Bonds Explained: How to Add Fixed Income to Your Portfolio
Bonds have a reputation for being boring. Compared to the drama of stock market swings, bonds seem like the financial equivalent of a beige cardigan. But that reputation is exactly the point — and understanding bonds is essential for building a portfolio that can survive the inevitable rough patches.
Here's the practical guide to bonds that actually makes sense.
What Is a Bond?
When you buy a bond, you're lending money to the issuer — a corporation, a city, a state, or the federal government. In exchange, the issuer promises to:
- Pay you a fixed interest rate (the "coupon") on a regular schedule
- Return your original loan (the "principal") at a specified future date (the "maturity date")
If you buy a $10,000 US Treasury bond with a 4.5% coupon and a 10-year maturity, you'll receive $450/year in interest payments for 10 years, then get your $10,000 back at the end.
Bonds are debt. Stocks are ownership. Bondholders get paid before stockholders if a company runs into trouble — which makes bonds less risky, but also less rewarding in normal times.
Why Bonds Belong in Your Portfolio
Bonds serve two main purposes:
Stability: Bonds typically don't fall as dramatically as stocks during market crashes. In 2008-2009, US stocks lost about 50% peak-to-trough. US Treasury bonds gained value during the same period as investors fled to safety.
Income: Bonds pay regular interest, which can be reinvested or used as income. In retirement especially, this predictable cash flow is valuable.
The classic "60/40 portfolio" — 60% stocks, 40% bonds — has historically provided solid returns with significantly less volatility than 100% stocks. For most people, some bond allocation makes sense, especially as they approach or enter retirement.
Types of Bonds
Not all bonds are equal in risk, return, or tax treatment:
| Bond Type | Issuer | Risk Level | Typical Yield | Tax Treatment |
|---|---|---|---|---|
| US Treasury Bills (T-bills) | Federal government | Lowest | 4-5% (varies) | Federal tax; state-exempt |
| US Treasury Notes/Bonds | Federal government | Lowest | 4-5% (varies) | Federal tax; state-exempt |
| TIPS | Federal government | Very low | Lower, but inflation-adjusted | Federal tax; state-exempt |
| Municipal Bonds ("munis") | State/local governments | Low-Medium | 3-4% (lower, but tax-free) | Federal-exempt; often state-exempt |
| Investment-Grade Corporate | Large corporations | Medium | 4.5-6% | Fully taxable |
| High-Yield ("Junk") | Riskier corporations | High | 6-9%+ | Fully taxable |
For most beginner investors, US Treasuries and investment-grade bond funds are the right starting point. High-yield bonds often behave more like stocks during downturns — which defeats the purpose of holding bonds for stability.
Understanding Bond Prices and Interest Rates
This is the most counterintuitive thing about bonds: when interest rates go up, bond prices go down.
Here's why: Imagine you buy a bond paying 3% when that's the going rate. Then rates rise to 5%. Your 3% bond is now less attractive than new bonds, so its market price drops — whoever buys it from you would pay less because they're accepting a below-market rate.
The reverse is also true: when rates fall, existing bonds paying higher rates become more valuable, so prices rise.
This relationship matters most if you buy individual bonds and need to sell before maturity. If you hold a bond to maturity, price fluctuations don't affect you — you get your principal back regardless.
For most individual investors, bond funds handle this complexity. You don't need to worry about individual bond maturities when you own a fund.
Bond Duration: Measuring Interest Rate Risk
Duration measures how sensitive a bond or bond fund is to interest rate changes. A fund with a duration of 7 means its price will fall roughly 7% if interest rates rise by 1%.
| Duration | Sensitivity | Examples |
|---|---|---|
| Short (1-3 years) | Low | Short-term Treasury ETFs, money market |
| Intermediate (4-7 years) | Moderate | Total Bond Market Index |
| Long (10+ years) | High | Long-term Treasury bonds |
If you're worried about rising interest rates, shorter-duration bonds are safer. If you're holding for a long time and don't need to sell, duration matters less.
How to Buy Bonds
Through bond funds (recommended for most people): The simplest approach is to buy a low-cost bond index fund:
- Fidelity US Bond Index Fund (FXNAX): Tracks the broad US bond market, expense ratio 0.025%
- Vanguard Total Bond Market ETF (BND): Similar, expense ratio 0.03%
- iShares Core US Aggregate Bond ETF (AGG): Industry benchmark, expense ratio 0.03%
These hold thousands of bonds, providing diversification you can't achieve buying individual bonds.
Directly through TreasuryDirect.gov: You can buy US Treasury securities — T-bills, notes, bonds, I Bonds, and TIPS — directly from the government with no brokerage fees. Minimum purchase is $100. This is the only place to buy I Bonds.
Through a brokerage: Most brokerages let you buy individual bonds, though the minimum is usually $1,000 per bond and you'll need to research creditworthiness yourself.
How Much Should You Hold in Bonds?
A classic starting point is the "your age in bonds" rule: if you're 30, hold 30% bonds; if you're 50, hold 50% bonds. This is outdated by most financial advisors' standards — with longer lifespans, many recommend something closer to (age - 10) in bonds.
A more practical framework:
| Life Stage | Suggested Bond Allocation |
|---|---|
| 20s, aggressive growth phase | 0-10% |
| 30s-40s, wealth building | 10-20% |
| 50s, approaching retirement | 20-40% |
| Retirement, income focus | 30-50% |
These are starting points, not rules. Someone retiring at 60 with a large portfolio might tolerate more stock volatility; someone retiring at 65 with a pension and Social Security may need fewer bonds. Your personal situation matters.
Municipal Bonds: The Tax Angle
Municipal bonds deserve special mention for high earners. The interest is exempt from federal income tax and usually from state income tax in the issuing state. This tax break makes munis especially valuable to people in the 32-37% federal tax brackets.
To compare a muni's yield to a taxable bond's yield, use the tax-equivalent yield formula:
Tax-equivalent yield = Muni yield / (1 - your marginal tax rate)
A muni yielding 3% is equivalent to a taxable bond yielding 4.41% for someone in the 32% bracket. If taxable bonds are only yielding 4%, the muni wins.
Below the 22% bracket, munis rarely make sense — taxable bond funds generally offer better yields after tax.
Common Bond Mistakes
Avoiding bonds entirely in your 30s and 40s. Even a 10-15% bond allocation meaningfully reduces portfolio volatility without sacrificing much long-term growth. The 2022 experience (when stocks and bonds both fell together) was unusual — over most market cycles, bonds provide cushioning.
Buying individual bonds without understanding duration and credit risk. Bond funds are simpler and safer for most investors.
Putting high-yield bonds in a taxable account. High-yield bonds generate lots of taxable interest income. If you want them in your portfolio, keep them in a tax-advantaged account (401k or IRA).
Panic-selling bond funds when rates rise. If you're a long-term holder, rising rates actually benefit you over time — your fund reinvests at higher yields. Stay the course.
The Bottom Line
Bonds aren't glamorous, but they're the foundation of a balanced, resilient portfolio. A modest bond allocation — even 10-15% — reduces volatility, provides income, and gives you something to rebalance from when stocks fall.
For most investors under 40, a low-cost total bond market index fund in your 401(k) or IRA is the right move. Start with a small allocation, understand what you own, and increase it as you approach retirement.
The goal of bonds isn't to get rich — it's to stay rich through the inevitable storms.
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