Q4 bond market outlook for ETF investors
The Federal Reserve’s conflicting monetary policy priorities and credit markets’ extended valuations warrant a tactical approach to fixed income late in the economic cycle.
Resilient growth, murky outlook
The US economy continues to demonstrate remarkable resilience, expanding at an annualized rate of 3.8% in Q2 2025—the strongest pace since Q3 2023.1 Despite headwinds from rising tariffs and a softening labor market, robust consumer spending helped sustain second quarter growth.
The divergence between solid economic growth and a weakening labor market—combined with persistent inflation— makes it difficult for the Federal Reserve (Fed) to achieve its dual mandate of price stability and maximum employment. The data delays resulting from the US government shutdown only further complicate the central bank’s policy decisions.
In this environment, bond investors should emphasize duration management and diversification across a broad set of return drivers and consider:
- High quality short-term and intermediate core bonds to strike a better balance between income and interest rate risk in the sweet spot of the curve and take advantage of historically elevated yields without extending down the credit spectrum
- Actively managed core and credit strategies where managers with broader mandates seek to enhance portfolio resilience and diversification by navigating evolving macro risks and capitalizing on relative value opportunities across sectors
The yield curve steepens
US Treasury markets have diverged notably this year. Short-term yields have declined on expectations for the Fed to cut rates, while long-term yields—particularly the 30-year Treasury—have remained elevated, in the top decile over the past decade.2 This dynamic has led to a steeper yield curve—with the short end falling and the long end remaining elevated (Figure 1).
Short-term yields are mainly driven by central bank policy, while longer-term yields are shaped by expectations for economic growth, inflation trends, and, more recently, fiscal sustainability concerns. The rise in 30-year yields—up almost 80 basis points (bps) since the Fed’s rate cut in September 20243—illustrates the disconnect between short-term rate cuts and longer-term risks like slowing growth, inflation pressures, and widening deficits.
The inflation outlook is a particular concern. Tariffs have yet to fully pass through to consumer prices, causing short-term inflation expectations north of 4%.4 And any perception that the Fed is cutting rates too aggressively (or too soon) could push those inflation expectations even higher. As inflation erodes the real value of fixed coupon payments, this represents a material risk for long-term bondholders.
Although inflation is still running above target, the Fed’s attention seems to have shifted to the downside risks to employment, which might prompt it to move more quickly toward a more neutral stance.
Meanwhile, concerns over fiscal sustainability are gaining traction and increasingly influencing the term premium—the additional yield investors demand to hold long-term debt. With the US federal deficit above 6% of GDP—significantly higher than the 3.7% average over the past 50 years5—and total debt approaching 120% of GDP,6 buyers of long-dated Treasurys are factoring in concerns over future fiscal discipline. Structurally larger deficits certainly seem here to stay with the One, Big, Beautiful Bill Act.
Viewing longer-term bonds as carrying elevated risks, investors are demanding more compensation to hold these bonds. In fact, term premiums have been positive for over 200 consecutive days—the longest stretch since 2012—and are at their highest levels since 2014, underscoring how much today’s bond market differs from markets in the past decade.7
Don’t stretch for yield
While the long bond has an asymmetric risk and return profile, the short and intermediate segments represent a more compelling option to balance yield and interest rate risk. This is a byproduct of a steepening curve that remains flatter than normal. The 2- to 10-year yield spread is currently around 0.5% relative to its long-term average of 1%.8 The yield difference between the 5- to 10-year maturity band of the US Treasury curve and the 10+ tenor is roughly 80 bps, but the duration differential is seven years.9
The yield-per-unit-of-duration ratio can help frame a bond sector’s potential value on a risk-adjusted basis. Today, yield-per-unit-of-duration declines significantly further out the curve, as the additional yield is small relative to the increased duration risk (Figure 2). Given political and fiscal headwinds, there is greater balance on the front end in terms of risk versus reward.
Look to IG credit for income
As investors consider where to take risk, it's important to recognize that the concept of “not stretching” also applies to credit. With spreads of investment-grade (IG) and high yield bonds at, or close to, all-time lows over the past 20 years,10 extended valuations pose a risk. This can lead to periods of heightened volatility, especially when risk assets are priced for perfection.
Despite these challenges, IG credit remains a valuable source of income. Current yields rank in the top quintile of historical observations,11 providing a meaningful carry advantage over other high-quality fixed income segments. In an environment where spread compression is unlikely to drive excess returns, performance is increasingly expected to be coupon driven.
This dynamic reinforces the importance of credit quality and diversification in portfolio construction. High-quality, actively managed core bond strategies are well-positioned to capture resilient income streams while mitigating exposure to idiosyncratic and macro-driven volatility. By avoiding overextension into lower-rated issuers, investors might preserve risk-adjusted return potential and enhance portfolio stability.
Looking at below-IG credit, the situation is particularly pronounced. Tight spreads have pushed high yield bonds to trade with negative convexity (Figure 3), where downside risks remain asymmetric. This dynamic suggests that future returns are likely to be dominated by carry rather than spread compression, increasing the importance of rigorous credit selection. Given the elevated sensitivity to macroeconomic shocks and idiosyncratic risk, especially in lower-rated segments, an active approach can help balance risk from areas most prone to fundamental weakness or equity growth scares.
While credit risk premiums are compressed relative to long-term averages, the current high carry acts like a buffer to absorb moderate spread widening before total return turns negative. In periods where high yield bonds’ starting yields fell in the 6%-8% band, historical data shows that in 55% of subsequent one-year periods, returns exceeded 7%. And returns exceeded 5% nearly 70% of the time.12
Meet macro uncertainty with diversification
A resilient yet slowing economy hints at the economic cycle oscillating around the later stages. But the Fed easing monetary policy and the stimulative effects of the One, Big, Beautiful Bill Act mean a fiscal impulse for growth to increase in 2026 and beyond.
Notably, late-cycle regimes have historically produced higher dispersion in returns and greater volatility in spreads and yield curves. Correlations between traditional fixed income sectors also tend to shift abruptly (Figure 4). For example, US Treasurys may not always rally during risk-off periods if inflation remains sticky. And credit spreads may widen even as yields fall if weaker growth is driving falling yields.
With market relationships growing less predictable, the later stages of the economic cycle are an opportune time to increase diversification with assets that behave differently under various economic conditions. In uncertain environments, diversifying return across maturities, sectors, and risk premia can be the most reliable path to achieving consistent outcomes.
Late cycle invites active management
Bottom-up security selection and the ability to tactically adjust exposures become increasingly important as credit fundamentals and market conditions shift. With potential idiosyncratic risk rising, active management may help navigate stressed fundamentals to identify relative value opportunities.
Another alpha generator for active fixed income managers can be tactically adjusting duration exposures along the curve. While the yield curve has steepened from deep negative territory, potential for further steepening creates opportunity.
By dynamically adjusting duration and sector exposures, emphasizing higher quality issuers, and tapping off-benchmark opportunities, active managers can benefit from additional return sources. And building greater diversification across risk and return drivers can help preserve income and limit drawdowns when markets reprice.
Implementation ideas for Q4
Slowing growth, stubborn inflation, easing monetary policy, a weaker labor market, and concerning fiscal deficits have distorted the Treasury yield curve. Short-term yields remain elevated but are trending lower, while longer-term yields have once again begun to command a premium. But despite potential tariff headwinds, there may be a positive growth impulse as rate cuts and tax measures make their way into the economy.
In this challenging environment, flexible duration management and diversification across a broader set of return drivers are essential—not just to navigate the shifting macro landscape, but to potentially profit from it. Investors can consider: