The Era of Low r-Star and Its Implications for Fixed Income Strategy

The natural interest rate, or r-star, has long served as a silent architect of global financial markets. For decades, it trended downward, driven by demographic shifts, productivity stagnation, and a global savings glut. This era of low r-star created a unique environment for fixed income investors, where long-duration bonds and alternative income strategies thrived. But as the forces shaping r-star evolve, so too must the strategies that rely on its behavior.

The Decline of r-Star: A Structural Shift

From the 1970s to the 2010s, r-star in the U.S. averaged around 2.5%. By 2019, it had fallen to near-zero levels, a decline attributed to aging populations, slower productivity growth, and a global surplus of savings. As people live longer and retire earlier, households save more to fund extended retirement periods, reducing the equilibrium rate at which savings and investment balance. Meanwhile, international capital flows—driven by demographic trends in Asia and Europe—further depressed global r-star, creating a "secular stagnation" narrative.

However, the pandemic disrupted this trajectory. Fiscal stimulus packages, soaring public debt, and a surge in aggregate demand reversed the downward trend. By 2023, r-star estimates had risen to 2.28% (per the Richmond Fed's updated Lubik-Matthes model), with some market-based indicators suggesting a structural shift to 4.5%. This reversal reflects a new equilibrium where fiscal policy and global rebalancing of savings and investment now dominate over demographic headwinds.

Yield Dynamics in a Shifting r-Star Environment

The relationship between r-star and bond yields is direct: as r-star rises, so do long-term yields. This is evident in the U.S. 30-year Treasury yield, which climbed above 5% in 2025—the highest since 2007. For long-duration bonds, this means higher coupon income but also heightened sensitivity to rate volatility. Investors who once relied on the stability of low-yield environments now face a paradox: while yields are attractive, the path to achieving them is fraught with uncertainty.

The challenge lies in timing. A rising r-star implies that central banks may need to maintain higher rates for longer to anchor inflation. This creates a "higher for longer" scenario where long-duration bonds, despite their yield appeal, carry significant duration risk. For example, a 30-year bond with a 5% coupon could lose 20% of its value if rates rise by just 100 basis points.

The Case for Long-Duration and Alternative Strategies

Despite these risks, long-duration bonds remain compelling in a higher r-star world. Historically, they have outperformed short-duration alternatives during periods of inflation and rising rates, as their higher coupons offset capital losses. Moreover, the current yield environment offers a buffer: a 5% yield on a 30-year bond provides a cushion against moderate rate hikes.

However, the era of low r-star has also left a legacy. Investors must now balance the allure of long-duration yields with the need for risk mitigation. This is where alternative income strategies shine.

1. Short-Duration Bonds: In an inverted yield curve environment, short-duration bonds offer liquidity and reduced interest rate risk. They are particularly effective when central banks signal rate cuts, as seen in the second half of 2025.
2. Credit-Driven Alternatives: Investment-grade corporate bonds, securitized assets, and municipal bonds provide higher yields than Treasuries while diversifying risk. For instance, the Bloomberg U.S. Aggregate Bond Index has outperformed cash by 2.5% annually since 2023.
3. Diversified Portfolios: A mix of durations and credit qualities can hedge against macroeconomic shifts. Portfolios with 60% short-duration, 30% intermediate, and 10% long-duration bonds have historically navigated rate volatility better than those concentrated in a single segment.

Strategic Recommendations for Investors

1. Rebalance Duration Exposure: Given the uncertainty around r-star's trajectory, investors should maintain average durations at or below benchmark levels. For example, a portfolio with a duration of 6 years (vs. the 10-year benchmark) can capture yield without excessive rate risk.
2. Prioritize Credit Quality: As fiscal deficits and inflationary pressures persist, high-grade bonds offer a safer yield. Avoid speculative-grade debt unless compensated with a risk premium of 400+ basis points.
3. Leverage Alternatives: Consider non-traditional income sources like private credit, infrastructure debt, or dividend-paying equities. These assets can provide stable cash flows while diversifying interest rate risk.

Conclusion

The era of low r-star is not over—it has simply transformed. While demographic trends still exert downward pressure, fiscal expansion and global rebalancing have pushed r-star higher. For fixed income investors, this duality demands a nuanced approach. Long-duration bonds remain a cornerstone of yield generation, but their risks must be tempered with alternatives and strategic duration management. As central banks navigate this new equilibrium, adaptability will be the key to capturing income without sacrificing stability.