Bottom Feeders

The bond market in 2026: what's everyone so worried about?

For over a decade leading into 2022, investors bottom fed on low interest rates.

Some (borrowers) locked in mortgages below 2%. Others (lenders) purchased bonds yielding below 2%.

Same market. Same interest rate environment. Completely opposite sides of the coin.

And completely different outcomes as we sit here in 2026.

Because in 2022, generation-defining inflation arrived.

Homeowners had borrowed money at cheap rates to purchase an appreciating asset. Many have watched their home equity soar, while relatively low fixed mortgage payments remain unchanged.

Bond investors? They'd lent money at low rates to own an asset that was highly sensitive to inflation shocks and changes in interest rates. Many lost 17%+ at the lowest point during the 2022 downturn, owning traditional bond funds they'd hoped would just earn a paltry 2% annually for a while.

So it goes. You pays your money and you takes your chances.

But now the tables have turned.

New homebuyers are miserable contemplating 7%+ mortgages, yet fresh money into bonds finds meaningful yields on high-quality debt across any maturity.

The Fed, Manipulation, and a Kinky Yield Curve

When inflation spiked in 2022, the Federal Reserve did what it was supposed to do: it raised ultra-short-term interest rates to cool off the economy and temper rising prices.

Many people complained: They're too late! They're too early! Their timing is wreckless! They're manipulating the market!

Lol. The Fed's job IS TO MANIPULATE THE MARKET. The Fed administers ultrashort-term policy rates, while investors, traders, borrowers, and lenders sort out the prices and yields of bonds across the rest of the maturity spectrum.

The result is the yield curve:

The Y-axis represents yield. The X-axis represents maturity.

The chart tells us what interest rate an investor can earn by lending money for different periods. Look at where we were one year ago (black), compared with today (blue).

One year ago, the curve was inverted: investors could earn higher yields on ultra-short-term bonds than on bonds maturing several years into the future. Such inversions are rare, peculiar, and hairy: normally, investors expect some compensation for lending money for longer periods, accepting more interest-rate sensitivity risk, and giving up flexibility to reinvest sooner.

But during inversions, investors are offered LESS yield for giving up MORE traditionally attractive qualities of bond investing, which is typically a pretty unappealing combination.

For asset allocators like me, whose response to investment questions in normal times is so frequently "it depends" — an inverted yield curve can make certain tradeoffs unusually straightforward for most investors.

Why continue to own as many longer-term bonds, and accept more expected price volatility, if you can earn a higher starting yield without it?

For every investor, that starting proposition should be difficult to ignore.

Rolling Downhill

There's another important consideration in bond investing: rolldown.

Every day, bonds get a little closer to maturity. A 3YR bond today becomes a 2YR bond one year from now.

Consider a hypothetical yield curve:

• 3YR bond yields 5%.

• 2YR bond yields 4%.

  
  

You purchase the 3YR bond, and one year passes.

If the yield curve remains unchanged, your bond now has two years remaining and trades at a yield of approximately 4.0%. Remember: bond prices and yields move inversely.

Yield down = price up.

Your bond has appreciated in price, in addition to the income you've earned. This is rolldown: the potential price appreciation associated with a bond moving toward maturity along a positively sloped yield curve.

It isn't guaranteed: the curve shape itself can change over time. But if you don't forecast interest rates, which I don't think anyone should — you'd generally default to an unchanging yield curve and simply update your inputs every day (nb: this is a slight generalization given we're already deeper in bond math than usual). As the curve iterates, so can your portfolio.

A positively sloped/normal curve can offer a favorable rolldown profile. While an inverted curve can create the opposite effect: as a bond moves toward maturity, it may roll toward a HIGHER yield and LOWER price for extended periods, assuming the curve remains unchanged.

Unfortunately for investors in something like a 3YR bond over the past year, price down/yield up is exactly what happened as the curve unkinked.

Starting yields and expected rolldowns explain why certain maturities can become relatively attractive or unattractive, and indeed the 3YR was very unattractive last year.

Yields get the attention, but the shapes of yields matters a lot, too.

Professional bond managers can exploit these opportunities by purchasing bonds on steep sections of the curve, holding them as they approach maturity, selling them after capturing favorable price movements, and resetting their exposure back to steep curve segments.

This is a systematic approach to bond investing, grounded in decades of research into expected bond returns. Importantly, it doesn't require predicting future interest rates.

Expected rolldown is one reason the normalization of today's yield curve deserves attention.

This Ain't 2022

Bond prices have struggled recently. Certain maturities have suffered more than others, and the changing shape of the yield curve has been part of the story.

But there's an important distinction between this bond downturn and the one we experienced in 2022.

We entered this downturn with meaningful starting yields.

Here was the worst of it in 2022, down 17%+ in traditional bonds (i.e. moderate sensitivity to interest rates) at their lowest point. An absolute shellacking.

Here's the same bond index return so far this year:

You wouldn't know we were only down 2% from the news!

Here is what representatives from Tikehau Capital and Jefferies told The Wall Street Journal recently:

Pain on the street? I won't even defend simply owning U.S. traditional bonds as your entire bond portfolio (though many people do), but sorry, down 2% YTD isn't much of a story.

Frustrating? Sure.

