Bonds Explained: The Quiet Half of Investing

Most discussions about investing focus on stocks: the markets, the ups and downs, which stock to pick, which one to avoid. Bonds, the other huge asset class, get far less attention, and for an understandable reason. They are rather boring. That is precisely the point, and it is also why most investors eventually want some.

A bond is a loan you are making

When you buy a stock, you are buying an ownership stake in a company. With a bond, you are lending money to the issuer, which is a government or a corporation. In exchange, they promise to pay you interest on the loan periodically (the coupons) and to repay the principal on the due date (the maturity).

If you buy a 10-year Treasury note with a 4% coupon, the government pays you $40 a year for every $1,000 of the bonds you own, then returns the $1,000 at maturity. The payments are spelled out in advance, which is why bonds are called "fixed income" securities.

	Stocks	Bonds
What you own	A piece of the company	An IOU from a company or government
How you are paid	Price gains and (sometimes) dividends	Interest payments
Long-term returns	Higher (roughly 10%/yr for the S&P 500)	Lower, but steadier
Bad year	Down 20-50%	Down a few percent for quality bonds
Main job in a portfolio	Growth	Stability and income

Why hold bonds when stocks return more?

Bonds usually offer lower long-term returns than stocks, but there are two reasons to include them in a portfolio.

The first is stability. While stocks are notorious for doing exactly the opposite of what you expect, quality bonds rarely do anything spectacular unless something goes very wrong. A stock-heavy portfolio can drop 20%, 30%, or even 50% in a crisis, whereas decent-quality bonds tend to give up only a small percentage. That cushion works as a shock absorber, and it helps you avoid selling your stocks cheap during a bear market. The steadiness matters most for retirees, who can't just work through a downturn and wait.

The second reason is income. Bonds pay cash on a schedule you can rely on, which is exactly what someone living off a portfolio needs, and it is the core of their appeal for retirees.

What can go wrong

Bonds are generally the safer bet, but they carry risks of their own.

First there is credit risk, the possibility that the borrower can't repay as promised. US Treasuries are considered essentially free of default risk, but it is real with corporate bonds, and "junk bonds" carry an especially large risk of default. Then there is interest rate risk, the chance that a bond's market value drops because overall rates rose. When that happens, older bonds with lower coupons are worth less if you have to sell before maturity, since their income stream can't compete with newer bonds. This risk is largest for long-dated bonds. Finally there is inflation risk. A bond's payments are fixed, so if you own a 4% bond while inflation runs at 5%, your income is losing purchasing power every year.

In short, bonds are not risk-free, but they pose a different set of risks than stocks, and the two tend to move differently. That is why it is wise to hold both rather than putting everything in one.

How to actually own bonds

Skip individual bonds in most cases, because a far superior and much easier option exists: a bond index fund, which holds thousands of different bonds and handles all the messy parts, like reinvesting when bonds mature. A simple total bond market fund covers the job for most individual investors. Another option worth knowing is US savings bonds, like I bonds, which are bought directly from the Treasury and pay interest tied to inflation, though annual purchase limits keep them a small-amounts tool. For the main bond slice of a portfolio, the fund is the flexible choice.

How much should go to bonds? A popular starting formula is your age as a percentage, so a 25-year-old holds around 25% bonds and shifts more in over time. Treat it as a guideline rather than a law. Some young investors with low risk tolerance want more bonds right away, and our asset allocation article goes deeper on that decision. Once you have picked a percentage, the portfolio rebalancer can help you set it up and keep it there.

Bonds may not make you rich. Their job is making sure the rest of your portfolio doesn't ruin your day.

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This article is for general educational purposes only and does not constitute personal financial, investment, tax, or legal advice. Consult a qualified financial professional before making major financial decisions. See our Disclaimer.