The third quarter produced constructive bond market performance with the Bloomberg US Aggregate Bond Index registering a 2.03% total return. The environment was positive for each of the major sub-sectors: US Treasurys, corporates (both investment grade (IG) and high yield (HY) and mortgage-backed securities. In fact, it’s hard to find a sector of the bond market that didn’t do well – including for the year-to-date as well, despite second quarter drama. High quality investment-grade performance for the period was perhaps easier to explain than the continued rally in low quality risk assets.
The solid bond performance was driven by modestly lower interest rates and constructive credit spreads
The solid bond performance was driven by modestly lower interest rates and constructive credit spreads, which moved back toward the tight levels achieved in late 2024 and early 2025. The fact that Treasury yields declined, particularly on the short end, made sense to us as we expected that a difficult labour market would eventually put the Federal Reserve (Fed) in play. Job numbers have reflected the ‘no-hire, no-fire’ mantra by averaging less than 100k per month in 2025, with significant downward revisions to historical figures. These numbers call into question how much the consumer will be able to contribute to overall GDP growth moving forward, despite reasonable balance sheets. We also understood that the other half of the stagflation-lite scenario we’ve been predicting, driven by tariff inflation, will be slow to show up due to front running of inventory building and delays in tariff implementation. For a data dependent Fed, the low employment figures overwhelmed the modestly worse inflation numbers, which, while inflecting upward, have not shown signs of accelerating – yet!
Three out of four: duration, yield curve, and currency have added value
Throughout the quarter we positioned for a bullish steepener – durations modestly longer than benchmark and a key rate structure overweight in the belly of the yield curve, with corresponding underweights in longer maturities. This proved beneficial, as rates were lower on average, with two-year yields declining by twice as much as 30-year yields. Additionally, with the US dollar down approximately 10% on a YTD basis, our non-dollar allocations in those portfolios allowing for currency positioning created another source of alpha, resulting in three of our four major alpha pod committees with positive contributions.
The one that wasn’t positive for us was sector allocation. The record tight in credit spreads reached in Q3 was not as clear to us – we thought the market would be more cautious on the prospects of slower economic growth and possible disruptions from tariffs, as demonstrated in early April’s market performance. But while the job numbers and associated revisions were shockingly weak, high levels of the investment component kept the overall GDP calculation fairly positive with upward revisions. The relief of steady earnings reports and more constructive forward guidance seemed to remove the highest levels of business environment uncertainty, allowing for further extension of the constructive spread environment.
It doesn’t get tighter than this
One of the benefits of bond investing is that it can be easier to know when the risks outweigh the potential benefit. Historically tight credit spreads mean that when the music does stop, there won’t be enough chairs. And corporate bond investors have rarely been paid less for credit risk than right now. To quantify how rare, our Head of IG Corporates in the US, John Gentry, reports that spreads have been tighter only eight days since 1999. High yield spreads, while not quite as extreme, are also significantly below historic means and medians. Maintaining a corporate underweight position in a historically tight spread environment seems like a very low-cost option to protect against potential spread volatility.
Cracks and canaries?
While we’ve been wrong recently on the strength of the mid to lower quality corporate market, our team’s value orientation and credit diligence did allow us to dodge the recent news on credit distress on major issuers (First Brands, Tricolor). This was a reminder to investors that it only takes a few of these types of events to eliminate the yield advantage that investors play for in allocating to corporates. Another indicator worth watching is the price of gold, which has risen by over 50% thus far in 2025. Gold had similar outsized increases in past periods prior to credit spread widening. In general though, one of the advantages of a diversified investment process is that if we have conviction, we can sit out one of the areas of fixed income management, in this case sector allocation, preferring instead to add value in other areas which our team feels represent a better risk-return play.
Absence of data won’t be evidence of market direction
At this writing, the government was experiencing its 11th shutdown since the first brief event in 1980. While investors have been conditioned to believe these typically short-lived disruptions don’t impact markets, things could be a little different this time, exacerbated by the administration’s aggressive approach to government lay-offs and the lack of economic data at a critical juncture for employment and inflation.
Both professional economists and the more mortal among us are famously challenged in predicting when creative destruction is well, destructive. Cracks in employment appear persistent. It’s the main reason the Fed resumed cuts. Inflation is also not showing any signs of retreating to targeted levels. Can 3% become the new 2% without repercussions? Tariffs remain in place, pending Supreme Court action that is still months away. And excesses from private credit and tight levels of bond issuance may begin to impact the market. In spite of recent good news on GDP, it seems caution on lower quality risk assets remains warranted.
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