Do Bonds Belong in Your Portfolio?

Do bonds belong in your portfolio?

They belong in mine, and I’ve held about 10% of my portfolio in bonds since I came up with my first basic Investor Policy Statement. It’s not a large percentage, but it’s enough to make me feel at least a little bit protected when the stock market does lose value, which it tends to do about 30% of the time.

There are many ways to invest in bonds. You can purchase individual bonds or you can buy them in bunches with an ETF or mutual fund. You can buy short-term or long-term bonds and many durations in between. They can be of the corporate, municipal, or federal variety, and some federal treasury bonds, known as TIPS, are inflation-protected.

I’ve taken the route of simplicity, owning about 20,000 different bonds via Vanguard’s Total Bond Fund.

The creator of the excellent IQ Calculators site penned this piece to explain in plain and simple terms how bonds work and why you should consider owning them in your portfolio. This is his second guest post on the site, having shared an article on tax-advantaged charitable giving, Giving Faceoff: Charitable Remainder Trust (CRT) versus Donor Advised Fund (DAF), in 2018.



Why Bonds Belong in Your Portfolio


Bonds are a debt investment where the investor lends capital to the borrower in exchange for a fixed rate of interest.

While a bond is held, it will typically make interest payments to the lender.  The interest is paid periodically up until maturity by what is called a coupon.  If there is no coupon payment, then the bond will be purchased at a discount to par value so that as time goes by, the bond appreciates as it gets closer to its maturity date.  This bond’s appreciation replaces the interest earned by the periodic coupon payment.  This is what is known as a zero coupon bond.

If a bond is held until maturity, then the rate of return the investor can expect is called the yield to maturity.  Maturity is the moment in time when the borrower must return the lender’s original capital as laid out in the bond’s contract.  The rate of return an investor expects to receive if held to maturity is called the yield to maturity.  The yield to maturity is the rate the investor will receive barring some other negative event like the company going bankrupt or the bond getting called (more on call risk below).


Bond Price vs Interest Rates


It is important to understand that a bond’s price will move while you own the bond.  A bond’s movement in price is usually due to a change in underlying interest rates, but it may also change due to the public’s trust in the company’s ability to pay back the debt and continue as a going concern.

Assuming the bond’s price moves due to interest rates…a bond’s price will move inversely to interest rates.   For example, if interest rates rise, then the price of the bond will decrease.  Conversely, if interest rates decrease, then the price of the bond will increase.




The reason that a bond’s price moves inversely to interest rates is because the lower the interest rate environment, the lower the yield one should expect to receive from a bond.  Thus, the market will require a higher price for the bond, thus decreasing the yield to be in line with the market interest rates.



Buying A Bond At a Discount Versus a Premium


When buying a bond in the open market, the bond will either be purchased at a premium to par value or a discount to par value.  All that this means is that the purchase price will either be above or below the par value.

What is par value?  Par value is the nominal or standard value of a bond as it is laid out in the contract of the bond.  Usually, this is an even number like $1,000 or $10,000 depending on how large of increments the bond is sold in.  The par value is the value the bond is issued at (in most cases) and the value at which it is redeemed at maturity.


Bond Premium-vs-Discount


Buying a bond at a discount creates the opportunity for a greater return than the rate of the coupon payment.  This is made possible by the bond appreciation towards the par value as the bond gets closer to maturity.  Remember, the bond will be redeemed at par value.  Conversely, buying a bond at a premium will decrease the rate of return below the rate of the coupon payment.



Duration vs Volatility


It is often misunderstood that bond prices are not volatile.  This is not always true as bond prices can be quite volatile.  But it is important to understand that if an investor’s intention is to hold the bond to maturity, then volatility won’t play a factor in the investor’s decision making process.  This is because the final price at maturity will be par value, regardless of the volatility before then.

If volatility does play a role, then it is important to understand that longer duration (synonym for time until maturity) bonds are more price sensitive to interest rates.  A one percentage point move in interest rates in either direction can make a bond with a duration over 10 years move quite significantly whereas it may only cause a short term bond’s price with 3 years until maturity to barely move.


If you are investing with hopes that the bond’s price will go up so you can sell it at a gain at some point in the future, then the prediction/hope is that interest rates will decrease in the future.  In this case, it would be more strategic to purchase a longer duration bond to capitalize on a larger increase in the bond’s price.



Risks of A Bond Being Called


When purchasing a bond, the investor should research whether the bond is callable.  A callable bond means that the bond can be called by the company issuing the bond at which time they would return the capital to their investors at par value.  The primary reason this sometimes takes place is so that the company can refinance their debt at a lower rate by reissuing new bonds.  The risk this presents to the investor is that they will not have received the future coupon payments were the bond held until maturity.  Rather, they will likely have to go back to the market to purchase a new bond, which will likely have a lower yield to maturity.

The second risk(and larger risk) is only a risk if the bond was bought at a premium above par value.  If this was the case, the bond return will be purchased back by the borrower at par value which could potentially create a negative rate of return.  When interest rates are low, bond prices tend to be higher, which makes this risk more common in a low interest rate environment.

If this risk is present, it is best to calculate a yield to maturity as well as the yield to worst.  The yield to worst is the yield that is the worst possible given the possibility of the bond getting called.


Should Bonds Be A Part of Your Investment Strategy?


Bonds should definitely be a part of every investors long term strategy.  Bonds add a degree of diversification that equities/stocks cannot offer.  The reason bonds make a great diversification tool is because interest rates are often moving downward at the same time that the economy is slowing and stocks are potentially decreasing in value.  If interest rates are decreasing, the value of a bond portfolio is likely increasing which can create a natural hedge against stock market volatility.  It doesn’t always work like this but it can in most cases.

