Gradually, Then Suddenly: What Q3 Revealed About Bond Markets

Volatility returned to fixed income in the third quarter as an energy-driven inflation scare and a hawkish Federal Reserve pushed Treasury yields sharply higher, with much of the move coming in September (Source: Bloomberg as of 09/30/26). The pressure was heaviest at the long end of the curve, where fiscal deficits, heavy Treasury supply, and record AI-related corporate issuance added to inflation concerns.

Credit held up better than rates, but it wasn’t immune. Spreads stayed near historic tights for most of the quarter before widening in September, led by lower-quality issuers. Volatility can make investors nervous, but we believe it can also reveal meaningful differences in how bond portfolios are positioned with respect to interest rate and credit risk.

Credit investors aren’t being paid much for risk right now

High yield corporate spreads ended the quarter at 311 bps, in the 16th percentile of their history (Source: Bloomberg U.S. Corporate High Yield since 8/14/2000). Put another way, spreads have been tighter only about 16% of the time, which leaves little cushion. If spreads widened back to their long-term average, high yield corporate bonds could potentially experience losses.

Many investors have already felt this year’s rise in rates, with some negative year-to-date returns through September, and are trimming duration out of fear for a continued rise in rates. It’s worth asking whether it makes sense to take on more credit risk at the same time, reaching for yield when spreads offer so little compensation.

Is a flight to safety underway?

Since 2022, the relationship between stocks and bonds has been less reliable. Bonds often haven’t rallied when equities sold off. That may be starting to change. During the recent pullback in AI-related stocks, Treasurys rallied, a response we hadn’t seen in other recent bouts of equity volatility.

We see two possible explanations. If enthusiasm for AI is cooling, the debt needed to fund its buildout may come in below market expectations, which would reduce bond supply and support prices. Or investors may simply be moving capital out of risk assets and into safety. It’s too early to say which. The 60/40 portfolio has been challenged in recent years, but the link between AI and fixed income may matter more than markets have assumed, and worth monitoring.

When markets get rough, the gap between funds opens fast

Dispersion among bond funds widened sharply in the quarter. In September alone, the return gap between the 25th- and 75th-percentile ranked funds in the Morningstar Multisector Bond Category was 85 bps. For the full quarter, it was 139 bps, roughly equal to the category’s three-year gap as of June 30, 2026 (139 bps).

For years, spreads tightened gradually for the most part. In September, the differences in how funds were positioned with respect to interest rate and credit risk suddenly showed up. We believe bond investing is about participating in the upside and managing the downside through a full market cycle, not chasing every last basis point of yield.

How we’re positioned in this environment

We remain cautious on credit. Even after September’s widening, spreads sit at the tighter end of their historical range. In our view, they still offer limited compensation for the risks of slower growth, higher refinancing costs, and rising leverage associated with AI infrastructure and private credit.

That positioning didn’t happen overnight. As spreads tightened over the past several years, we gradually reduced the high-yield exposure in Thornburg Strategic Income Fund to about half its long-term average. When investors were better paid to take credit risk, in our view, as in 2014–2016 and 2020, our team held considerably more high-yield within the Fund.

Today, we favor higher-quality issuers and maintain an underweight to high yield relative to our historical norm. With spreads still tight, we believe there is little margin for error if defaults rise, and we would look to add credit risk when the compensation improves.