In a world of double-digit returns in high-flying stocks like Nvidia and Apple, it is challenging to spark a scintillating conversation about bonds. For one thing, many investors confess a lack of understanding about how they work. For another, bond returns haven’t exactly been stellar over the past 10 years.
All the more reason to take a closer look.
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While stocks are admittedly more exciting and, over a longer time horizon, generally produce higher returns than fixed income (bond) investments, that juicier average return necessarily comes with greater risk. Over time, bonds provide stable income with less volatility to help smooth the ride. With stocks near record-high valuations and bonds coming off a decade in the doldrums, it may be time to reconsider fixed income.
A fundamental paradigm of investing is that future returns depend to a significant degree upon the entry point. “Buy low and sell high” contains much wisdom. The trick is in the execution. To be sure, stocks have performed exceptionally well over the past four years while bonds have been a drag on portfolio returns. Such stark imbalances can present opportunities for patient long-term investors.
To say that fixed income returns have been disappointing is an understatement. The 10-year annual return on long-term U.S. treasury bonds is a negative 2%. For emphasis, investors who purchased 30-year government bonds 10 years ago have lost money on paper. That is unprecedented, even going back to 1959 when the rolling 10-year average fell to zero. Ouch.
The key is understanding why returns have been so poor. For more than a decade leading up to the pandemic, interest rates were exceptionally low in the wake of the great financial crisis in 2008 and fell to historic lows in 2020. However, government pandemic stimulus, a surge in personal consumption spending, and a massive supply chain disruption triggered a spike in inflation that prompted the Federal Reserve to raise rates aggressively in 2022.
As we saw last week, rising interest rates cause fixed-income investment to decline in value. The sharp rate hikes in 2022, the largest relative increase in U.S. history, in turn produced the greatest percentage decline in bond prices on record. Still smarting from those losses, many investors have questioned the wisdom of holding fixed-income instruments at all.
Today, the landscape is very different and the case for bond investing is much more enticing.
Consider an example of how the outlook for fixed-income investing has improved. Recall from last week that bond prices move inversely with changes in interest rates, and bonds with lower coupons are more sensitive to rate shifts than those with higher stated interest rates.
In the immediate aftermath of the Covid pandemic in 2020, the average annual yield on the broad U.S. Aggregate Bond Index was a miserly 1%, a historic low since at least the end of World War II. Bondholders were earning less than the rate of inflation and falling behind in purchasing power. Investors holding those bonds in 2020 only needed to see interest rates rise by 0.2% for their bond values to fall enough to wipe out their entire annual return. In response to the surge in inflation, interest rates on the aggregate bond index soared by over 3 percentage points, causing the overall bond market index to plummet 13%, the biggest decline in the modern era. Not exactly what conservative investors had in mind.
Fast forward to October 2026. The average yield on the aggregate bond index is around 5.5%, providing a real return of around 2% after inflation. Yields at this level now offer a meaningful cash return and provide a greater cushion against rising interest rates. In contrast with 2020, the average bond in the aggregate index could tolerate a rate increase of a full 1 percentage point and still provide the holder with a positive annual return. Much more appealing.
Given the stickiness of inflation and the exuberance in the artificial intelligence infrastructure, a modest increase in rates is likely over the next year. However, we are now much nearer the end than the beginning of the rate cycle. A softening in the economy, inevitable if not predictable, would initiate a rate-cutting regime that would put bond investors in the catbird seat.
While rising rates hurt bonds, falling rates are manna from heaven. The market value of a newly issued 30-year treasury bond paying 5.5% would surge by about 15% if rates were to fall by 1% with all else being equal. A 10-year treasury bond could theoretically gain 8%. Now we’re cooking with gas. And even if rates merely stabilize at current levels, a 6% to 7% return on a well-constructed high quality bond portfolio could rival the much riskier expected return on stocks over the next five years if current elevated equity market valuations revert to their long-run averages.
With a more favorable risk-return profile, bonds are gaining attention from many investors who shunned them over the past few years. Aside from the more attractive interest income, fixed-income investments are now more likely to reclaim their role as a portfolio diversifier and a buffer against stock volatility, especially for long-term retirement savers. Net inflows into U.S. bond ETFs and mutual funds are expected to exceed $500 billion in 2026.
As to the risk of more Fed rate hikes: probably not much to worry about. The likelihood of another increase in the Fed’s benchmark rate in December is fully anticipated, with an additional quarter-point hike or two in 2027 also baked into expectations. Bond investors generally believe the Fed is behind the curve, and market yields are already reflecting that expectation. The actual announcement of a perceived fait acompli is unlikely to move the needle that much.
The past decade has been an extraordinarily disappointing stretch for bond investors. But understanding why fixed income has struggled and recognizing how much the landscape has changed should offer investors a compelling reason to take another look.
Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.