On October 29, 2025, both the Bank of Canada (BoC) and the US Federal Reserve (Fed) implemented policy rate cuts of 0.25%. This decision in Canada was primarily driven by continued fallout from US tariffs and subsequent reduction in economic growth projections. The decision in the US was driven by their dual-mandate for labour market stability (which has softened) and inflation (tilted to the upside in the near-term). With rates now expected to be near the end of the cutting cycle in Canada (pending future economic and inflation data), and to continue declining in the US into 2026, it’s important for bond investors to understand how their investment portfolios could be impacted.

How declining interest rates impact fixed income (bonds) 

Bonds play a crucial role in diversified investment portfolios, providing stability and income. In a declining interest rate environment, investors face both challenges and opportunities. When central banks lower overnight rates, it can create a favourable environment for existing bond investments, as shorter-term bond prices tend to rise. For investors looking at new bond investments, different time horizons have different interest rates or yield to maturities as represented in the the yield curve (see Canadian government yield curve chart below). The yield curve is an important factor to consider as it guides your investment time horizon and investment return on your bonds. 

What are overnight rates?

At its core, the central bank rate, often referred to as the overnight lending rate, serves as a foundational element of the economy. Central bank actions directly impact the cost of borrowing for governments and corporations, thereby affecting bond yields. The BoC sets a specific target for the overnight rate, while the US Fed uses a target range for the federal funds rate. The visual below incorporates the recent October 2025 rate cuts, in which the BoC and US Fed both cut by 25 basis points. 

How overnight rates impact Canadian bond yields

The Canadian government yield curve is heavily influenced by the BoC’s policy rate. Since early 2025, yields on Canadian government bonds, especially those maturing within one year, have fallen faster than medium- to longer-term bonds which causes the yield curve to steepen. It is important to note that while central bank decisions primarily affect short-term yields, other factors can significantly impact medium- to longer-term government bond yields. These factors include, but are not limited to: economic growth, labour market conditions, inflation expectations, investor sentiment and even geopolitical risk events (such as US tariff trade disruptions). In other words, a central bank rate cut does not uniformly impact all maturities across the yield curve in the same way.

The relationship between rates and bond portfolios

A fundamental principle of bond investing is the inverse relationship between interest rates and bond prices. Generally speaking, this means:

• When interest rates rise, existing bond prices fall. 
  • Why? Newly issued bonds can offer higher coupon rates (the fixed annual interest rate paid by a bond issuer to bondholders), making existing bonds with lower coupons less attractive. To compete, the price of existing bonds must drop to offer a comparable yield to maturity with new bonds.
    
    
• When interest rates fall, existing bond prices rise. 
  • Why? Existing bonds with higher coupon rates become more attractive than new bonds issued at lower rates. Investors are willing to pay a premium for these higher-yielding existing bonds.