I’m hearing more concerns about bonds recently. Morningstar put out an article last month, more people are asking about them, and even a tennis partner asked if my clients are worried about their bonds.
My feeling is that most people aren’t sure how to feel about their bond portfolio because they don’t completely understand how it fits into their larger financial picture. When news outlets release a flurry of articles, we tend to view bonds in isolation.
It’s hard to ignore the noise when the 10-year U.S. Treasury yield climbed above 5% last month — a rate that hasn’t been sustained since 2007!
Let’s answer what bonds are, how they work, the different types of bonds, why you might own them, and how they fit into a portfolio. We will talk about an example of how they can be used in retirement, discuss individual bonds vs. funds/ETFs, the risks of owning bonds, when you might sell bonds, and whether other investments are good substitutes for bonds.
What is a Bond?
A bond is you lending money to a government, company, or other organization. It’s an IOU.
They agree to pay you interest and return what you originally lended them (the principal) at a certain point in time.
For example, you could loan the government $10,000 for 10 years with a 5% coupon. Since that type of bond pays interest semiannually, you’d receive $250 twice a year, or $500 annually, for the next 10 years. Over that time, you’d receive $5,000 in interest and at the end of 10 years, your original $10,000 back.
How Do Bonds Work?
Before we discuss how bonds work, let’s discuss how stocks work because why a stock goes up and down in value is very different from a bond.
Stocks normally go up in price when the company is expected to do better in the future.
Doing better can take many forms:
- Company earning more money over time (i.e. big consumer staples companies like Procter & Gamble, Coca-Cola, or Johnson & Johnson, but this can also include other sectors and companies)
- People expecting the company to earn more (i.e. AI, tech, or companies with breakthrough developments)
- More people want to own the stock (i.e. meme stocks)
Essentially, people are willing to pay more money for a stock when profits are expected to grow (even if it’s merely optimism and nothing has changed for the business yet).
This can often be confusing for people because a particular company or the world can feel awful and yet, the stock market can do quite well.
So, if stocks generally go up because people expect a company to earn more in the future, how do bonds go up or down in value?
Before we answer that question, let’s define two terms:
- Interest rate: the rate that says how much interest the bond pays
- Maturity: when the bond comes due and you are returned what you lended them
Here is what you need to remember: Bond prices generally move the opposite direction as interest rates.
In other words, as interest rates go up, bond prices generally go down. As interest rates go down, bond prices generally go up.
As a simple example, if you bought $10,000 of a bond paying 5% and interest rates go down to 3%, people are willing to pay more than $10,000 for your bond because they can earn $500 in coupon payments annually instead of $300 on new bonds.
This relationship is more pronounced the longer the maturity of the bond.
If interest rates go up, a 30 year bond will generally go down in value more than a 10 year bond.
For example, if you had $10,000 worth of a 30 year bond at 3% and interest rates went up to 5%, you’d be stuck with a bond only paying $300 annually instead of $500. You have 30 years of that difference instead of only 10 years.
When interest rates suddenly went up a lot in 2022, you saw bond prices decline. Morningstar has a good chart showing how short-term bonds were down about 5%, intermediate about 10%, and long-term about 20%.
What Are Different Types of Bonds?
There are many types of bonds and they can broadly be categorized into the following:
- Government (treasury bills, treasury notes, treasury bonds, treasury-inflation protected, agencies)
- Municipal bonds (general obligation vs. revenue)
- Corporate bonds (investment-grade, high-yield/junk bonds)
Bonds have different credit risks.
Generally, government bonds are very low credit risk. One can argue the U.S. has technically defaulted on their debt a handful of times, but they have never truly defaulted. In other words, historically, if you’ve lended the U.S. government money, there were always very good odds you’d get your money back.
Municipal bonds generally are low credit risk. The 10-year cumulative default rate has been about 0.1%. Intuitively, this makes sense. General obligation municipal bonds are backed by the “full faith and credit” of the state or municipality. If they run into financial issues, they typically can raise taxes. For revenue bonds, they are typically backed by a specific project, such as an airport, toll road, bridges, water or sewer utilities, or hospitals. If they run into financial issues, they can often raise the fees people pay for those services.
