Bonds just finished a very challenging quarter. The Bloomberg US Aggregate Bond Index, the main benchmark for US fixed income, was down roughly 3.33% for the quarter, marking the lowest performing three months since the third quarter of 2022. The yield on the all-important 10-year US Treasury reached 5.29% at the end of September, its highest level since June 2007. In this piece we’ll cover some basics about the bond market, what’s driving yields higher, and why bonds still deserve a place in a diversified portfolio.
What is the Bond Market?
Bonds don’t get nearly the attention of their flashy capital market cousin, the equity market, but it’s bonds that really power the global economy. When something needs to be built, such as a school, factory, airport, or housing development, the bond market is often used to raise funds for the project. Any time you take out a loan, from a mortgage to a credit card, you’re interacting with the bond market. Bonds are a key touchstone in the economy; it’s where finance interacts with the real world and our daily lives.
Bond investors tend to be a skeptical bunch. Before investing, they worry about what can go wrong and what recourse they have if the worst case occurs. Equity investors are the opposite. They think about what can go right, dream a little, and weigh the odds of the best case before putting money to work. This difference makes sense. When an equity investment goes well, the upside can be huge. With a bond, most of the return comes from the income, so bond investors focus on making sure the bond pays as promised.
Functionally, a bond is just a tradable loan, something that can be bought and sold similar to a stock. The owner of a bond receives interest payments (the coupon) over the life of the bond and gets the principal back at the end of the loan (maturity). An investor can collect that income for years or days before selling to another investor or hold to maturity and receive income and the principal. An equity, by contrast, is a claim on a firm’s future income. The firm may pay part of that income to investors as a dividend or reinvest in the business with the hope of growing income in the future. These are two different ways to invest: bonds are for income and stability, while equities are for growth.
Why are Rates Rising Now?
Part of the story for bond performance in 2026 comes down to changing expectations. The year began with investors expecting a gentle slowdown in US economic growth and easing inflation. It was thought this scenario would allow the Federal Reserve to lower its benchmark rate for very short-term loans (the overnight rate) by about 0.75%, or three 0.25% cuts. Lower rates mean higher bond prices, all else being equal. There are scenarios where this relationship does not hold, but that was the market’s expectation ten months ago.
The expected path for interest rates hasn’t materialized; in fact, the exact opposite happened. The US economy is performing well, despite poor consumer sentiment, and inflation is seemingly stuck above 3%. Instead of three rate cuts, investors now expect three rate hikes between now and the end of 2027, on top of the hike a more assertive Federal Reserve delivered at its last meeting. When rate expectations move higher, bond prices generally fall. While this is the textbook answer and true today, it is not always the case. Market forces set interest rates for longer-term bonds in ways that can be complex and counterintuitive.
What’s Pushing Yields Higher?
Bond investors worry about a lot of things. With the rapid rise in rates over the past month, a few catalysts are being floated in the financial press. Some make sense. Others are fear mongering.
There isn’t one key reason interest rates are moving higher; it’s more a collection of reasons. The most prominent near-term factor is energy costs. With the ongoing Iran War, bond investors are concerned about the price of oil feeding through to inflation. We know from the pricing of various inflation instruments that this concern isn’t wildly unanchored. The market still believes the Federal Reserve will get inflation back to 2% over time. The uncertainty is more about when, and in the short term, that depends heavily on the price of energy. You can see this concern in the daily gyration of oil prices: positive stories about an end to hostilities in the Middle East push bond yields down, and vice versa.
Another explanation making the rounds is that foreign central banks are actively selling Treasuries, which would push up yields. This is a consistent storyline in some of the more marginal corners of financial media and it doesn’t stand up to the data. It’s true that foreign central banks are buying a declining share of new US debt, but the overall level of Treasuries they hold has remained steady. What’s noteworthy is as the US Treasury has issued more debt to fund the growing deficit, “normal” investors like you and me, along with hedge funds and banks, have stepped up to absorb the additional supply. This group is more sensitive to earning a positive return on their holdings than a foreign central bank buying Treasuries for its capital reserves. A more price-sensitive buyer is one reason day-to-day swings in yields have increased.
The most compelling reason for higher rates, in our view, is simple supply and demand. We all learned in Econ 101 that where supply and demand meet, we find the price. Interest rates are the price of money for a defined period. Supply in this case is savings from investors, both large and small. The supply of savings is tough to measure in real time, but the evidence suggests there hasn’t been a significant change at the aggregate level.
