October 20, 2026 – The third quarter was a difficult one for bond markets. The 10-year Treasury yield rose 82 basis points to 5.29%, its highest level since 2002, and the core U.S. bond index recorded its worst quarterly return since 2022. Stocks finished modestly higher, supported by strong corporate earnings.
Our shorter-duration, higher-quality bond positioning helped limit losses during the quarter. We have been cautious about extending duration and taking on additional credit risk, and the market environment reinforced our approach.
Market Review
Stocks and bonds moved in opposite directions during the quarter. The S&P 500 gained 2.3%, while the Bloomberg U.S. Aggregate Bond Index fell 3.5%, bringing its year-to-date return to negative 2.9%. Beneath those headline numbers, however, performance varied considerably. Energy stocks led the market with a 17.2% gain as oil prices rose. Interest-rate-sensitive sectors struggled, with utilities falling 12.4% and real estate declining 5.6%. Small-cap stocks also gave back some of their strong first-half gains.
Bond market volatility increased sharply as yields rose across the curve, with the largest moves occurring in longer maturity debt. By some measures, this was the largest quarterly increase in benchmark Treasury yields since 2009. The 10-year yield crossed 5% in mid-September, while the 30-year Treasury ended the quarter at 5.64%, a level last seen in 2002.
The pattern of losses reflected the effect of duration, a measure of a bond’s sensitivity to changes in interest rates. Longer-duration bonds suffered the steepest declines. According to Morningstar, the typical long-term bond fund lost 6.9% during the quarter, and the core bond index experienced its fourth-worst quarter in 25 years. Shorter-term and floating-rate bonds held up considerably better, while leveraged loans were the only major bond sector to post a gain.
Several factors contributed to the selloff:
Energy and inflation: Renewed conflict with Iran pushed oil above $107 per barrel in mid-September before prices settled near $90 at quarter-end.
Government borrowing: Persistent federal deficits kept Treasury supply elevated. Investors demanded more compensation to hold longer-dated government debt. In August, the Treasury doubled its debt buyback program from $4 billion to $8 billion, but long-term yields continued to rise.
AI-related borrowing: Large technology companies increasingly turned to the bond market to finance data-center investment, adding to corporate debt issuance.
Global bond markets: Yields also rose in Europe, Japan, and the U.K., indicating that the pressure extended beyond the United States.
Municipal bonds had a difficult quarter as well. Rising interest rates and heavy new issuance contributed to losses that exceeded those of every major bond sector except long-term Treasuries.
Inflation and Fed Policy
Inflation remains above the Fed’s 2% target, although recent increases have been driven largely by energy costs. Headline CPI eased to 3.4% in August from a May peak of 4.2%. Core PCE, the Fed’s preferred inflation measure, declined to 3.0% from 3.4% in May.
The underlying concern is that higher energy prices will eventually creep into a broader range of goods and services. Diesel prices rose sharply during the quarter, increasing costs for transportation, manufacturing, and agriculture. Tariffs are also continuing to work their way through the economy. The Fed’s projections call for headline PCE inflation to reach 3.7% by the end of 2026 before declining to 2.3% in 2027.
On an optimistic note, wage growth has not accelerated meaningfully, and longer-term inflation expectations have remained relatively stable. This suggests that at least part of the increase in Treasury yields reflects higher real, or inflation-adjusted, interest rates rather than a significant deterioration in confidence in the Fed’s ability to control inflation.
On September 16, the Fed raised its policy rate by a quarter percentage point to 3.75%–4.00%, its first increase in three years. The vote was unanimous, a sharp change from July, when three members dissented in favor of a rate increase.
This was the first rate hike under Chair Kevin Warsh, who took over from Powell in May. Warsh characterized the move as removing monetary accommodation rather than tightening policy and declined to commit to a specific path for future rates. The Fed’s median projection places the policy rate around 4.1% through 2027, while markets indicate a meaningful possibility of additional increases. The Fed will meet again in late October and December.
