It’s Been a Long Time Since Bonds Looked This Good

Bond yields have been rising for years now, and that’s been tough on fixed-income investors. Here are the trailing 10-year annual returns of some leading bond indexes as of Oct. 31, 2026. In all but one case, bond investors lost money after inflation.

While that’s been disappointing, it’s had a silver lining: Bonds’ risk/reward profile has greatly improved. To illustrate, here’s a chart in which I’ve plotted out the changes in the average monthly duration (a measure of interest rate sensitivity; that is, risk) and yield to maturity (that is, reward) of the iShares 7-10 Year Treasury ETF IEF.

Yields were recently the highest they’ve been in a decade and, conversely, durations have drifted down from the heights they reached amid covid and its aftermath. (All else equal, bonds become less rate-sensitive the higher their yields in absolute terms, and vice versa.) That is, bonds offer far more reward and pose slightly less risk than they did 10 years ago.

How has the relationship between potential upside and downside shifted over time? I’ve rendered that picture below using the iShares ETF’s average monthly durations and yields, assuming the upside represents the potential payoff from a 1% decline in rates at the time and the downside the penalty from a 1% rate rise.

To put things in perspective, as of July 31, 2020, the ETF’s yield to maturity had shriveled to 0.47%, and its duration had ballooned to nearly 8.0 years. Given that, investors stood to earn as much as an 8.5% total return in the highly unlikely event yields fell another 100 basis points from there. But they’d have lost almost 7% if yields rose 1 percentage point. In other words, there was only a 1.6-percentage-point difference between reward (that is, the 8.5% potential upside) and risk (that is, the 6.9% potential loss).

Contrast that with where things stood as of Oct. 31, 2026: The ETF’s yield to maturity was 4.94%, and its duration had shrunk to around 7.0 years. Thus, investors were poised to notch a nearly 12.2% total return if yields fell 1 percentage point compared with a potential 1.7% loss if yields rose 100 basis points. Meaning that the risk/reward has tilted much more in investors’ favor, with 10.5 percentage points separating potential upside (12.18%) and downside (negative 1.73%).

While it helps that durations have come down, this is really a story of higher yields providing much more cushion, as my colleague Dan Lefkovitz recently explained. To illustrate, I’ve plotted the monthly potential upside and downside returns for the iShares ETF, broken down by the yield to maturity at the time. As yields rose, the risk/reward bent higher.

More Where That Came From

How does it look for other types and maturities of bonds? I used the average monthly durations, convexities, and yield to maturities of all funds in the six largest diversified or government-related fixed-income Morningstar Categories to derive the difference between the potential upside and downside in the same way I did for the iShares ETF mentioned above. Here’s a time-lapse of those differences.

(The chart above only runs through Sept. 30, 2026, as many bond mutual funds hadn’t reported their portfolio holdings as of Oct. 31, 2026.)

So, it’s easier to make out; here’s a compare-and-contrast of the starting and ending potential upside minus downside for each category.

In nearly every case, rising yields and falling durations greatly improved the risk/reward trade-off investors face. Based on this, it’s hard not to conclude that bond-fund investors are being fairly compensated for the interest rate risk they court for the first time in a long time.

Caveats

That said, some important caveats apply to the preceding analysis:

For one, I only factored in one risk—duration. I didn’t account for others like yield-curve risk (as duration assumes a parallel shift in rates across the curve), credit risk, or prepayment risk. Let’s say we get a recession, rates fall, but credit spreads widen. That’s not necessarily going to be a picnic for bond-fund investors, yet it’s not reflected above. (And let’s not overlook the fact that credit spreads are quite narrow by historical standards.)

Also, if inflation takes off, far exceeding the expectations investors are pricing in, then the improved risk/reward could prove illusory. In such a scenario, investors might be able to scratch out a positive nominal return but end up underwater after inflation. (This, incidentally, is why I’d previously said Treasury Inflation-Protected Securities could be worth considering as a potential substitute for nominal Treasuries.)

In addition, plump cash yields continue to beckon. Bonds certainly look less bad against cash than they did before, thanks to an upward-sloping yield curve that ensures bondholders are paid for the extra duration risk they court. But with the three-month Treasury bill recently yielding 4% and having virtually no downside, some might decide they’d rather keep the bat on their shoulder instead of taking a swing at potentially bigger returns in longer-tenor bonds.

Finally, even though things are looking up for bonds, it doesn’t mean they should take the place of stocks. You could argue that bonds’ improved risk/reward means equities have to clear a higher hurdle rate than they have in years, with all the attendant questions. But if you have a long time horizon, diversified stocks are the more prudent choice, given the expectation they’ll generate a higher return than fixed income over decades.

Switched On

Here are other things I’m reading, saying, watching, and listening to:

• A manager changes his mind about AI
• A thing that exists: An ETF that’s a 161-bagger yet has seen $9.1 billion in lifetime outflows
• I chatted about investor outcomes, fund selection, and much more with Dr. Abhishek Gadre on his excellent “Money Matters MD” podcast
• “My First Day Seems So Much Older Than Me” by Jeffrey Eugenides
• “No Country for Old Men” rewatch
• AC/DC’s “Thunderstruck” on xylophone (and it rocks)

Don’t Be a Stranger

I love hearing from you. Have some feedback? An angle for an article? Email me at jeffrey.ptak@morningstar.com. If you’re so inclined, you can also follow me on Twitter/X at @syouth1, and I do some odds-and-ends writing on a Substack called Basis Pointing.