Bonds

Bonds are debt securities where you lend money to a government or corporation in exchange for regular interest payments and return of principal at maturity. They provide income and stability to investment portfolios.

What Are Bonds?

The Bond Contract

• Principal - Amount you lend (face value)
• Coupon Rate - Interest rate paid annually
• Maturity Date - When principal is repaid
• Issuer - Entity borrowing money (government or corporation)

How Bonds Work

1. You purchase a bond (lend money)
2. Issuer pays you regular interest (coupon payments)
3. At maturity, issuer repays the principal
4. You can also sell bonds before maturity on secondary market

Types of Bonds

Government Bonds

U.S. Treasury Bonds

• Backed by full faith and credit of U.S. government
• Considered virtually risk-free
• Taxable at federal level, exempt from state taxes
• Terms: Bills (≤1 year), Notes (2-10 years), Bonds (10-30 years)

Municipal Bonds

• Issued by states, cities, counties
• Often tax-free at federal and state level
• Lower yields than taxable bonds
• Good for high tax brackets

Corporate Bonds

• Issued by companies to raise capital
• Higher yields than government bonds (compensate for risk)
• Credit ratings indicate default risk
• Investment-grade vs. high-yield (junk) bonds

International Bonds

• Bonds from foreign governments and corporations
• Currency risk (exchange rate fluctuations)
• Diversification benefits
• Can be accessed through bond funds

Bond Characteristics

Maturity

• Short-Term - ≤3 years (less interest rate risk)
• Intermediate-Term - 3-10 years (balanced)
• Long-Term - >10 years (higher interest rate risk, typically higher yields)

Credit Quality

• AAA/AA - Highest quality, lowest default risk
• A/BBB - Investment-grade, moderate risk
• BB and below - High-yield/junk bonds, higher default risk

Interest Rate Risk

• Bond prices move inversely to interest rates
• When rates rise, existing bond prices fall
• When rates fall, existing bond prices rise
• Longer maturities = more interest rate sensitivity

How to Invest in Bonds

Individual Bonds

• Buy specific bonds directly
• Hold to maturity to avoid price fluctuations
• Requires larger investment amounts
• More control over maturity and credit quality

Bond Mutual Funds

• Professionally managed portfolios of bonds
• Diversification across many bonds
• Active management
• Higher fees than index funds

Bond Index Funds/ETFs

• Track bond market indices
• Low-cost, passive investing
• Broad diversification
• Easy to buy and sell

Target-Date Funds

• Automatically adjust stock/bond mix over time
• More bonds as retirement approaches
• One-fund solution for retirement savings

Bond Returns

Interest Income

• Regular coupon payments (typically semi-annual)
• Predictable income stream
• Lower than stock returns historically (~5% average)

Price Appreciation

• Bonds can be sold before maturity
• Prices fluctuate with interest rates
• Can realize capital gains or losses

Total Return

• Interest income + price changes
• Important to consider both components
• Bond funds show total return

Role of Bonds in Portfolio

Stability

• Less volatile than stocks
• Provide ballast during stock market downturns
• Preserve capital

Income Generation

• Regular interest payments
• Important for retirees needing income
• More predictable than stock dividends

Diversification

• Bonds often move differently than stocks
• Reduce overall portfolio volatility
• Improve risk-adjusted returns

Asset Allocation

• Conservative - 60-70% bonds
• Moderate - 30-40% bonds
• Aggressive - 10-20% bonds
• Age-Based - Roughly your age in bonds (e.g., age 50 = 50% bonds)

Bond Risks

Interest Rate Risk

• Bond prices fall when interest rates rise
• Longer maturities = more risk
• Can lock in losses if you need to sell

Credit Risk

• Issuer may default (not repay)
• Higher-yield bonds = higher default risk
• Diversification helps reduce impact

Inflation Risk

• Fixed interest payments lose purchasing power
• Inflation erodes real returns
• Treasury Inflation-Protected Securities (TIPS) help

Reinvestment Risk

• When bonds mature, may reinvest at lower rates
• Falling interest rates reduce future income
• Laddering strategies can help

Bond Investment Strategies

Bond Laddering

• Buy bonds with staggered maturities
• Provides regular income and flexibility
• Reduces interest rate risk
• Can reinvest at different rates over time

Barbell Strategy

• Invest in short-term and long-term bonds
• Avoid intermediate-term
• Balances income and flexibility

Bullet Strategy

• Concentrate bonds around specific maturity
• Matches known future expenses
• Useful for specific goals

Duration Matching

• Match bond duration to investment horizon
• Reduces interest rate risk
• More sophisticated approach

Tax Considerations

Taxable Bonds

• Interest taxed as ordinary income
• Government bonds: federal tax only
• Corporate bonds: federal and state tax

Tax-Exempt Bonds

• Municipal bonds often tax-free
• Good for high tax brackets
• Calculate tax-equivalent yield

Tax-Advantaged Accounts

• Hold taxable bonds in retirement accounts
• Tax-free or tax-deferred growth
• Maximize after-tax returns

Common Bond Investing Mistakes

1. Ignoring interest rate risk - Not understanding price volatility
2. Too much credit risk - Chasing high yields without considering defaults
3. Not diversifying - Concentrating in one issuer or type
4. Ignoring inflation - Fixed income loses purchasing power
5. Wrong asset allocation - Too many or too few bonds for situation
6. High fees - Active bond funds often underperform after fees
7. Not matching maturities - Mismatch with investment horizon

The Bottom Line

Bonds provide stability, income, and diversification to investment portfolios. While they typically offer lower returns than stocks, they also carry less risk and volatility. A balanced portfolio typically includes both stocks and bonds, with the mix depending on your age, risk tolerance, and financial goals.

For most investors, low-cost bond index funds provide the best way to access the bond market with diversification and low costs.