Why Bonds Stumbled and Stocks (Mostly) Stood Strong in Q3, and What Lies Ahead for Investors

Bonds had a rough third quarter. Inflation worries, concerns about government deficits, and the Federal Reserve’s September rate hike pushed yields higher and prices lower across nearly every part of the fixed-income landscape. Stocks, meanwhile, held up relatively well and eked out a roughly 1% gain in the quarter.

Morningstar’s research team digs into both stories and much more in this quarter’s Morningstar Markets Observer. Below are some notable observations from the report.

Bonds Fall Across the Board

With significant interest rate increases along the yield curve during the third quarter, fixed-income sectors sold off across the board aside from leveraged loans, which are not hurt by rate hikes like other sectors. In addition to rate hikes, municipal bonds were hurt by surging new-issue supply, causing them to cheapen relative to Treasuries.

The recent bond selloff has caused most fixed-income sectors to have negative returns over the trailing 12 months, with credit-heavy, less interest rate sensitive sectors being the main exception.

The Treasury Yield Curve Shifts Higher

The Federal Reserve contributed to the pressure on bond prices by raising the federal-funds target rate by 0.25 percentage points in September, the first hike since 2023. Intermediate- and long-term bonds continued to sell off as longer-term yields rose more than rates at the short end of the curve.

The Fed wasn’t alone in trying to quell persistent inflation. The European Central Bank, Bank of Japan, and Reserve Bank of Australia each raised rates by 25 basis points during the quarter. The Bank of England was an outlier, holding rates steady at its last meeting.

Higher Real Yields Drive Most of the Increase, Not Inflation Fears

Persistent inflation and higher oil prices played a role in the bond selloff, but they do not explain most of the increase in Treasury yields.

The 10-year real yield, or what a Treasury pays after accounting for inflation, jumped to 2.93% at the end of September from less than 2% at the start of 2026. The 10-year breakeven inflation rate, which reflects the bond market’s inflation expectations, didn’t increase as much and ended September at 2.36%.

That suggests investors are not bracing for runaway inflation. Instead, stronger economic growth, heavy government borrowing, and spending on artificial intelligence infrastructure and data centers have increased the competition for available capital. Investors are demanding greater compensation to lend money, pushing real yields higher.

Globally, yields rose more in countries with heavier debt burdens since mid-September, and the gap between French and German 10-year government-bond yields widened by roughly 0.4 percentage points.

Still, Morningstar’s senior US economist Preston Caldwell believes economic strength, underpinned by investment in artificial intelligence, explains more of 2026’s increase in US yields than government debt concerns.

Bonds Crack Under Pressure As Rates Rise

Higher rates exposed cracks in some corners of the bond market. Mortgage rates surpassed 7.25% in September, marking their highest level since 2023 and rising by 25 basis points in the final week of the month alone.

Stress also surfaced at the bottom of the leveraged-loan market. Spreads on CCC rated loans widened to levels last seen briefly after the 2020 coronavirus selloff. Many of these borrowers issued debt at lower rates in 2021 and 2022. As that debt approaches maturity, they face much higher refinancing costs and a greater risk of default.

Municipal bonds also had a painful September, suffering their worst month since the 2008 financial crisis. Macroeconomic headwinds and heavy new issuance drove the selloff rather than deteriorating credit quality. Munis have historically recovered quickly from similar declines, and the resulting increase in tax-free income has made them more appealing for long-term income-seeking investors.

Stocks Shrug Off Rising Rates

The rise in yields did not derail the US stock market to the same degree it did the bond market. Healthy corporate earnings and a resilient economy helped US stocks gain about 1% in the third quarter and roughly 12% in 2026 through September. That extended the market’s expansion to 33 months, climbing 108.8% cumulatively since the 2022 downturn.

There’s some variability beneath the surface, though. Energy led the way as oil prices recovered, rising about 15% in the quarter and nearly 40% this year. Utilities and industrials each fell by around 12% as higher rates weighed on these rate-sensitive areas. US small-cap stocks shed 5.6%.

International stocks delivered mixed results. Developed markets gained 1.3%, but emerging markets lost 0.9% after advancing 22.4% in the second quarter. Japan and developed Asia ex-Japan led foreign markets, while Asian emerging markets gave back some of their earlier technology-driven gains. South Korea remains the standout, up 74.5% in 2026 through September thanks to the rally in semiconductor and memory-chip companies.

What Comes Next for Investors

Morningstar expects one more rate hike from the Fed in 2026, followed by rate cuts starting in the second half of 2027. That could bring the federal-funds rate to 2.50%-2.75% by year-end 2028 and the 10-year Treasury yield to 3.25% by 2029.

Bonds could remain under pressure until rates turn lower, particularly those with longer maturities. But the selloff has also restored much of their income appeal, so investors should weigh the higher payouts with their current precarious position. Investors can now find yields above recent norms without necessarily taking on substantial credit risk.

A turn in rates could also reshape the stock market. Stocks held up this quarter, but top-line gains were narrow, and some segments sputtered. Lower rates could broaden the rally, but until then, a diversified portfolio can reduce reliance on a narrow group of market leaders across both bonds and stocks.

Joe Bullard, Preston Caldwell, Mary Marshall, and Thomas Murphy contributed to this article.

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