Demand for savings is clearly moving higher. After decades of sluggish economic growth and deferred investment, the world is suddenly awash in the need for capital. The poster child of this demand is AI. The Wall Street Journal recently ran an article suggesting the AI buildout is on track to become the biggest economic bet in US history. At the same time, the US is reinventing supply chains for everything from steel to rare earth minerals, adjusting to an energy shock, and ramping up defense production. All of this is happening while the Federal budget deficit sits at 6% of GDP, which serves as yet another source of demand for capital.
If the supply of savings hasn’t moved but the demand for savings has increased, we should expect higher interest rates, and that’s exactly what we’re seeing. Interest rates are higher, in part, for good economic reasons. Borrowing from the bond market is how firms turn savings into capital investment, and new investment helps them grow earnings and increase the value of their stock. Higher interest rates partly reflect savings being put to productive use.
The Outlook for Bonds is Better Than You Think
A 10-year US Treasury is a compelling investment at a 5.2% yield. Many investors are worried about how much higher rates can go, on which we won’t speculate. Instead, we’ll focus on what is on offer today.
Say you buy a 10-year Treasury with a 5.2% yield. Here’s the total return you could expect over the next year for a given change in interest rates:
| Scenario | Total return |
| Rates rise to 6.2% | −1.5% |
| Rates unchanged at 5.2% | +5.2% |
| Rates fall to 4.2% | +12.7% |
Hypothetical illustration only; not a prediction of future results. Figures assume the purchase of a 4.625% Treasury with an 8/15/36 maturity, a one-time parallel move in rates, coupons reinvested, and a one-year holding period. Excludes fees, expenses, and taxes. Actual results will differ. Source: Bloomberg.
This is one of the underappreciated features of bonds. Because a bond’s cash flows are fixed, we can show what it will be worth under different rate scenarios ahead of time. With higher yields comes more income to offset price declines. At today’s yields, a full year of income can absorb a meaningful rise in rates before a Treasury loses money, a kind of downside protection equities rarely offer. That is the silver lining to this year’s bond market performance.
Most investors own their bonds through funds rather than individual Treasuries. Most bond allocations hold much more than US Treasuries. Yet, the same math applies to a fund through its yield and duration after adjusting for credit risk. Fund yields have moved higher, which means expected returns going forward have moved higher as well. If rates keep rising, the income gets reinvested at better yields, so an investor with a longer time horizon ends up ahead. Viewed this way, the past year’s changes are less of a loss than an upgrade in income. History backs this up. Historically, starting yields have been closely linked to bond returns over the following decade.
It’s important to remember why bonds are in a portfolio in the first place: diversification. When the 10-year yielded 1.5% back in 2021, bonds had almost no room to rally in a downturn, which is a big part of why they offered so little protection when stocks fell, or when inflation rose in 2022. At 5.2%, that cushion is back. In an economic slowdown, a “flight to quality” from equities to bonds could produce double-digit Treasury returns at exactly the moment equities are falling.
For many investors, the sleepy bond market looks like a poor alternative to equities. That’s especially true after the past few years, as equity returns have been so very strong. Federal Reserve data show that US households’ equity holdings as a percentage of financial assets hit an all-time high last year, which suggests many investors have thrown in the towel on bonds.
That could be a mistake. We won’t claim we’ve seen the peak in yields, but the return profile above is compelling, particularly in light of how equities are currently valued. The benefits of fixed income are getting hard to ignore in a 5% rate world.
Sources:
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US 10y Treasury, Bloomberg, as of 9/30/26
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Rate Cuts, Bloomberg, as of 01/01/26
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Rate Hikes, Bloomberg, as of 9/30/36
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10 US Treasury; yield changes, Bloomberg as of 9/30/26.
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“The AI Build-Out Is Becoming the Biggest Economic Bet in U.S. History.” ©2026 Dow Jones & Company, Inc. The Wall Street Journal. Sept. 23, 2026.
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Board of Governors of the Federal Reserve System (US), Households and Nonprofit Organizations; Directly and Indirectly Held Corporate Equities as a Percentage of Financial Assets; Assets, Level [BOGZ1FL153064486Q], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BOGZ1FL153064486Q, October 7, 2026.
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