The smell of fear is permeating the bond market and wafting into other markets. This year's aggressive run-up in interest rates has pushed bond prices lower while volatility has increased. After serving as the "boring" side of investment portfolios for decades, bonds have become an unruly asset class.

A convergence of powerful forces -- re-emerging inflation, strong economic growth, and ballooning sovereign debt -- led to this era. The shift has created palpable anxiety that higher rates, which increase the cost of capital for corporations and can make fixed income relatively more attractive than stocks, could derail the long-running bull market in equities.

The benchmark 10-year Treasury yield, which influences mortgages and other loans, hit 5.36% on Oct. 7, its highest level in nearly 25 years and more than a full percentage point higher than a year ago.

The catalysts for that shift -- and the potential that they could push rates still higher -- can appear daunting. For example, global debt this year surpassed $365 trillion, according to the Institute of International Finance, while U.S. government debt breached $40 trillion for the first time.

Governments aren't the only borrowers. Corporations have been issuing debt hand over fist to finance spending on the artificial-intelligence infrastructure buildout -- spending that Standard & Poor's expects to hit $1.3 trillion next year. Morgan Stanley predicts that companies will rack up about $570 billion in AI-related debt this year alone.

Strategists say this is already pushing yields higher. Christian Hoffmann, head of fixed income at Thornburg Investment Management, says there are some warning signs in noninvestment-grade, triple-C-rated corporate debt, where the so-called spread, or difference between the yields of that debt and Treasuries, has been widening in recent months.

"Whenever the cost of capital moves this far, this fast, one should expect breakage," wrote Lisa Shalett, chief investment officer of wealth management at Morgan Stanley, on Oct. 5. She wrote that she is watching for three signs of stress: earnings revisions, a jump in spreads, and currency-market volatility. "Now is the time to review portfolios for vulnerabilities in the year ahead," she added.

The Good News

So far, equity markets have been resilient. The S&P 500 index is up about 14% this year. Many investment pros don't expect rates to continue to surge, and some even welcome the more normal recent level of yields compared with the era following the 2008-09 financial crisis, when interest rates were extremely low or even negative.

"We're getting a resetting of many different things at the same time," says Luis Alvarado, co-head of global fixed-income strategy at the Wells Fargo Investment Institute. "Some people like to call this 'higher for longer.' What we've been telling our clients is that this is more like 'normal for longer.' "

Julian Emanuel, Evercore ISI's head of equities, derivatives, and quantitative strategy, says the Federal Reserve's commitment to fighting inflation and expectations for more Fed rate hikes is keeping stocks on an upward trajectory. "The market now understands that the Fed is serious about beating inflation," he says. "That doesn't stop the 10-year [yield] from going higher, but it keeps it from exploding higher."

Emanuel says his firm's research shows that stocks run into trouble when the 10-year Treasury yield breaches 4.75%. Yet, it is now well above that. "Did it kill the entirety of the rally?" he says. "I don't think it does until we see credit spreads start to widen materially or the economy starts to weaken, and we don't have any signs of that."

Earnings growth is also helping stocks stand up against higher interest rates. "You're looking at the third straight quarter of above 25% year-over-year earnings growth," says Michael Arone, State Street Investment Management's chief investment strategist. "If the economy and earnings were in a different position, the threat of higher yields would become more problematic. I think we're probably getting into the tail end of some of this move higher in rates."

For stock investors, it's important to monitor whether the coming third-quarter earnings reports reveal significant weakening.

For now, Arone says he favors stock sectors including technology, industrials, materials, healthcare, and financials. "What's interesting here is financials, banks in particular," he says, because investors are expecting more aggressive Fed rate hikes than will actually occur. If the Fed doesn't raise rates as expected, short-term rates will fall. "Should we get some relief, [financials] may be one of the big beneficiaries," he says.