Within the realm of possibility? By a wide damn margin!

Rates rising can be a big deal, but it's more important to you as an investor what that means and can mean for your actual portfolio. And this ain't 2022.

A bond investor's return comes from two primary sources:

Total Return = Income + Price Change

Through 2022, bond investors earned very little on their bonds. When inflation and interest rates spiked, there was barely any income to cushion the resulting price declines.

This time, we entered the year with yields above 3% across the Treasury curve, and considerably higher yields in certain high-quality bond funds.

That starting income has helped offset price declines. Hopefully, you don't just own intermediate term U.S. bonds but also international, and also some short or ultrashort bonds. Let's add them:

Actual bond investors are not struggling the way that the media would have you believe. And there's even better news ahead:

The very price declines that have frustrated bond investors have created higher yields for the future.

A bond fund that yielded 4% before a price decline might now offer 5%+.

The Bond Market Is Back to Tradeoffs

Let's bring back the yield curve.

The curve is now positively sloped. The 1YR-3YR segment, which previously offered relatively unattractive yields compared with cash/ultrashort bonds, now presents a different proposition.

Investors can potentially earn more yield by extending beyond cash, while also benefiting from favorable rolldown if the curve remains unchanged. Further out, investors can consider accepting additional duration risk in exchange for higher yields.

Normal stuff. Normal-shaped yield curve. Normal economics. Normal tradeoffs.

For much of the inversion, cash was an unusually compelling proposition: high relative yield, minimal duration risk, and flexibility.

Today, investors have more meaningful choices across the maturity spectrum.

What Should Investors Do About It?

We hosted a webinar for Peltoma clients last week, and here's what we told them.

1. It's been a fantastic year so far!

Emerging-market stocks are crushing it. International and U.S. stocks are doing above average. Ultra-short-term bonds and cash are positive. Traditional bonds are slightly negative or muted. For balanced investors, it's been a great year, and bonds have higher yields going forward.

2. Higher yields are good news for long-term bond investors.

If we aren't excessively worried about default risk (previous post about this), higher starting yields improve prospective returns and help compensate investors for the price declines they've experienced. And it's not just nominal yields, but real (after-inflation) yields are higher, too. All good things for long-term planning. The path may be uncomfortable because bonds are sensitive to interest rates along their journey to maturity, but bonds that eventually mature...mature at par, and you get your yield.

3. Cash isn't necessarily king anymore.

During the inversion, investors could earn attractive yields on cash and ultra-short-term bonds without accepting much interest-rate risk. That was unusual. Today, investors should reconsider whether holding bonds in the 1YR-3YR maturity range better fits their goals. Cash remains excellent for near-term spending needs, emergency reserves, and money that simply cannot tolerate price volatility.

But for money with a longer investment horizon, extending maturity may now offer a more attractive combination of yield and potential rolldown.

4. Tax-loss harvesting opportunities abound.

Bond funds generally deliver their yield through income rather than price appreciation. That means price declines can create an interesting opportunity for taxable investors.

If a bond fund has fallen in value, an investor may be able to realize a capital loss, purchase a suitable replacement that isn't substantially identical, and maintain appropriate bond exposure while potentially lowering their tax bill.

To readers: tax loss harvesting is nuanced and would suggest consulting your investment professional.

5. Consider extending duration.

Once you've calibrated your investment portfolio to your financial plan, consider whether extending the duration of your bond allocation makes sense.

Maybe that's cash moving into 1YR-3YR bonds. Maybe that's 3YR bonds moving into 5YR-10YR bonds. Or maybe your current allocation is exactly right. There is no universal answer.

But if a longer maturity profile/duration fits within your financial planning needs based on what reliability you need around your bond portfolio, the highest yields currently come from extending out.

To readers: suggest also consulting your professional here, hopefully that has both knowledge of your financial plan and the investment expertise to potentially evolve a bond portfolio accordingly.

Okay, let's bring it home:

Expected Returns Are Just Expected

We can't lose sight of one of the most useful investing frameworks:

RETURN = EXPECTED RETURN + UNEXPECTED RETURN

When you purchase a quality bond/bond fund, its starting yield is ~ its expected return. But interest rates can change. Inflation can surprise. Credit spreads can blow out. The yield curve can twist into a pretzel.

Those unexpected developments create price movements that can overwhelm the income you expected to earn (which is what calculates the yield), particularly over short periods.

The shorter your investment horizon, the greater the the "unexpected return" component dominates your overall return.

This is why a disappointing year for intermediate-term bonds doesn't necessarily mean you made a mistake. It may simply mean unexpected stuff happened (like in 2022 or 2026), and your expected return got overwhelmed.

Historically over longer periods, for both stocks and bonds, the impact of "unexpected returns" decreases so that the "expected returns" component is the primary driver of total returns.

The Lenders' Turn

The very thing causing so much anxiety — falling bond prices — is creating the opportunity.

• It doesn't mean bonds can't fall further.

• It doesn't mean every maturity is attractive, or that everyone should rush out and extend duration.

• It means the price of lending money has improved, and investors finally have a meaningful menu of tradeoffs across the yield curve.

After a long stretch of successful outcomes by bottom feeding as borrowers, this current environment appears to be for the lender.

What's everyone so worried about?

End.