Looking forward, we are focused on these core issues that are likely to drive markets in the coming quarter:
Corporate earnings remain strong. Consensus estimates call for S&P 500 earnings growth of nearly 32% in 2026, driven largely by AI investment and wider profit margins. Earnings growth, rather than rising valuations, has accounted for most of the market’s gains this year.
Market concentration remains elevated. The 10 largest AI-related companies account for approximately 41% of U.S. market value, matching the peak reached during the 2000 technology bubble. Many individual stocks struggled during the quarter even as the broader index remained near its high.
Bonds are a competitive alternative to stocks. High-quality corporate bonds yield around 6%, providing investors with meaningful income without taking on the same level of risk as equities.
Economic growth continues, but there are signs of strain. Second-quarter GDP grew at a 2.2% annual rate, and unemployment improved to 4.1%, although hiring has slowed. Mortgage rates are back above 7%, and consumer sentiment fell to 46.3 in October, near historic lows.
The midterm elections add another source of uncertainty. Housing affordability and energy prices are likely to be central campaign issues, with potential implications for fiscal and economic policy.
Portfolio Positioning
We expect interest-rate volatility to remain elevated as the Fed responds to higher energy costs and works to bring inflation back toward target. Oil prices, federal borrowing, and the pace of AI investment will all influence the direction of longer-term yields. Even if economic growth slows, these forces could keep pressure on the long end of the Treasury curve.
Yields above 5% also create opportunities that have been largely absent for much of the past two decades. We see room to extend duration over time, but we are not prepared to make that shift all at once. We will look for opportunities to add exposure as market volatility creates more attractive entry points, while keeping overall interest-rate risk within our desired range. In credit, we intend to remain selective until spreads provide better compensation for the risk.
Equities face a different set of considerations. Strong earnings continue to support the market, but elevated valuations and concentration among a relatively small group of companies leave less room for disappointment. We believe diversification and regular rebalancing remain important in this environment, particularly when market leadership is narrow.
Q3 2026 Quarterly Letter: The Bond Market Has Spoken
Christopher Abbruzzese
October 20, 2026 – The third quarter was a difficult one for bond markets. The 10-year Treasury yield rose 82 basis points to 5.29%, its highest level since 2002, and the core U.S. bond index recorded its worst quarterly return since 2022. Stocks finished modestly higher, supported by strong corporate earnings.
Our shorter-duration, higher-quality bond positioning helped limit losses during the quarter. We have been cautious about extending duration and taking on additional credit risk, and the market environment reinforced our approach.
Market Review
Stocks and bonds moved in opposite directions during the quarter. The S&P 500 gained 2.3%, while the Bloomberg U.S. Aggregate Bond Index fell 3.5%, bringing its year-to-date return to negative 2.9%. Beneath those headline numbers, however, performance varied considerably. Energy stocks led the market with a 17.2% gain as oil prices rose. Interest-rate-sensitive sectors struggled, with utilities falling 12.4% and real estate declining 5.6%. Small-cap stocks also gave back some of their strong first-half gains.
Bond market volatility increased sharply as yields rose across the curve, with the largest moves occurring in longer maturity debt. By some measures, this was the largest quarterly increase in benchmark Treasury yields since 2009. The 10-year yield crossed 5% in mid-September, while the 30-year Treasury ended the quarter at 5.64%, a level last seen in 2002.
The pattern of losses reflected the effect of duration, a measure of a bond’s sensitivity to changes in interest rates. Longer-duration bonds suffered the steepest declines. According to Morningstar, the typical long-term bond fund lost 6.9% during the quarter, and the core bond index experienced its fourth-worst quarter in 25 years. Shorter-term and floating-rate bonds held up considerably better, while leveraged loans were the only major bond sector to post a gain.
Several factors contributed to the selloff:
Energy and inflation: Renewed conflict with Iran pushed oil above $107 per barrel in mid-September before prices settled near $90 at quarter-end.
