Bonds are loans you make to governments or corporations in exchange for regular interest payments. They provide stability, income, and diversification in a portfolio.
What Is a Bond?
When you buy a bond, you're lending money to:
- Government: Treasury bonds, municipal bonds
- Corporation: Corporate bonds
In return, you receive:
- Interest payments (coupon) — typically semi-annually
- Principal back at maturity
Key Bond Terms
| Term | Definition |
|---|---|
| Face Value (Par) | Amount you'll receive at maturity ($1,000 standard) |
| Coupon Rate | Annual interest rate based on face value |
| Maturity | When the bond expires and returns principal |
| Yield | Your actual return, accounting for price paid |
| Duration | Sensitivity to interest rate changes |
Types of Bonds
Treasury Bonds
- Backed by U.S. government
- Virtually no default risk
- Interest exempt from state tax
- Types: T-bills, T-notes, T-bonds, TIPS, I-Bonds
Municipal Bonds
- Issued by states, cities, counties
- Interest usually tax-free federally
- Often tax-free at state level too
- Great for high-tax-bracket investors
Corporate Bonds
- Issued by companies
- Higher yields than government
- Higher risk (company could default)
- Investment grade vs. high yield (junk)
Bond Funds
- Mutual funds or ETFs holding many bonds
- Instant diversification
- More liquid than individual bonds
- No fixed maturity date
How Bond Prices Work
Bond prices move opposite to interest rates:
| Interest Rates | Bond Prices |
|---|---|
| Rise | Fall |
| Fall | Rise |
Example: You own a bond paying 3%. New bonds pay 5%. Who wants your 3% bond? Its price drops until the yield matches market rates.
Duration: Measuring Sensitivity
| Duration | If rates rise 1% |
|---|---|
| 2 years | Price drops ~2% |
| 5 years | Price drops ~5% |
| 10 years | Price drops ~10% |
Watch Out
Long-duration bonds are much more volatile than short-duration. In rising rate environments, they can lose significant value.
Why Own Bonds?
1. Stability
Bonds are less volatile than stocks. They cushion portfolio drops.
2. Income
Regular interest payments provide cash flow.
3. Diversification
Bonds often rise when stocks fall (not always, but historically).
4. Capital Preservation
Near retirement, bonds protect what you've built.
Asset Allocation: How Much in Bonds?
Traditional rule: Age = Bond percentage
- Age 30: 30% bonds
- Age 50: 50% bonds
- Age 70: 70% bonds
Modern view: Depends on:
- Risk tolerance
- Time horizon
- Other income sources
- Goals
Pro Tip
A common allocation: "120 minus your age" in stocks, rest in bonds. More aggressive than the old rule, reflecting longer lifespans and low bond yields.
Bond Ladders
A bond ladder staggers maturities for steady income and flexibility.
Example: 5-Year Ladder
| Maturity | Amount | Rate |
|---|---|---|
| 1 year | $20,000 | 4.5% |
| 2 years | $20,000 | 4.7% |
| 3 years | $20,000 | 4.8% |
| 4 years | $20,000 | 4.9% |
| 5 years | $20,000 | 5.0% |
When the 1-year matures, reinvest at the new 5-year rate.
Benefits
- Reduces interest rate risk
- Provides regular liquidity
- Captures better rates over time
- Predictable cash flow
Where to Hold Bonds
Tax-Advantaged Accounts (IRA, 401k)
- Corporate bonds
- High-yield bonds
- TIPS
Taxable Accounts
- Municipal bonds (tax-free interest)
- Treasury bonds (state tax-free)
- Tax-efficient bond funds
Pro Tip
Municipal bonds in taxable accounts, corporate bonds in IRAs. This maximizes tax efficiency.
Bond Fund Options
| Type | Risk | Yield | Best For |
|---|---|---|---|
| Short-term Treasury | Very low | Lower | Safety, cash alternative |
| Intermediate-term | Low-moderate | Moderate | Core bond holding |
| Long-term | Moderate-high | Higher | Income seekers |
| High-yield (junk) | High | Highest | Aggressive income |
| TIPS | Low | Inflation-linked | Inflation protection |
Popular Bond ETFs
- BND: Total bond market
- VGSH: Short-term Treasury
- MUB: Municipal bonds
- TIP: TIPS
When to Increase Bond Allocation
- Approaching retirement (5-10 years out)
- Need for stability over growth
- Want reliable income
- Concerned about market volatility
- Rebalancing after big stock gains
The Bottom Line
Quick Win
If you're 100% stocks and approaching 40, consider adding bonds. Start with a total bond market index (BND) or intermediate Treasury ETF. Even 10-20% allocation adds meaningful stability.
Bonds may be "boring," but they serve essential functions: stability, income, and diversification. The right bond allocation depends on your age, goals, and risk tolerance.