Quarterly Market & Performance

The second quarter of 2025 was marked by significant interest rate volatility, with yields swinging sharply as shifting economic data, sticky inflation readings, and new tariff policy announcements all added uncertainty to the growth and inflation outlook.

Amidst this backdrop, the Federal Reserve held the federal funds rate steady at 4.5%, maintaining its data-dependent stance as inflation remains above its 2% target. Markets continue to price in two rate cuts before year-end, consistent with expectations from the start of the year, though the path remains clouded by sticky inflation and policy uncertainty.

The latest core CPI reading came in at 2.8%, indicating that the pace of deceleration has slowed notably following its initial pullback after the COVID-driven inflation spike[1]. Meanwhile, tariff policy remains a wildcard for the Fed and bond investors to consider. New or expanded tariffs act as indirect taxes on American consumers by raising the cost of imported goods, which could potentially reaccelerate inflation, particularly in globally integrated core goods categories.

Looking ahead, markets are beginning to consider Fed Chair Jerome Powell’s potential replacement when his term ends in 2026. The current administration has signaled its preference for a dovish successor, potentially setting the stage for lower short-term rates in the years ahead. If Fed policy shifts away from a data-driven approach under new leadership, the risk of economic overheating could push long-term yields even higher than they are today, resulting in a steeper yield curve.

Despite a volatile quarter for interest rates, yields ended the quarter near where they began and bonds ultimately delivered solid returns for investors. The Bloomberg Aggregate Bond Index returned 1.2% in the quarter, bringing its year-to-date gain to 4.0%, with an index yield of 4.5% at quarter-end[2]. Returns reflected both income generation and price appreciation from declining yields – most notably on shorter maturities.

The Return of Real Returns

Real rates represent the yield investors earn after accounting for expected inflation, reflecting the true increase in purchasing power over time. For example, if a bond yields 4.5% and market-implied inflation expectations are 2.0%, the real yield is 2.5%. Sizable real yields have been rare in the decade and a half following the 2008 Global Financial Crisis, when real yields frequently hovered near zero or were negative due to aggressive monetary stimulus and persistently low inflation expectations.

In May, the 30-year Treasury real yield peaked at 2.75% – its highest level since before the Global Financial Crisis[3]. This structural shift offers bond investors a rare opportunity to generate returns that significantly outpace inflation, a meaningful change from the low real yield environment of the past decade.

Figure 1: 30-Year Treasury Real Yield Over Time

Source: Bloomberg

Several structural, economic, fiscal, and policy factors are driving today’s elevated real yields:

· Growth Expectations: Innovations in AI and technology are boosting productivity growth expectations, supporting higher equilibrium real yields by lifting potential output.

· Fiscal Deterioration: Concerns over the US government's credit quality and rising Treasury issuance have contributed to higher term premiums. In May, Moody’s downgraded the US from its last remaining AAA rating to Aa1, reflecting fiscal challenges that pose a headwind to maintaining low borrowing costs and supporting higher yields for long-dated Treasuries.

· Global Central Bank Policy: After years of aggressive monetary stimulus, central banks are maintaining tighter policy stances, removing the yield suppression effects of post-GFC quantitative easing and supporting higher real rates.

· Foreign Demand Headwinds: Deglobalization and rising tariffs are dampening foreign demand for US Treasuries as countries shift capital flows inward and diversify currency reserves elsewhere, contributing to higher real yields.

Taking a long-term view, these developments are a net positive for bond investors. Higher real yields enable investors to build true wealth after inflation and taxes, without requiring the equity-like risk taking that has been necessary in the past decade of suppressed yields. With valuations elevated across equities and private markets, the ability to earn a meaningful real return in high-quality bonds represents a bright spot in building diversified, resilient portfolios.

At Kovitz, we are positioning portfolios to take advantage of these favorable developments by:

· Selectively extending duration to capture attractive term premiums in a steepening yield curve environment.

· Maintaining high credit quality while credit spreads remain compressed. This allows us to extract these elevated absolute yields while avoiding taking increased risk that we are not adequately compensated for.

· Enhancing after-tax returns through allocations to municipal bonds, which are attractive on a tax-equivalent basis for high-bracket clients, further improving real wealth creation without a commensurate increase in risk.

Conclusion

Today’s interest rates create opportunities to preserve and grow wealth in ways not seen since before the Global Financial Crisis. Elevated real yields provide a rare chance to earn meaningful returns above inflation without relying solely on equity markets or taking undue risk.  At the same time, ongoing policy uncertainty, shifting Fed leadership, and structural changes in inflation and growth trends underscore the importance of remaining disciplined and flexible.

We believe an approach focused on high-quality credit, selective duration extension, and after-tax efficiency remains the best path for navigating market uncertainty and capturing the opportunities available in today’s bond market. We are committed to aligning our strategies with client goals while managing risk thoughtfully as market conditions change.

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[1] US CPI Urban Consumers Less Food & Energy Year-over-Year, May 2025.

[2] Bloomberg US Aggregate Bond Index. Yield measured as yield-to-worst.

[3] Federal Reserve, Constant Maturity 30-Year Real Yield Curve Rate. This rate reflects market yields on 30-year Treasury Inflation-Protected Securities (TIPS) and represents the real yield investors earn after accounting for expected inflation.

DISCLOSURES

Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. The information and opinions expressed in this publication are not intended to constitute a recommendation to buy or sell any security or to offer advisory services by Kovitz. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to participate in any trading strategy, and should not be relied on for accounting, tax, or legal advice. This report should only be considered as a tool in any investment decision matrix and should not be used by itself to make investment decisions.

Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.