The Treasury Market Just Suffered a Historic Sell-Off. History Says the Next Move Could Surprise Investors.

The Treasury market just experienced a sell-off that makes investors question whether bonds still belong in their portfolios. According to Reuters, Treasuries suffered their worst quarter since 1994 in Q3, while the 10-year Treasury yield reached 5.36% in early October. Fixed-income investors have struggled to justify owning this asset class for almost the entire past six years since the COVID pandemic.

But the damage in long-term Treasury bonds in 2026 also presents an opportunity. The same sell-off that's punished existing bondholders has substantially increased income for new buyers. History suggests that the distinction could matter a great deal over the next several years.

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The bond market has been here before

The Treasury market's worst periods have usually occurred when investors thought that rates had nowhere to go but up. 1994 was a great example. The federal funds rate started the year around 3% but finished it at 5.5%. That resulted in huge losses for long-term bonds as investors adjusted to unexpectedly aggressive monetary tightening.

But the damage didn't last forever. The Federal Reserve stopped tightening in early 1995, yields began to drop, and Treasuries slowly began to produce positive returns again.

The early 1980s were another rough period for bond investors. Paul Volcker's Fed pushed the target rate up to around 20% to combat inflation. Treasury investors got hammered, but rates fell back into the single digits by the end of 1982. Investors who bought long bonds near the peak in yields got the double benefit of locking in high yields and enjoying capital growth.

Then came 2022. The Bloomberg U.S. Aggregate Bond index lost approximately 13%, its worst calendar year performance in decades. Rising inflation and aggressive Fed tightening far outweighed any yield that investors captured. The recovery has been choppy. Bond yields continue to fluctuate, and Treasuries still haven't made a meaningful recovery.

The lesson in this is that buying bonds at higher starting yields can materially improve the risk/reward trade-off over longer holding periods.

Why higher yields change the math

Consider a scenario in which two Treasury bonds with five-year durations are issued at different points in time. One yields 2%, and the other yields 5%.

If Treasury yields rise 1%, the bonds would decline approximately 5%. For the 2% bond, that price drop represents two-and-a-half years of income. If the bond's price holds steady from there, that's a fairly long time to get back to breakeven.

The 5% bond, however, would only lose one year's worth of income. That would be a much quicker trip back to breakeven and a much bigger cushion of protection in case the bond market doesn't cooperate for even longer.

The underlying lesson is important to remember. Higher starting yields give investors more ways to earn positive returns without requiring a huge rally in the bond market.

Three bond ETFs worth considering now

There are a few different ways to approach investing in bonds:

• The Vanguard Total Bond Market ETF (NASDAQ: BND) offers the broadest diversification across Treasuries, investment-grade corporate bonds, and mortgage-backed securities. It makes a solid core fixed income holding, although the introduction of credit risk in this portfolio changes the dynamics somewhat.
• The Vanguard Intermediate-Term Treasury ETF (NASDAQ: VGIT) targets Treasuries with maturities of three to 10 years. It's a nice middle-of-the-road option for investors who want to capture most of the bond market's potential yield while still limiting interest-rate sensitivity.
• The Vanguard Long-Term Treasury ETF (NASDAQ: VGLT) is the more aggressive choice. It's highly rate-sensitive and becomes more of a bet on which way you think interest rates are headed, rather than a pure income vehicle.

What I'd do with my portfolio

I'd personally stay away from long-term Treasuries. There's just too much volatility there, and the interest rate sensitivity makes it feel more like a gamble than an investment.

In my opinion, the Vanguard Intermediate-Term Treasury ETF is the more reasonable option. It has a 5% yield right now and a duration of 4.8 years. So it's very similar to the previous example. That provides some of the best balance between yield and risk.

Long-term yields could still very well head higher. But at least you're not facing a severe adverse scenario if it does happen. The current high-yield environment can be leveraged. It's not without risk, but you shouldn't look solely at what's happened in the past as your deciding factor.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Total Bond Market ETF. The Motley Fool has a disclosure policy.