Buy Bonds

Despite volatility, Russ Brownback, deputy CIO for global fixed income at BlackRock, doesn't see a further spike in yields ahead. At some point over the next couple of quarters, he expects that growth will decelerate and yields could fall back. "I think the opportunities in these [current] yields are so great. I'm just going to sit back and clip the coupon," he says, referring to the way bond investors traditionally collected regular interest payments. "That's the secret sauce. We've been waiting for this moment for a very long time."

For now, investment pros recommend sticking with bonds with shorter maturities.

"Our conclusions are we're not shying away from bonds, but we would rather earn our yields toward the front end of the curve," or shorter-term bonds, says Jack Ablin, Cresset chief investment strategist. He pointed to the iShares 1-3 Year Treasury Bond exchange-traded fund.

Ablin says his firm doesn't "mind credit risk or illiquidity risk," so it also finds the Invesco Senior Loan ETF and the iShares 0-5 Year High Yield Corporate Bond ETF interesting. The Invesco fund has a 30-day SEC yield of about 6.9%, while the iShares ETF, which focuses on below-investment-grade corporate bonds, yields about 7.1%.

Arone of State Street agrees that the one- to five-year durations are attractive. "That seems to be a sweet spot," he says. "You don't have to extend too much in the way of interest-rate risk or credit risk to capture a healthy yield above the rate of inflation. We would prefer to get our volatility in stocks instead of bonds."

Other ETFs that focus on short-duration bonds include iShares Short Duration Bond Active, State Street Short Duration IG Public & Private Credit, Pimco Enhanced Low Duration Active, and Vanguard Short-Term Corporate Bond.

Among short-duration managed mutual funds, the Holbrook Income fund has been one of the top performers, according to Morningstar, returning 5.3% for the year ended on Aug. 31. The Pimco Low Duration Income fund and Pimco Low Duration Opportunities were also top performers for the period, returning nearly 5.1%

Arone says investors have been interested in floating-rate funds because they expect rates to keep edging higher. Floating-rate ETFs include iShares Treasury Floating Rate Bond, WisdomTree Floating Rate Treasury, and State Street SPDR Bloomberg Investment Grade Floating Rate.

"I think yields are incredibly attractive for investors today," says Brownback. "I think people need to stop absorbing and digesting this idea that rising yields are bad. High yields are good for savers. It's a shifting narrative to: 'Oh gosh, this is a real opportunity and not a real risk.' "

In a shorter-duration portfolio of 21/2 to three years, investors can lock in a 7% average rate of return with a single-A rating. "The better opportunities are in the front and belly of that curve -- corporate credit, securitized assets, emerging market, and some developed market rates," he says.

Think Taxes

Many investors may not associate tax-loss harvesting with bond investments, but selling some losing fixed-income investments to offset capital-gain taxes from winning stock investments can be useful in the current environment to maximize one's after-tax returns.

Jim Caron, CIO at Morgan Stanley Investment Management Portfolio Solutions Group, tells the story of a 93-year-old investor who was surprised when his financial advisor recommended selling bonds to harvest tax losses. In past years, he combed the stock side of his portfolio for losers and said he had never heard this type of advice before.

"I told him you haven't," Caron says. "That's because for the last 40 years interest rates have gone straight down, so today, people are going to sell bonds to get losses to offset their equities."

Tax-sensitive investors may also want to consider adding to their municipal bond holdings, says Shalett of Morgan Stanley. One popular muni ETF is iShares National Muni Bond.

AI Risks

One important question for both stocks and bonds is whether fixed-income investors will continue to finance the AI buildout.

"I think the most probable case for a de-risking event as it comes to the AI trade is the market questioning the rate of return on this capex and changing investors' ability and willingness to fund it," says Thornburg's Hoffmann. "How that reverberates across all financial markets -- I think that would be pretty significant."

Hoffmann expects AI issuance to continue. "We don't see that freight train of issuance coming to a halt," he says. "When it does, that's likely going to be in this period of reckoning that we've been describing."

The fact the bond market is so engaged in funding the AI buildout while AI optimism is driving stock market gains presents a conundrum for investors. The timing of any major equity selloff is harder to predict because the same trend driving the stock market is also raising the cost of capital.