- U.S. bonds posted their best year since 2020 in 2025, with broad core indexes returning about 7%–8%.
- Returns were driven by roughly 75 bps of Fed rate cuts, cooling inflation, and tight credit spreads supported by a resilient economy.
- For 2026, expectations are for more muted gains as rate cuts slow, fiscal deficits keep long-term yields elevated, and tight spreads leave less cushion.
- Preferred exposures include income-focused, higher-quality sectors (agency MBS, investment-grade corporates, municipals) and intermediate duration, while long-duration Treasurys and lower-quality credit look riskier.
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2025 Performance & Key Drivers
The bond market in 2025 registered its best year since 2020, with the Morningstar US Core Bond Index returning about 7.3% total return, surpassing performance in recent years. This was largely driven by the Federal Reserve cutting its policy rate by roughly 75 basis points during the year, which reduced short-term rates and pushed yields down—particularly benefiting bonds with higher coupons and longer maturities. Inflation decelerated from its peaks, labor market growth slowed modestly, and macro uncertainties—including those related to trade policy—eased enough to improve sentiment for fixed income.
Current Yield Environment & Credit Spreads
Bond yields, especially in core bonds, have reached levels far above those seen during the zero-rate era, offering attractive current income streams. The Morningstar US Core Bond Index, for instance, yielded around 4.3% toward end-2025. Among sectors, credit spreads tightened significantly throughout 2025: investment-grade corporates and high-yield bonds both enjoyed strong returns (~8%) as spreads reached multi-year lows.
Risks & Headwinds Going Into 2026
Multiple factors suggest that bond returns in 2026 may be less robust. The Fed is projected to cut rates less aggressively in 2026—a scenario that reduces the potential for price gains. Fiscal stimulus and rising deficits may increase supply of long-duration Treasury debt, exerting upward pressure on long-term yields. Credit spread cushions are limited, leaving sectors with tight valuations vulnerable to reversal should growth, inflation, or credit quality surprises emerge.
Strategic Implications & Opportunity Areas
– Duration positioning: With rate cuts expected to be modest and long-term yields under pressure from fiscal dynamics, a neutral duration stance—favoring intermediate maturities—may balance income potential vs. interest rate risk.
– Credit sector tilts: High-quality investment-grade corporates, municipals, and agency MBS (specifically current coupon MBS) are compelling due to their yield premiums and relative cushion if spreads widen.
– Avoid overexposure in long-duration government bonds and lower-rated credit assets: Valuations are stretched, and downside risk from inflation surprises, fiscal imbalance, or economic softening is elevated.
Open Questions
– Will inflation remain anchored at or above the Fed’s 2% target, potentially forestalling deeper rate cuts?
– How will the new Fed Chair’s regime (post-May 2026) influence policy sensitivity to fiscal dominance and labor market dynamics?
– Can fiscal deficits be managed without worsening long-end yield pressures?
– To what extent will external demand (foreign investors, pension funds, etc.) continue to support U.S. Treasurys amid rising global fiscal risks?
Supporting Notes
- The Morningstar US Core Bond Total Return Index returned ~7.3% in 2025, marking its strongest annual gain since 2020.
- The Bloomberg U.S. Aggregate Bond Index delivered ~6.7% as of late 2025, also reflecting peak bond market performance since 2020.
- The Federal Reserve reduced the federal funds target rate by approximately 75 basis points in 2025.
- The yield on the 10-year U.S. Treasury fell more than 40 basis points over 2025 to about 4.10%, as a result of rate cuts and weaker labor market signals.
- Credit spreads for investment-grade corporates stood near historic lows (~80 bps over Treasuries) by year-end 2025.
- Forecasts for 2026 foresee fewer rate cuts, with the fed funds rate likely easing to ~3.00%–3.50%, and the 10-year Treasury yield range expected between ~3.75% and ~4.25%.
- Agency mortgage-backed securities, municipals, and high-quality corporates are highlighted as sectors offering superior yield and spread value compared to low-yield, high-risk assets.
- Long-duration Treasurys are viewed as riskier in 2026 due to elevated deficits and weaker external demand.