After a relatively quiet third quarter, bond markets are ripe for some volatility and bigger waves as major central banks begin to unwind quantitative easing. For global bond investors, that could lead to new opportunities. But for now, with valuations in many sectors stretched, it pays to be selective.

Fixed-income markets were remarkably tranquil in the last quarter. The global economic backdrop was bright, with major developed and emerging markets—including China—growing at a decent clip. At the same time, inflation was moderate. The combination provided a friendly atmosphere for most bond prices.

Benchmark government bond yields finished the quarter about where they started it. The 10-year US Treasury yield stood at 2.33%, compared to 2.30% at the end of June, while the 10-year German Bund yield was virtually unchanged at 0.46% (Display).

Credit spreads in the US and Europe tightened, keeping spreads near multiyear lows (Display), and most credit sectors outperformed developed-market (DM) government bonds.

UNWINDING OF QE COULD UNLEASH VOLATILITY

Investors should be prepared, however, for more volatility in the months ahead. Major central banks say they want to normalize monetary policy, which suggests higher interest rates and the eventual end of nearly a decade of quantitative easing.

As widely expected, the US Federal Reserve said in September that it would begin the multiyear process of reducing its $4.2 trillion portfolio of US Treasury and mortgage-backed bonds. But it also confirmed that another interest-rate hike is likely in December.