Government borrowing: Persistent federal deficits kept Treasury supply elevated. Investors demanded more compensation to hold longer-dated government debt. In August, the Treasury doubled its debt buyback program from $4 billion to $8 billion, but long-term yields continued to rise.
AI-related borrowing: Large technology companies increasingly turned to the bond market to finance data-center investment, adding to corporate debt issuance.
Global bond markets: Yields also rose in Europe, Japan, and the U.K., indicating that the pressure extended beyond the United States.
Municipal bonds had a difficult quarter as well. Rising interest rates and heavy new issuance contributed to losses that exceeded those of every major bond sector except long-term Treasuries.
Inflation and Fed Policy
Inflation remains above the Fed’s 2% target, although recent increases have been driven largely by energy costs. Headline CPI eased to 3.4% in August from a May peak of 4.2%. Core PCE, the Fed’s preferred inflation measure, declined to 3.0% from 3.4% in May.
The underlying concern is that higher energy prices will eventually creep into a broader range of goods and services. Diesel prices rose sharply during the quarter, increasing costs for transportation, manufacturing, and agriculture. Tariffs are also continuing to work their way through the economy. The Fed’s projections call for headline PCE inflation to reach 3.7% by the end of 2026 before declining to 2.3% in 2027.
On an optimistic note, wage growth has not accelerated meaningfully, and longer-term inflation expectations have remained relatively stable. This suggests that at least part of the increase in Treasury yields reflects higher real, or inflation-adjusted, interest rates rather than a significant deterioration in confidence in the Fed’s ability to control inflation.
On September 16, the Fed raised its policy rate by a quarter percentage point to 3.75%–4.00%, its first increase in three years. The vote was unanimous, a sharp change from July, when three members dissented in favor of a rate increase.
This was the first rate hike under Chair Kevin Warsh, who took over from Powell in May. Warsh characterized the move as removing monetary accommodation rather than tightening policy and declined to commit to a specific path for future rates. The Fed’s median projection places the policy rate around 4.1% through 2027, while markets indicate a meaningful possibility of additional increases. The Fed will meet again in late October and December.
Looking forward, we are focused on these core issues that are likely to drive markets in the coming quarter:
Corporate earnings remain strong. Consensus estimates call for S&P 500 earnings growth of nearly 32% in 2026, driven largely by AI investment and wider profit margins. Earnings growth, rather than rising valuations, has accounted for most of the market’s gains this year.
Market concentration remains elevated. The 10 largest AI-related companies account for approximately 41% of U.S. market value, matching the peak reached during the 2000 technology bubble. Many individual stocks struggled during the quarter even as the broader index remained near its high.
Bonds are a competitive alternative to stocks. High-quality corporate bonds yield around 6%, providing investors with meaningful income without taking on the same level of risk as equities.
Economic growth continues, but there are signs of strain. Second-quarter GDP grew at a 2.2% annual rate, and unemployment improved to 4.1%, although hiring has slowed. Mortgage rates are back above 7%, and consumer sentiment fell to 46.3 in October, near historic lows.
The midterm elections add another source of uncertainty. Housing affordability and energy prices are likely to be central campaign issues, with potential implications for fiscal and economic policy.
Portfolio Positioning
We expect interest-rate volatility to remain elevated as the Fed responds to higher energy costs and works to bring inflation back toward target. Oil prices, federal borrowing, and the pace of AI investment will all influence the direction of longer-term yields. Even if economic growth slows, these forces could keep pressure on the long end of the Treasury curve.
Yields above 5% also create opportunities that have been largely absent for much of the past two decades. We see room to extend duration over time, but we are not prepared to make that shift all at once. We will look for opportunities to add exposure as market volatility creates more attractive entry points, while keeping overall interest-rate risk within our desired range. In credit, we intend to remain selective until spreads provide better compensation for the risk.
Equities face a different set of considerations. Strong earnings continue to support the market, but elevated valuations and concentration among a relatively small group of companies leave less room for disappointment. We believe diversification and regular rebalancing remain important in this environment, particularly when market leadership is narrow.
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