25%.

“That higher tax bracket makes the muni exemption that much more worthwhile,” says Close.

Close sees better opportunities in longer-term munis, where “you’re getting paid to take that risk,” he says.

The benchmark for a 14-year muni bond with a triple-A rating yields 2.85%, compared with 2.3% for a two-year triple-A issue, according to FactSet.

Lawrence Strauss is a writer in Millburn, N.J. He can be reached at reports@wsj.com.