Government bonds may not get as much attention as stocks, but they are a critical part of the financial system.

Last year, U.S. Treasuries — like stocks and other investments — were hard hit as the Federal Reserve jacked up interest rates to fight high inflation.

The Bloomberg Barclays U.S. Aggregate Bond Index, a benchmark that is kind of like the S&P 500 for bonds, fell by roughly 15% — its steepest drop since 1976, when it was created.

This year, stocks have staged an impressive recovery — the Nasdaq is up more than 30% so far. But the bond market has barely rebounded.

That's largely because investors are betting inflation will remain above the Fed's target for a while, which means policymakers will have to keep interest rates high.

Weaker bond markets have all kinds of implications for the economy — and for consumers and businesses.

Here are three key ones.

Borrowing costs will stay expensive

When bond prices decline, their yields rise — and yields influence all kinds of interest rates.

"Credit card rates are going to stay elevated, too," says Stephen Juneau, a senior U.S. economist at Bank of America. "Mortgage rates are going to stay elevated. Auto loan rates are going to stay elevated. And all of that starts to eat into your consumption spending ability, because so much of your money is going to servicing those debt payments."

In other words, borrowers end up paying more in interest. That could lead to a broader slowdown in the economy, and potentially, to more delinquencies and defaults.

Businesses are also feeling the pressure. As their debt gets more expensive to service, they may shy away from hiring and investments.

"Higher interest rates are slowing down economic activity from households, but also business spending and investment decisions," says Carl Riccadonna, the chief U.S. economist at BNP Paribas. "As we look at things like surveys of small business sentiment, economic sentiment, and business conditions, they are facing some difficulty accessing credit."

The government is going to have to pay more

Governments issue bonds to raise money, and right now, the United States needs to borrow extensively for a variety of reasons.

This quarter, the U.S. Treasury Department says it plans to borrow more than $1 trillion — over $250 billion more than it forecasted a few months ago.

Given the state of bond markets, the government needs to pay higher interest rates to investors.

That means things can get very expensive very quickly, widening the country's budget deficit.

Fitch Ratings singled out the cost of higher interest as a factor when it downgraded the U.S.'s long-term credit rating last week.

Fitch says it expects the U.S. deficit "to rise to 6.3% of GDP in 2023, from 3.7% in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden."

As that burden gets bigger and bigger, the U.S. government is going to have to issue more debt to pay that interest. This is a cycle that is tough to break.

Investors and economists have questioned the timing of Fitch's downgrade, but they acknowledge it highlighted some real problems — including the growing debt pile, and the country's inability to tackle its worsening finances.

"I'm not sure how you can look at the fiscal picture in the United States, or the political dysfunction, and think that this country is close to having its fiscal house in order," says Jon Lieber, who heads the U.S. practice at Eurasia Group, a political risk consultancy.

Higher yields make life difficult for banks

The spike in yields and the decline in bond prices also impacts another critical part of the financial system: banks.

Lenders are traditionally big buyers of government bonds, so when the value of those investments decline, it can spell trouble.

In March, Silicon Valley Bank collapsed when investors started to worry about that lender's bond portfolios. Fears about its balance sheet sparked a bank run, creating intense volatility in markets.

Almost six months later, the worst of that turbulence in the U.S. banking sector is behind us, Riccadonna says. But how firms manage their bond holdings in this interest rate environment is a "persistent problem," he notes.

This week, another credit rating agency, Moody's, downgraded 10 regional banks, including Buffalo-based M&T Bank and St. Louis-based Commerce Bank. It also put several other lenders on notice, citing the size of their bond holdings.

Rising rates have also introduced more competition among banks, as customers demand higher returns on their deposits.

That means not only are banks seeing their bond holdings decline in value, they're also having to pay more interest to depositors, which also hurts the bottom line.

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