Corporate bonds are low to medium risk, depending on the investment grade quality of the corporate bond. For example, AAA corporate bonds may have a 10-year default rate below 1% while B-rated corporate bonds are above 20%. People like the yields offered on lower quality bonds, but it’s one of those, “it’s okay until it’s not” situations. A shock to the system, such as the 2008 financial crisis and the dot-com bubble, can wipe away and take back more than you’ve earned in a short amount of time.
The type of bond is important because while interest rates impact bond prices, what is happening in the economy, inflation expectations, a specific region, and credit quality changes can also change the price of bonds.
For example, if you owned a municipal bond in a municipality that was struggling, such as Detroit in 2013, Stockton in 2012, or Jefferson County, Alabama in 2011, you may only recover a portion of what you were owed, such as 50 cents on the dollar.
Why Should You Own Bonds?
Now that you know more about bonds, let’s talk about why you should own bonds.
The primary reason is that they go up and down in value less (i.e. less volatility).
They add stability. They may help you stay invested when stocks swing 30%+ in a year — that way you can actually earn the long-term return of stocks.
A bad year for bonds might be a decline of 5% to 10%. A moderate bad year might be 2% to 5%.
Said a different way, a bad year for bonds is like a bad day for stocks.
Bonds help balance out risk while still providing an expected return. For most people, unless they have an insanely high tolerance for risk or incredibly high income from other sources, bonds can help meet short-term to medium term spending needs.
For example, people often buy bonds for the following reasons:
- Smooth out investment returns and provide opportunities for rebalancing (i.e. buying stocks when they go down)
- Support spending in retirement
- House down payment in 3 to 5 years
- Meet other short term needs (sabbatical, extra child expenses, home upgrades, moving, etc.)
- Match specific future liabilities to expenses (i.e. debt comes due in three years)
Bonds are not going to be the driver of growth or significant wealth creation. They help preserve wealth. They help with confident spending.
How Do Bonds Fit Into a Portfolio?
Since the reason for buying bonds is dependent on the person, how they fit into an investment portfolio will also vary.
Here are a few ways they can fit:
- Time horizon: money you need in the next few years can be in bonds.
- Risk tolerance: if you have a 100% stock portfolio and stocks go down 50%, can you hang on? Do you have the funds to support yourself in the meantime without selling stocks at a 50% discount?
- Other income sources: if you have large pension or Social Security payments, you may need less money in bonds to support your spending.
- Spending needs: if you aren’t spending from your investment portfolio, you may need less/nothing in bonds.
There is no perfect stock to bond mix. How much you own is going to come down to how comfortable you are with the ups and downs of an investment portfolio, what your other income sources look like, and when you need money from the portfolio. Don’t forget to document it in your investment policy statement!
Retirement Example: How Bonds Work in Retirement
Let’s say you are 60, married, have $3 million invested, and spend $150,000 per year. You will receive Social Security, but you decide one of you won’t claim until age 67 and the other at age 70.
For now, you’ll be spending $150,000 from the portfolio for the next seven years. After that, it will be a little less, and once you are both collecting Social Security, it may only be $90,000.
At a minimum, I’d consider having $450,000 in bonds or other short-term investments, which is three years worth of spending. For most people, a more comfortable amount is going to be $750,000 — five years worth of spending.
Historically, most markets have recovered within three to five years. That can help provide peace of mind that regardless of how stocks are performing, you know your spending is coming from bonds, which are unlikely to fluctuate as much as stocks. Remember, a bad year for bonds may be a bad day in stocks.
You aren’t forced to sell stocks at one of the worst possible times.
From an allocation perspective, that means at least 15% to 25% of the investment portfolio in bonds; however, from a risk tolerance perspective, that may not feel good to some people.
If you are 75% stocks and 25% bonds and stocks go down 40%, that means your portfolio may drop in value $900,000. Add on a $150,000 withdrawal to meet your spending and $1,050,000 has disappeared. Your $3 million portfolio is now worth less than $2 million.
How does that feel?
If that feels okay, 75% stocks and 25% bonds may be okay. If that doesn’t feel good, you may want to consider adding more bonds to the portfolio.
