What Are Bonds?
A bond is essentially a loan you make to a government, corporation, or other entity. In exchange for your money, the borrower promises to pay you regular interest (called coupons) and return your principal when the bond matures.
Unlike stocks, which represent ownership in a company, bonds represent debt. This fundamental difference makes bonds generally less volatile and more predictable - you know exactly what payments you'll receive and when.
Key Bond Terms
Face Value (Par): The amount paid back at maturity, typically $1,000.
Coupon Rate: Annual interest rate paid on face value.
Maturity Date: When the principal is repaid.
Yield: Your actual return based on purchase price.
Why Invest in Bonds?
- Predictable income: Regular coupon payments provide steady cash flow
- Capital preservation: Principal returned at maturity (if no default)
- Portfolio diversification: Often move opposite to stocks
- Lower volatility: Less price fluctuation than equities
- Retirement planning: Match income to future expenses
Types of Bonds
Government Bonds
Corporate (Investment Grade)
High-Yield (Junk)
Government Bonds
Issued by national governments to fund operations. Considered the safest bonds because governments can raise taxes or print money to pay debts.
- US Treasury Bonds: Backed by US government, considered risk-free benchmark
- UK Gilts: British government bonds
- German Bunds: Eurozone benchmark for safety
- Municipal Bonds: Issued by local governments, often tax-exempt
Corporate Bonds
Issued by companies to raise capital. Higher yields than government bonds but carry credit risk - the company could default.
| Rating | Category | Default Risk | Typical Yield Spread |
|---|---|---|---|
| AAA | Investment Grade | Extremely Low | +0.5-1% |
| AA/A | Investment Grade | Very Low | +1-2% |
| BBB | Investment Grade | Low | +2-3% |
| BB/B | High Yield | Moderate | +3-5% |
| CCC or below | Junk | High | +5-10% |
Understanding Bond Yield
Yield is what you actually earn from a bond. It's more important than the coupon rate because it accounts for what you paid for the bond.
Current Yield vs Yield to Maturity
Current Yield is simple: annual coupon divided by current price. But it ignores capital gains or losses at maturity.
Yield to Maturity (YTM) is the complete picture. It calculates your total return if you hold the bond until maturity, including all coupon payments and any gain or loss from the difference between your purchase price and face value.
Yield to Maturity Concept
Bond Prices and Yields Move Inversely
When interest rates rise, existing bond prices fall (their fixed coupons become less attractive). When rates fall, bond prices rise. This is the fundamental law of bond investing.
Duration and Interest Rate Risk
Duration measures how sensitive a bond's price is to interest rate changes. Think of it as the bond's "interest rate risk score."
- Short duration (1-3 years): Less sensitive to rate changes, lower yields
- Intermediate duration (4-7 years): Balanced risk/return
- Long duration (10+ years): Most sensitive, highest yields typically
Rule of thumb: If a bond has 5-year duration and interest rates rise 1%, the bond's price will drop about 5%. If rates fall 1%, it rises about 5%.
Duration Risk in Rising Rate Environments
In 2022, long-term Treasury bonds lost over 30% as the Fed raised rates aggressively. If you hold to maturity, you get your principal back. But if you need to sell early, duration risk is real.
Building a Bond Ladder
A bond ladder is a strategy where you buy bonds with staggered maturity dates. It's one of the most effective ways to manage interest rate risk while maintaining steady income.
Example: 5-Year Bond Ladder ($50,000)
How a Bond Ladder Works
- Divide your investment across bonds maturing in consecutive years
- Each year, one bond matures - reinvest in a new long-term bond
- This gives you regular liquidity while capturing long-term yields
- If rates rise, you reinvest at higher rates. If they fall, you still have locked-in yields
Bonds in Your Portfolio
The classic rule was "own your age in bonds" - if you're 40, hold 40% bonds. Modern thinking is more nuanced, but bonds remain essential for risk management.
Asset Allocation Guidelines
| Life Stage | Stocks | Bonds | Rationale |
|---|---|---|---|
| 20s-30s (Accumulation) | 80-90% | 10-20% | Long time horizon, can weather volatility |
| 40s-50s (Growth) | 60-70% | 30-40% | Balance growth and stability |
| 60s+ (Preservation) | 40-50% | 50-60% | Protect capital, generate income |
Bond ETFs vs Individual Bonds
Bond ETFs (like BND, AGG) offer diversification and liquidity but never mature. Individual bonds let you build ladders and guarantee principal return at maturity. Both have their place.
Frequently Asked Questions
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