Just When Investors Thought They’d Changed, Bonds Are Acting Like Bonds Again

On this episode of The Long View, Sara Devereaux, Chief Investment Officer of Vanguard Capital Management and Global Head of Fixed Income, breaks down Vanguard’s fixed-income strategy, how ETFs and active management are evolving the bond market, and what risks she sees for the bond market in 2026.

Here are a few excerpts from Devereux’s conversation with Morningstar’s Christine Benz and Ben Johnson.

Key Drivers of the Bond Market 2025

Ben Johnson: I want to shift gears and zero in on what’s going on, ultimately, in the underlying bond markets, and begin by taking a look back at 2025. Last year was a good one, generally speaking, for bond investors. If you look at the Morningstar US Core Bond Index, it was up just over, shade over 7% on the year. That was its best year since 2020. So what were some of the key forces that drove fixed-income markets in 2025?

Sara Devereaux: Yeah, 2025 was a good year for fixed income. I would say bonds did exactly what investors count on them for. They provided income, and they provided stability. The first thing is that those elevated starting yields really provided that powerful source of income, and that income, investors haven’t felt that income for a while, and it’s powerful. And so the majority of the returns were really driven by the fact that we started with higher yields than that coupon.

The second thing is that bonds protected portfolios against downside risks. Early in the year, we had equity market weakness. You remember DeepSeek? People forgot about that that was a while ago. It was about this time of the last year. DeepSeek, tariffs, headwinds, et cetera. And then later in the year with labor market weakness, bonds helped protect portfolios against the downside in those cases.

And then finally, price appreciation. As inflation moderated, the Fed was able to deliver on cuts. We saw the front and intermediate parts of the curve rally, which provided that price appreciation on top of that income component that I was talking about. Just to go into some of the sector’s old credit, strong corporate fundamentals, strong investor demand, help keep those IG and high-yield spreads near multidecade heights.

And munis were interesting, too. They had a challenging start to the year, marked by heavy supply, but in the back half of the year, they really caught up and actually outperformed the taxable market. So I would link this all back to sort of like that we’re in this new era for fixed income that we’ve been talking about since the rate reset in 2023. The higher rate environment really continues to set the market up for success. That income is back in fixed income.

Can Bonds Still Be Ballast in 2026?

Christine Benz: Sara, I want to follow up on your point about bonds being ballast in rough equity markets. We’ve had a couple of periods, one quite recently during some tariff-related issues, stocks fell, Treasuries fell as well. Can you talk about that? How you think about that? Why that’s happening? And should that cause investors to revisit how they are using high-quality fixed income in their portfolios if the goal is to build a diversified portfolio?

Devereaux: Yeah, I think we do believe that bonds are an effective diversifier to equities. It doesn’t hold every minute of every day, but it holds over the long run. And I think when we’re in this environment now, when we have the higher income, they’re in a position to do that again. When bonds were at the zero lower bound, they were pretty unattractive and we were there for a while. We had better part of a decade after the GFC when yields were very low. And so you didn’t have that income component, so you didn’t have a great return, but also the price action couldn’t be symmetric from there. When you’re already at zero, it’s hard for rates to rally, right? So the price can’t rally. And then when rates back up in 2022, there was no cushion. And I would contrast that to today when we’re back in a more normal environment, where you have that income, today what you get is that ballast where bonds can rally and if bonds sell off, you have a head start, just to do the simple bond math. You have a 5% coupon out of a five-year bond. It could back up a 100 basis points and all you would lose is one year’s worth of income, right? So, I think that that ballast is there.

Now, you’re asking about a specific instance and a few times over the past year or so where we’ve seen some price action where bonds sold off. And I think in those cases, they’re volatile periods where it doesn’t hold the whole time, but you look back, example, for “Liberation Day” last year, by the time we got to the end of April, bonds were up 3% or 4% in the year and equities were materially lower. And so even there’s that intermittent volatility, it still ended up being a great year and the diversification benefit was there in the end.

The thing to keep an eye on that we have as a watch item is that term premium. So when we’re talking about the ballast benefit of bonds, what I’m talking about on average over time, and what’s on average, well, what’s the Agg? That’s the secure duration, OK? What I’m not talking about is the 30-year long bond. The 30-year long bond can have a bit of a life of its own. And so when we’re talking about the term premium, how the term premium can steep in, that’s going to be a risk that’s going to be around as long as we have high deficits, right? And people start talking about the supply and demand of US Treasuries, that comes into question and the long end of the curve can be sensitive to that.

Now, I would call it some mitigants on the term premium, steeping out. We’ve seen spikes in that, it usually is proven to be a buying opportunity, but we acknowledge it does remain a risk and will be volatile. The mitigants that we think about are that, first of all, on the deficit, I don’t know, you want to call them a bond vigilantes, they’re not hibernating, they’re still watching, but they haven’t really been coming out that often, but the deficit itself is high, but people are talking more and more about our ability to grow our way out of it. The AI boom and the high growth forecast for this year, people are starting to get a little more comfortable around the edges of the possibility of growing out of the deficit. So that’s one mitigant.

The second mitigant is just that that term premium has repriced a lot. When the Fed started cutting rates in September of 2024, from then until January of 2025, just a quarter, Fed cut our basis points, raised back up the 10-year, backed up 100 basis points. So that term premium really increased. I think it’s, if you look at like the ACM term premium, it was negative for a long time, and now it’s a positive 80 or so. So about 100 basis points more in term premium. And in a world where everyone’s talking about risk premiums being compressed, spreads are tight, equity market valuations are high, wow, what’s the one place where risk premiums, right, are actually higher, the term premium. So that’s another mitigant that maybe it’s priced in, maybe that price action could be more symmetric from here.

And then the third one, which I think is really important right now, is that the administration really has their eye on the term premium, that 10-year point of the curve, Secretary Bessent called out explicitly early last year, and with the focus on affordability right now, we expect there to be continued focus. And the administration’s shown that they’re willing to take action. We saw them recently say they’re going to have the GSEs buy mortgages. And then, I look at last year, and they called up the 10-year, there were many, many steps taken to really bolster and ensure that supply/demand balance of Treasuries is good and healthy. There were many steps taken. And guess what, after the term premium peaked in January, it stayed pretty stable over the course of the year. So I would expect that focus to continue. If we see any material spikes in long-end rates, I would expect some action.