High starting yields strengthen the long-term outlook for bonds

High starting yields have materially improved the long-term risk-return case for high-quality bonds and their potential role as portfolio diversifiers.

• Over the past five years, the S&P 500 gained close to 90% cumulatively while the broad bond market was slightly negative; over ten years, equities outperformed a high-quality bond index by around 300% cumulatively.
• Ten-year annualized bond returns have fallen to around zero versus a long-term average of roughly 5%, while high-quality fixed income now yields above 6% and real yields are near 25-year highs.
• Schroders' Aladdin analysis indicates that a 100-basis-point yield rise could still leave five-year Treasuries with positive 12-month returns, and could produce positive three-year returns across all three maturities.
• US headline inflation is expected to average around 3.4% in 2026 before falling in 2027 as energy prices normalize, while housing, autos, small businesses, freight and lower-income consumers face growing pressure beneath strong AI investment and large-cap earnings.
• Reshoring, deglobalization, fiscal expansion and investment in AI, energy, defense and infrastructure are likely to keep inflation, term premia and competition for savings higher, limiting the case for excessive long-duration exposure.

Takeaway: Investors can earn attractive prospective returns from bond income without requiring a recession or major rally, while bonds could regain their diversification value if inflation falls below 3%; fiscal risks and structurally higher rates argue for caution at the very long end of the curve.