Second, although bonds can have volatility, most bonds are not as volatile as the stock market.  This offers the portfolio greater stability.

And lastly, bonds can be a great income strategy both before and in retirement.  Because most bonds pay interest via periodic coupon payments, the coupon payments create a natural income strategy for retirees.


In Conclusion


Bonds are another tool every investor should understand so that they can add it to their investing tool belt.  By understanding how bonds work and behave in different interest rate environments, it can help an investor better position their portfolio and reduce volatility risk to the portfolio.


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Are bonds a part of your portfolio? At what percentage? What stage of life are you in (early career, late career, retired, etc…)?

13 thoughts on “Do Bonds Belong in Your Portfolio?”

  1. I should add that callable bonds are only exercised when interest rates fall. When they rise they are never called. So as the holder of the bond you end up taking this asymmetrical risk profile- if you are compensated for this with a penalty fee in your favor or a higher yield, fine. If not then it seems like a poorer investment, relatively speaking.


    • Great post. The simplicity of the seesaw helps with understanding the relationship between bond price and interest rates. Another way I like explaining the mechanics of bonds to new investors in simple terms is comparing is comparing them to rental properties. The bond’s coupon is like the rental income from the tenant and behind the scenes the value of the real estate is fluctuating. It’s not a perfect comparison but it seems to help people understand what to expect. I did want to point out that maturity and duration are not synonymous. They are actually two different things. Maturity is simply a measure of time until the bond’s principal must be paid back. Duration is a measure of the bond’s sensitivity to changes in interest rates. The value of a bond with a duration of 1 can be expected to fluctuate equally to changes in rates. In other words, a change in rates of 1% would also effect the value by 1%. The value of a bond with a duration of 3 would fluctuate 3% for every 1% change in rates.

      Here’s a discussion of this relationship from Morningstar.

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  3. I have entered my 5 year to retirment window last year and because of it I decided to de-risk my portfolio and did so by upping my bond component. Of course I was “rewarded” by this smart move by not fully capturing all the amazing gains the market had this past year. But in the end it still is a move that makes sense.

    It is a little more risky but in the beginning I had a very low percentage of bonds because the yield was so low and instead decided to go higher on REITs. Because REITs are required to distribute 90% of their proceeds you can build a sizeable fixed income stream that way. The issue is that it is a volatile asset that is highly correlated with stocks. But if you never plan on selling and just want the distributions it lessens this negative.

      • It is mainly my 401k that I have kept the REITS and they only offer Vanguard REIT as a choice. It has been a pretty good gamble as it has produced much better yield than if I had put it in a bond plus the shares appreciated quite a bit. I did take some off the table last year and put it into bonds though b/c of my de-risking strategy at this stage.

  4. The way I see it, early in my career (now) the importance of asset allocation is dwarfed by the importance of diligent saving and not panic-selling.

    By the time I get to a substantial portfolio size, I will want some bonds to ease the ride anyway.

    So I might as well have some now and keep things simple. That’s what led me to my current 10% allocation.

  5. This post is a nice primer to understanding bonds. They certainly aren’t the sexiest investment, but one that is a worthwhile portion as a portfolio volatility smoother.

    I’ve had to do some investment soul-searching (aka risk assessment) and in using a 3rd party to determine this, I realized I was way too invested in equities. We are at 70/30 stock/bond portfolio mix currently.

  6. I dunno, I bought EDV last year and made 25.88% for my trouble. Don’t think I missed much when it came to return. What I did gain was non correlated diversity and a decrease in the risk of equity concentration both of which I find highly desirable since I’m fully retired and living off the nest egg.

    Right now “bonds” are expensive in that the yields are close to zero and even negative if you take inflation into account. So there isn’t a lot of upside unless the FED goes to negative interest rates aka DISASTER. IMHO do not own bonds regardless if they go negative. You can make money with negative rates as a trader but you 100% loose if you’re a buy and hold type. Homey don’t play that. Also if you own a “total fund” you get what you get. If your total fund owns 10% BBB paper and the market craps, that BBB can get marked down and suddenly gets paid pennies on the dollar and your “safe fund” takes a hit. This is what happened in 2008 and the reason the FED had to step in and trade bad paper for treasuries so the banks and therefore the country didn’t go broke. The FED still has the toxic paper on their balance sheet 12 years later and is part of the reason they can’t raise interest rates without the market going into a tail spin, witness Dec 2018.

    Pension funds typically can only hold BBB paper and above. If the BBB goes to C (junk) the funds necessarily MUST sell and it’s supply and demand. If supply goes up the price goes down = a buy high sell low condition is triggered, so there is quite a bit of unrecognized risk in bonds these days. That being said I own bonds 26% of my portfolio of varying duration but presently no corporates or junk because of the default risk. I own EDV TLT TIP and SHY or their admiral share mutual fund equivalents in both Roth and TIRA and vary the asset allocation based on inflation and economic risk. I also own some foreign exposure

  7. I also have around 10% in bonds. I think diversification is key for anyone that wants to invest their money. Even if the stock market has been on a roll for the last years, we don’t know what will happen in the future and it can be full of surprises.
    Thanks for writing this article about bonds because I think people need to understand better what they are and why they should own them.

  8. In addition to the total bond fun, is it a good idea to keep a little bit of Total Stock Market (VTSAX) and/or REIT in a SEP or 401k in case you want to rebalance?


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