Q3 Bond Market Meltdown: Why and What's Next?

The culprit for the market's poor performance is the term premium—the extra yield that investors demand to tie up their money in longer-term bonds versus holding short-term bonds and reinvesting them. In other words, it's the risk premium that compensates investors for the possibility that the path of short-term interest rates diverges from what's discounted in the market.

During the third quarter, nearly the entire rise in Treasury yields was attributable to the rise in the term premium. Notably, the term premium for 10-year Treasuries is now positive for the first time since early 2021. As the Fed signals it will keep interest rates higher for longer, the market appears to be reflecting the uncertainty about the path of policy going forward. How much higher for how much longer?

Not surprisingly, spikes in the term premium have often occurred during periods of volatility in the bond market. The more uncertain investors are about where short-term interest rates are going, the more yield they demand to take on duration risk.

In this case, the market appears to be adjusting to a new world of higher short-term policy rates from central banks, with the federal funds rate holding at 5.5% this year and staying at 5% or higher throughout next year. That expectation is pulling intermediate- and long-term rates higher. The market is getting more closely aligned with the Fed's forecasts released at the September Federal Open Market Committee meeting, which indicate a median expectation that the federal funds rate will be lowered by 50 basis points (i.e., 0.50%) in 2024 and trend down to about 3% longer term. However, these forecasts have shifted rapidly over the past two years, keeping investors cautious.

Looking ahead to Q4

The uptrend in yields could continue as long as the economy and/or financial markets don't have an adverse reaction to Fed tightening. A move toward 5% in 10-year Treasury yields can't be ruled out. However, we see room for yields to fall longer term. A lot of potential negative news appears to be discounted at current yields. Real interest rates—adjusted for inflation expectations—are at the highest levels since 2008, which should dampen business and consumer spending and mitigate some of the risks associated with holding intermediate- to long-term bonds.

Most notably, inflation is trending lower. The benchmark inflation measure that the Fed uses in setting policy—the deflator for personal consumption expenditures excluding food and energy—has posted very modest increases over the last few months. On a three-month rate-of-change basis, it is near the Fed's 2% inflation target.

With inflation cooling and yields moving in line with the Fed's projections, the worst of the bond market selloff should be behind us. The Fed is signaling one more rate hike at the most, depending on how the labor market and inflation look. In past cycles, yields have typically fallen in the 12 months after the peak in the federal funds rate. Moreover, returns for intermediate-term bonds have outperformed short-term bonds due to the higher starting yields.

One factor supporting the outlook for total returns is that starting yields are so much higher than they have been for many years. The coupon income can mitigate the impact of price changes. Another way to look at the current market is to assess the potential total returns for bonds of different maturities, given a change in yields over the next 12 months. If yields hold steady, then returns over the next year should be in the 4.5% to 5.1% region depending on maturity. A move up of 50 basis points from current levels would still produce positive returns for all but 30-year bonds. Meanwhile, a decline of 50 basis points should produce positive returns, all else being equal.

We tend to use the Bloomberg US Aggregate Bond index as our benchmark when looking at duration. It currently has a yield-to-worst¹ of 5.5% with an average duration of 6.2. For investors looking to generate income without taking a lot of credit risk, we think a benchmark allocation can make sense.

Overall, the lesson of the third-quarter bond market selloff is that volatility is likely to be higher going forward than it was for much of the past decade. As the Fed and other major central banks step back from their zero-interest-rate policies, investors are demanding higher risk premia to compensate for the uncertainty about the direction and level of rates longer term. This new normal is challenging for anyone trying to time the market but also opens up opportunities for long-term investors.

We continue to suggest using strategies like bond ladders (a portfolio of individual bonds that mature on different dates) to avoid trying to time the interest rate market and to use the recent rise in yields as an opportunity to add intermediate term duration bonds to add income to fixed income portfolios. At current yields, the risk/reward looks attractive to us for investors with a longer time horizon.

¹ Yield-to-worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. It is a type of yield that is referenced when a bond has provisions that would allow the issuer to close it out before it matures.

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