Individual Bonds vs. Bond Funds
One of the more common questions is, “Should I own individual bonds or bond funds (such as an ETF)?”
In most situations, I’m a fan of owning them in a diversified ETF.
“But what about the fact that if interest rates go up, the price of my ETF will probably go down? If I own an individual bond, I know what I’m getting at maturity.”
Sure, you know what you are getting back at maturity, but a few counterpoints:
- The individual bond value is also going down when interest rates go up — similar to the ETF. If you need to sell it, you are getting the same price (but probably worse because you don’t trade billions of dollars a year) as the bond manager who needs to sell within the ETF. A bond ETF is simply a collection of individual bonds.
- You are getting your money back in nominal terms. Those dollars are worth less in the future. If you sell your bond when it drops in price, you can always reinvest that money in a bond that yields more, and it will likely put you in a similar place as holding it. In that case, you are getting your return via more income and a principal loss versus lower income and a stable principal value (if you were to hold the bond to maturity).
- Some people don’t like that bond ETFs never mature, but you are likely going to reinvest some of your maturing bonds into more individual bonds in the future (i.e. yours don’t mature either!). An ETF simply does it sooner than maturity.
Generally, individual bonds are going to lead to higher trading fees (try getting a bid on $50,000 worth of a bond you want to sell and see what pricing you get versus an ETF getting pricing on $5,000,000).
Individual bonds are also harder to diversify, harder to rebalance a portfolio, and adds complexity. They can make sense when you are trying to match an expense to a certain timeline or favor emotions when it comes to “getting your money back at maturity.”
Other than that, bond funds generally can be owned at a low ongoing cost, making it easier to diversify and simpler to rebalance.
There are multiple articles if you want to read more about individual bonds vs. bond funds.
- The Dilemma That Isn’t: Bonds versus Bond Funds
- Owning Individual Bonds vs. Owning a Bond Fund
- The Myth of Holding to Maturity: Bond Funds vs. Individual Bonds
What Are the Risks of Owning Bonds?
The two biggest risks of owning bonds are interest rate risk and credit risk, though there are a couple of others I’ll talk about at the end of this section.
Interest rate risk is where changing interest rates can reduce the value of bonds. As discussed earlier, generally when interest rates go up, bond prices go down. The longer the maturity or duration of a bond, the more sensitive it is to changes in interest rates.
Maturity and duration are different. To simplify it, think of maturity as when the bond matures and the principal is repaid. Duration estimates how much a bond’s price will change when interest rates change.
For example, you might have a 10 year bond with a duration somewhere between 7.5 and 9 years, depending on coupon rate and current yields. A 5 year bond might have a duration of around 4.5 and 4.9 years.
This isn’t a perfect formula, but generally, if interest rates go up by 1%, you’d expect a bond with a duration of 1 year to go down by 1%, a bond with a 5 year duration by 5%, a bond with a 10 year duration by 10%, and a bond with a 20 year duration by 20%.
The second big risk is credit risk, or said another way, the risk that the bond issuer may default and you don’t get your interest or principal payments.
As discussed earlier, historically, treasury bonds, municipal bonds, and investment-grade corporate bonds have generally had low credit risk. Once you start investing into high-yield or junk bonds, credit risk goes up and you generally see more defaults. That doesn’t always mean you’ll lose your full investment, but it often means you’ll only recover a fraction of what you put into it.
Another bond risk is inflation risk. If you hold bonds paying a fixed coupon payment, a spike in inflation erodes the purchasing power of both the interest payments (they aren’t rising with inflation!) and the principal amount you’ll get back when the bond matures.
Think about the cost of beef and other groceries in 2019 compared to the cost in 2026. Ground beef went up about 88% in that time. You used to be able to get it for about $3.80 a pound. Now the average is about $7.16. If you invested $10,000 in a bond back in 2019, it could have bought 2,632 pounds of ground beef. When it matures this year, it’s only buying about 1,397 pounds.
