Bonds and Fixed Income
Understanding debt investments for stability and income.
What Are Bonds
A bond is a loan you make to a government or corporation.
You lend money → They pay you interest → They return your principal at maturity
| Term | Meaning |
|---|---|
| Principal (Face value) | Amount you lend (typically $1,000) |
| Coupon | Interest rate paid |
| Maturity | When principal is repaid |
| Yield | Your actual return |
Example
$1,000 bond with 5% coupon, 10-year maturity:
- You pay: $1,000
- You receive: $50/year for 10 years
- At maturity: Get $1,000 back
- Total: $1,500 over 10 years
Why Own Bonds
Role in Portfolio
| Purpose | How Bonds Help |
|---|---|
| Stability | Less volatile than stocks |
| Income | Regular interest payments |
| Diversification | Often move opposite to stocks |
| Capital preservation | Protect principal |
| Rebalancing | Sell bonds high, buy stocks low in downturns |
Bonds vs. Stocks Volatility
| Event | Stocks | Bonds (Intermediate) |
|---|---|---|
| 2008 Financial Crisis | -37% | +5% |
| 2020 COVID Crash | -34% (then recovered) | +3% |
| Typical year range | -20% to +30% | -5% to +10% |
Bonds smooth the ride. They help you stay invested when stocks crash.
Types of Bonds
By Issuer
| Type | Issuer | Risk | Yield |
|---|---|---|---|
| Treasury | US Government | Lowest | Lowest |
| Agency | Government agencies (Fannie Mae) | Very low | Low |
| Municipal | State/local government | Low | Low-Medium (tax-free) |
| Investment-grade corporate | Strong companies | Low-Medium | Medium |
| High-yield (junk) | Weaker companies | Higher | Higher |
| International | Foreign governments/companies | Varies | Varies |
By Maturity
| Term | Duration | Interest Rate Risk |
|---|---|---|
| Short-term | 1-3 years | Low |
| Intermediate | 3-10 years | Medium |
| Long-term | 10-30 years | High |
Longer maturity = more interest rate risk.
Treasury Securities
| Type | Maturity | Features |
|---|---|---|
| T-Bills | 4-52 weeks | Sold at discount, no coupon |
| T-Notes | 2-10 years | Pay interest semi-annually |
| T-Bonds | 20-30 years | Pay interest semi-annually |
| TIPS | Various | Inflation-adjusted principal |
| I-Bonds | 30 years | Inflation-protected savings bonds |
I-Bonds: Great for inflation protection, limited to $10,000/year purchase.
Bond Pricing and Yields
The Inverse Relationship
When interest rates go up, bond prices go down (and vice versa).
Why? If new bonds pay 6% and your bond pays 4%, yours is less attractive.
| Rates Move | Bond Prices | Explanation |
|---|---|---|
| Up | Down | Existing bonds less attractive |
| Down | Up | Existing bonds more attractive |
Yield Concepts
| Yield Type | Meaning |
|---|---|
| Coupon rate | Stated interest rate |
| Current yield | Coupon ÷ current price |
| Yield to maturity (YTM) | Total return if held to maturity |
Example:
- Bond: $1,000 face, 5% coupon, trading at $900
- Coupon rate: 5%
- Current yield: $50 ÷ $900 = 5.6%
- YTM: Higher (includes the $100 gain at maturity)
Duration
Duration measures sensitivity to interest rate changes.
| Duration | Meaning |
|---|---|
| 2 years | 1% rate increase → ~2% price drop |
| 5 years | 1% rate increase → ~5% price drop |
| 10 years | 1% rate increase → ~10% price drop |
Shorter duration = less interest rate risk.
Bond Risks
| Risk | Description | Mitigation |
|---|---|---|
| Interest rate risk | Prices fall when rates rise | Shorter duration |
| Credit risk | Issuer defaults | Higher quality bonds |
| Inflation risk | Returns don't beat inflation | TIPS, shorter terms |
| Reinvestment risk | Lower rates on reinvested payments | Laddering |
| Call risk | Issuer pays off early | Non-callable bonds |
Credit Ratings
| Rating | Meaning | Risk |
|---|---|---|
| AAA | Highest quality | Lowest |
| AA | Very high quality | Very low |
| A | High quality | Low |
| BBB | Medium quality | Moderate |
| BB and below | Speculative (junk) | Higher |
Investment grade: BBB or higher High yield (junk): Below BBB
Bond Investing Approaches
Individual Bonds vs. Funds
| Individual Bonds | Bond Funds |
|---|---|
| Hold to maturity, get principal back | No fixed maturity |
| No management fees | Low expense ratios |
| Need significant capital | Invest any amount |
| Must research each bond | Instant diversification |
| Less liquid | Trade daily |
For most investors: Bond index funds are simpler and better.
Bond Funds
| Type | Description | Use |
|---|---|---|
| Total bond market | Broad diversification | Core holding |
| Short-term | Lower interest rate risk | Conservative |
| Intermediate | Moderate risk/return | Balanced |
| Long-term | Higher risk/return | More growth |
| TIPS | Inflation protection | Inflation hedge |
| Municipal | Tax-free income | High tax brackets |
Bond Laddering
Buy bonds with staggered maturities.
Example ladder:
- 1-year bond: $10,000
- 2-year bond: $10,000
- 3-year bond: $10,000
- 4-year bond: $10,000
- 5-year bond: $10,000
As each matures, buy a new 5-year bond. Provides regular liquidity and averages interest rates.
Bonds in Your Portfolio
How Much in Bonds
Traditional guideline: Bond allocation = your age
- Age 30: 30% bonds
- Age 50: 50% bonds
- Age 70: 70% bonds
Modern approach: Consider risk tolerance, not just age.
| Profile | Bond Allocation |
|---|---|
| Aggressive | 10-20% |
| Moderate | 30-40% |
| Conservative | 50-60% |
| Very conservative | 70-80% |
When to Increase Bonds
- Approaching retirement
- Need the money sooner
- Lower risk tolerance
- Want to sleep better at night
Bond Allocation by Account Type
| Account Type | Best Bond Placement |
|---|---|
| Taxable | Municipal bonds (tax-free) |
| Tax-deferred (401k, IRA) | Taxable bonds, TIPS |
| Roth | Stocks preferred (tax-free growth) |
Asset location matters: Put tax-inefficient bonds in tax-advantaged accounts.
Current Considerations
Interest Rate Environment
| Rate Environment | Strategy |
|---|---|
| Rising rates | Shorter duration, delay long-term bonds |
| Falling rates | Lock in longer-term yields |
| Stable rates | Maintain target allocation |
Bonds After Rate Increases
Higher rates are good for future bond investors:
- New bonds pay more
- Reinvested coupons earn more
- Short-term pain, long-term gain
Recommended Bond Funds
| Category | Example Funds |
|---|---|
| Total bond market | Vanguard Total Bond (BND), Fidelity US Bond (FXNAX) |
| Short-term | Vanguard Short-Term Bond (BSV) |
| TIPS | Schwab US TIPS (SCHP) |
| Municipal | Vanguard Tax-Exempt Bond (VTEB) |
Look for:
- Low expense ratio (under 0.15%)
- Broad diversification
- Appropriate duration for your needs
Key Takeaways
- Bonds provide stability - They balance stock volatility
- Prices and rates are inverse - Rates up = prices down
- Duration = risk - Longer duration = more interest rate risk
- Quality matters - Stick with investment grade for safety
- Use funds - Easier than individual bonds for most
- Match to timeline - Shorter horizon = shorter bonds
- Consider taxes - Munis for taxable, corporates for tax-advantaged