Why the Bond Market Sold Off in Q3—Will the Losses Continue in Q4?

Key Takeaways

• Bond markets sold off in the third quarter, with Treasury yields reaching their highest levels in more than two decades.
• With inflation still above target, the Fed hiked interest rates at its September meeting, pushing yields further upward.
• Analysts expect yields and rates to remain elevated in the fourth quarter and into next year.

Bonds are in a serious slump. Over the third quarter, fixed income markets sold off sharply as concerns about sticky inflation, oil price spikes and heavy corporate borrowing to fund the artificial intelligence buildout put upward pressure on yields.

The yield on the 10-year Treasury hit 5.26% and the yield on the 30-year hit 5.59% just this week—their highest levels since the financial crisis—as the selloff intensified. Bond yields move inversely with prices. Even escalating Treasury buybacks weren’t enough to calm bond investors’ nerves.

“Year-to-date yield moves up have been substantial,” says Dominic Pappalardo, chief multi-asset strategist for Morningstar Wealth. “They’ve been driven mostly by inflation concerns.”

Those rising yields came against the backdrop of anxiety over unsustainable fiscal deficits and an economy that’s still running hot despite rising rates. The Federal Reserve hiked interest rates for the first time in more than three years, and investors expect at least one more hike for the remainder of the year.

Q3 Bond Market Performance

The Morningstar US Core Bond Index fell 3.35% over the third quarter. Long-term Treasury bonds fared worst, losing 7.65%. That makes sense; long-dated bonds tend to have longer durations, making their prices more sensitive to interest rates. As rates soared this year, longer-term bonds sold off more than short-term ones, fueled by worries about uncertain fiscal policy and stubborn inflation. Short-term core bonds fared best, with losses of 0.89%. High-yield bonds, which tend to have shorter durations and are less sensitive to rate fluctuations, lost 1.71%.

All Eyes on AI Debt

Looming large for the bond market is the booming issuance of debt related to the artificial intelligence buildout, as mega-cap tech firms borrow billions to fund data centers and other infrastructure.

A recent estimate from Goldman Sachs suggests debt issuance from hyperscalers could reach $420 billion in 2027. That would represent an increase of more than 60% from 2026, their analysts say. So far this year, they find that hyperscaler firms have issued $229 billion in debt.

“A new dynamic is changing the composition of the credit markets,” says Morningstar Wealth’s Pappalardo. He notes that concentration risk—a familiar phenomenon in equities markets—could come into play if the trend continues. If the share of hyperscaler debt in fixed-income markets continues to increase, “that concentration problem will become concerning at some point.”

Pappalardo says he isn’t seeing signs of bond market concentration yet, but that it’s worth keeping an eye on. Earlier this year, he says AI-related debt accounted for about 15% of the corporate bond universe.

Fed Rate Hike Pushes Yields Upward

The Fed raised interest rates at its September meeting for the first time in more than three years, bringing the federal-funds target to a range of 3.75%-4.00%. The move pushed up yields on both short- and long-term bonds as the market priced in expectations of persistent inflation and a higher rate environment in the months and years ahead.

Inflationary pressures are clearly top of mind for policymakers. The war in Iran is driving up oil prices and energy costs. At the same time, the AI boom appears to be raising costs elsewhere in the economy.

After the September decision, analysts quickly turned their attention to the Fed’s next move. “It’s rare that they only hike once,” Morningstar Wealth’s Pappalardo says. And some analysts argue that with other measures of economic health (like employment and business activity) looking robust, the central bank has plenty of reasons to keep raising interest rates to prevent overheating. As of this writing, bond futures markets are pricing in more than 50% odds that the Fed hikes twice before the end of the year. That would bring the federal-funds target rate to a range of 4.25%-4.50%.

Yields Likely to Stay Higher for Longer

Analysts agree it’s unlikely that yields will drop significantly anytime soon. Inflation is still sticky, which has ramifications for both longer-dated bonds and yields across the board. Pappalardo says the outlook for bonds depends on two key questions: “How high will rates go from here, and what will bring them back down?”

Pappalardo says that with elevated energy prices from the Iran war keeping inflation above target, it’s reasonable to expect yields to remain high for some time. More Fed hikes are on the table, too. On the other hand, resolving tensions in the Middle East could ease the pressure and help rates fall. “You would expect energy prices to start to work their way back lower, taking the top off inflation and pushing it closer to the 2% target,” he says.

Some analysts have argued that markets should get used to a new paradigm of higher yields after two decades of rock-bottom levels. Going forward, 10-year yields of 4%, 5%, or even higher might not be all that abnormal. “We’re in a different era,” characterized by larger-scale fiscal spending, higher inflation, and higher growth, according to Sebastien Mallet, manager of the $313 million T. Rowe Price Global Value Equity TRGVX.

But it’s not all bad news for investors. Strategists emphasize that, while painful on paper, higher yields also mean more income for bond investors, as well as a bigger cushion to offset price declines.