The 40% Problem

What followed was a 39-year stretch of disinflation, financial globalization, and central bank credibility, which drove yields lower and bond prices higher.

For fixed income investors, it was a golden era where being long duration paid off. A simple strategy of buying 10-year Treasuries and rolling them annually would have delivered over 8% in annualized returns from 1981 to 2020. ^{[ 2 ]} The Bloomberg Barclays Aggregate Bond Index returned a similarly impressive 8% over that same period. Bonds weren’t just a buffer against equity risk; they were a consistent source of performance.

But that golden era followed a very different one. In the 35 years before 1981, yields climbed steadily and were far more volatile. Bondholders clipped coupons while watching principal values erode. Price appreciation simply wasn’t part of the fixed income playbook. There were no “total return” bond funds because, frankly, there was no total return to chase.

But we’re also not in a new bond bull market. Instead, we’re in a period of normalization where rates are higher than the recent past but still lower than long-term historical norms.

Following the Global Financial Crisis (GFC), the Fed supported the bull market in bonds with quantitative easing (QE). But in 2022, the Fed began reducing its balance sheet, and by continuing to let its treasury holdings mature without reinvesting the proceeds, it has kept upward pressure on rates with the increased supply. Increased fiscal spending and higher deficits bring uncertainty and expectations of higher future Treasury issuance, increasing the term premium demanded by investors.

This middle ground comes with consequences: greater volatility and interest rate risk, less price support, and less reliable diversification.

We’ve written extensively about how rising rates scramble traditional asset relationships. In 2022, when the Fed launched its most aggressive hiking cycle in decades, the longstanding negative correlation between stocks and bonds broke down. Since then, the two have moved in the same direction in 31 of the past 40 months, nearly 80% of the time—a dynamic that undermines the very foundation of balanced portfolios. ^{[ 4 ]} If you believe that we’re beginning a normalized inflationary regime, different from the sub-2% post-GFC era, the unreliable stock-bond correlation is likely to continue. Based on historical data, the stock-bond correlation becomes positive beginning at 2% inflation, strengthening as inflation increases. ^{[ 5 ]}

It’s not just the lack of diversification that’s troubling. Bond market volatility, once rare, is becoming routine as a result of policy uncertainty. Modest data surprises or policy comments now trigger exaggerated moves across the yield curve, and central banks retreating as a steady source of demand has reduced market liquidity that helped keep bond prices stable and predictable.

Once major buyers of Treasuries, central banks are pulling back as rising yields in markets such as Germany and Japan make US Treasuries less appealing, especially after factoring in currency hedging costs. At the same time, heightened uncertainty has caused the term premium to resurface, hitting an 11-year high in May. ^{[ 6 ]} Investors are demanding more compensation for interest rate risk, reflecting a structurally different regime. In April, high yield bond prices suffered their steepest drop since the early days of the pandemic—second only to March 2020. ^{[ 7 ]}

That resilience is showing up in the data. April’s tariff driven-volatility caused liquid credit spreads to swing sharply- widening in one of the most significant moves in history, before recovering around 71% by early May. ^{[ 9 ]} In contrast, the private credit market operated as usual, providing a stable source of funding for companies throughout the turmoil.