Quarterly Market & Performance

The third quarter of 2025 delivered outsized gains for bond investors as markets responded to the Federal Reserve’s decision to restart its easing phase at their September meeting and growing conviction that additional cuts could follow. Much of the quarter’s bond rally actually came before the September meeting, as markets priced in the same economic concerns the Fed later acknowledged. By quarter-end, yields had moved lower across the curve, delivering strong gains for bondholders. The Bloomberg U.S. Aggregate Bond Index returned 2.0% for the quarter, bringing year-to-date performance to 6.1%. The index yield closed at 4.4%, still appealing compared with much of the last decade.[1]

At the September FOMC meeting, the committee cut the federal funds rate by a quarter of a percent to 4.25%, marking the first reduction since late 2024. While widely anticipated, the cut marked a meaningful pivot. Chair Jerome Powell framed the decision as a “risk-management” move – a precaution against downside risks rather than the start of a full shift toward aggressive easing.

Powell emphasized that balancing the Fed’s dual mandate is particularly challenging at this stage of the cycle, stating, “There is no risk-free path.” Inflation remains above the 2% target, but labor market data have softened. As he explained, “While the unemployment rate remains low, it has edged up, job gains have slowed, and downside risks to employment have risen.” Markets interpreted this as confirmation that the Fed may now weigh labor conditions as heavily as inflation when setting policy.

The updated dot plot showed a year-end 2025 projection of 3.75%, implying two additional cuts from current levels. Yet the dispersion of views was striking: one participant penciled in a hike, while another projected as much as 125 basis points of easing over just two meetings. The final vote passed 11–1, highlighting consensus on the September cut but ongoing divergence about the road ahead.

Illiquidity Premiums: A Pocket of Value

Bond investing is always about trade-offs: to earn returns, investors must accept some form of risk. In fixed income, the two primary risks are duration (sensitivity to interest rates) and credit (the possibility of default).

Today, compensation for both types of risk is slim. The yield curve remains unusually flat – 10-year Treasury bonds yield less than half a percent more than 1-year Treasuries – offering little reward for taking on additional interest-rate risk. On the credit side, the excess returns investors earn for owning corporate bonds have narrowed to about 0.7%, down from roughly 1.7% at the end of 2022.[2] In other words, investors are being asked to take traditional risks without being paid much extra for doing so. This pattern isn’t unique to bonds. Across most asset classes, the premiums investors earn for taking risk have steadily compressed.

One pocket of value that remains is the illiquidity premium – the additional yield earned for holding assets that cannot easily be traded daily. While small illiquidity premiums exist in public markets, such as those available on smaller municipal or corporate issues, the most compelling opportunities are in private credit. These loans, often made by investment firms to businesses and other borrowers that can’t or choose not to access public bond markets, offer higher yields in exchange for reduced liquidity and less frequent trading.

For example, private corporate loan yields have consistently exceeded those of their broadly syndicated counterparts, and that spread has held steady even as other premiums narrowed. According to the Cliffwater Direct Lending Index, the spread in direct loans is in line with its three-year average since the Fed began raising rates.

Figure 1: Corporate Loan Yields: Private vs Public

Source: Cliffwater Direct Lending Index Yield-to-Maturity (3 Yr Takeout Yield), Morningstar LSTA US Leveraged Loan 100 Index (Wtd Average Yield).

There is, of course, no such thing as a free lunch. Illiquidity is a real trade-off, but it can also vary relative to the needs of specific investors. Some investors truly need daily access to capital, while others can set aside a portion of their portfolio for years at a time. For the latter group, using that advantage thoughtfully can meaningfully enhance long-term outcomes. At current yields, the illiquidity premium in private credit would compound to roughly a 50% higher total return over a decade.[3]

We remain defensively positioned given how compressed traditional risk premiums are. But today’s interest rate environment still allows for attractive absolute returns in high-quality bonds. Investors can earn meaningful income without reaching into lower-rated areas that do not adequately compensate for risk. For those able to tolerate reduced liquidity, we continue to advocate selectively for private credit as a way to improve returns without relying on duration or credit risk alone.

Conclusion

The third quarter reinforced how quickly sentiment in fixed income markets can shift as the Fed balances its dual mandate. Policy uncertainty remains high, and traditional sources of risk premiums are offering less reward, making selectivity more important than ever.

Our focus continues to be on quality, flexibility, and patience – earning attractive income while maintaining discipline on both credit and duration. For investors able to take a longer view, illiquidity remains one of the few sources of genuine excess return, but across all markets, the key will be staying intentional rather than reaching for yield.

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[1] Bloomberg US Aggregate Bond Index. Yield measured as yield-to-worst.

[2] Bloomberg US Agg Corporate Average Option-Adjusted Spread.

[3] Illustration assumes annual compounding of current yields over ten years. For informational purposes only; not a projection or guarantee of future results.

DISCLOSURES

Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. The information and opinions expressed in this publication are not intended to constitute a recommendation to buy or sell any security or to offer advisory services by Kovitz. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to participate in any trading strategy, and should not be relied on for accounting, tax, or legal advice. This report should only be considered as a tool in any investment decision matrix and should not be used by itself to make investment decisions.

Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.