There is also reinvestment risk, which means as bonds pay interest or mature, you may have to reinvest it at lower rates if interest rates drop. You may have had a 10-year Treasury note paying above 3% in 2010 and when it matured in 2020, you may have been faced with the choice to buy another 10-year Treasury note with rates below 1%.
Should I Sell My Bonds?
If your bonds just declined and nothing has changed for you, it’s probably not the right time to sell them. It sounds like you are reacting to a situation instead of making a proactive decision.
Below are a few reasons I’d think about selling bonds:
- Regular Withdrawals: If you regularly take money from your portfolio and stocks aren’t doing well, that’s what the bonds can be used for. You can sell them, in alignment with your normal target allocation, to get the cash you need.
- Rebalancing: Maybe stocks have gone down a lot and are within your rebalancing thresholds. That’s a point where you can sell bonds, which have done well, to buy stocks, which are down. Remember the phrase, “buy low, sell high?”
- Future Needs Have Changed: Your investment portfolio should follow your financial plan. If you received a large inheritance, found out about another pension, or your spending went down, you may not need as much money in bonds. You may be able to take more risk with the investment portfolio, which might mean selling bonds and buying more stocks.
- Tax-Loss Harvesting: It’s rare because bonds often don’t go down in value enough to make tax-loss harvesting worthwhile, but there can be cases, like in 2022, where bonds declined enough that selling them and buying a reasonable substitute investment was a good idea to help offset taxes.
- Improve Portfolio: Perhaps you bought a very long dated bond, junk bond, or other type of bond where you didn’t fully understand how it behaved or how it fit into the portfolio. Now that you understand it better, you may want to change the structure and risk of the bond portfolio.
Again, I want to emphasize that making changes to your bonds simply because they went down means you aren’t understanding their purpose in the first place, and if you do this, it’s highly unlikely to work out in your favor.
Bonds will fluctuate in value. Sometimes they go down. They aren’t meant to be the engine of growth in your investment portfolio. They help ride out the really scary times in stocks and help support your cash needs in the short-to-medium term.
Bonds vs. Cash, CDs, Preferred Stocks, High Dividend Stocks
One of the more common questions is “Why should I own bonds? I’ll just own XYZ” and XYZ can be cash at the bank, CDs, preferred stocks, or high dividend stocks.
The short version is that bonds tend to be uncorrelated to stocks, which means they often perform differently. That’s important because diversification is important.
Yes, you have time periods where both can be positively correlated, such as in 2022 when stocks and bonds went down. Positive correlation tends to happen during economic shocks — often when inflation is higher than anticipated.
But, generally, bonds provide good diversification. The same can’t be said for the other assets.
Cash at the bank is likely to lose inflation meaning you won’t see your value go down, but it’s going to buy less and less every year. Remember the ground beef example from earlier?
CDs might slightly beat inflation, but you aren’t really getting ahead.
Preferred stocks generally have a moderate positive correlation to stocks, but generally, they are more sensitive to interest rate movements than short or intermediate-term bonds. In other words, preferred stocks may drop more when interest rates increase.
High dividend stocks are not a good diversifier because they mostly behave like stocks. You might find a stock yielding 8%, but if it goes down 20%, you are still down 12%.
Bonds are one of the few assets that provide diversification in a portfolio (i.e. help reduce volatility), give you the opportunity to come out ahead of inflation over time, and can be used for rebalancing.
Final Thoughts – My Question for You
Bonds serve an important role in many investment portfolios.
In my experience, many people don’t fully understand how bonds work, how they behave, and how they fit into a portfolio. They are often viewed in isolation and compared to stocks — which is not a good comparison. The lack of understanding often leads to actions that people might not make if they better understood their role.
There are many ways to use bonds. The bonds you choose and how you structure them depends largely on how you intend to use them.
It’s like going for a hike. You need different gear for different hikes and seasons.
Sometimes I need heavy duty, waterproof boots with snow pants, multiple layers, a warm hat, sunglasses, and a large pack. Other times, I need trail runners with shorts, a t-shirt, and a water bottle.
Once you figure out what purpose your bonds serve, you can make educated decisions about how to own bonds and when it’s appropriate to sell them.
I’ll leave you with one question to act on.
How will you keep or change your current bond portfolio?
