Bonds

Lending, not owning

A stock makes you a part-owner of a company, sharing in whatever profit or loss follows. A bond makes you a lender: you provide money to a company or government, and in exchange you receive scheduled interest payments. Because you're owed a fixed return rather than a share of the upside, bonds generally offer lower potential gains than stocks, in exchange for meaningfully lower volatility.

That distinction decides everything else. A shareholder benefits without limit if the company thrives, and can lose everything if it fails. A lender receives the agreed payments and nothing more, no matter how well the borrower does, but stands ahead of shareholders if things go wrong.

How a bond actually works

Three numbers define most bonds. The face value is the amount repaid at the end. The coupon is the interest rate paid along the way, usually annually or twice a year. The maturity is when the loan ends and the face value is returned.

The yield is what matters more than the coupon once a bond has been issued, because bonds trade on a market. If you buy that same bond later for less than $1,000, your actual return is higher than 4%, since you are receiving the same payments for less money.

Why prices fall when rates rise

This is the part that surprises people who expected bonds to be simple. Bond prices move in the opposite direction to interest rates, and the reason is straightforward once you see it from a buyer's perspective.

This is why 2022 was unusual and worth understanding. Rates rose quickly from very low levels, and bonds fell alongside stocks rather than cushioning them. The stabilising role bonds usually play is real, but it is not a guarantee that applies in every kind of downturn.

Duration: how sensitive your bonds are

Duration measures how much a bond's price moves when rates change, expressed in years. A longer duration means larger swings in both directions, which makes it the single most useful number to check before buying a bond fund.

The practical takeaway is that duration should match your purpose. Money needed within a few years belongs in short-duration bonds, where rate moves barely register. Long-duration bonds behave far more like a volatile asset than most people expect from something described as safe.

Not all bonds are the same

Calling something a bond says almost nothing about how risky it is. The range runs from near-riskless government debt to corporate borrowing that behaves much like equity.

Higher yields are compensation, not a free upgrade. A bond paying noticeably more than a government equivalent is paying you to accept a real possibility that you will not be repaid in full. That may be a reasonable trade, but it should be a deliberate one rather than a search for the biggest number available.

The three risks that actually matter

Bonds are lower risk than stocks, not risk-free, and their risks are different in kind rather than simply smaller.

• Interest rate risk, where rising rates reduce the market value of what you hold. This affects even government bonds with no chance of default.
• Credit risk, where the borrower fails to pay. Negligible for stable governments, real for weaker companies.
• Inflation risk, the quietest of the three, where fixed payments buy less each year. A 3% coupon during 5% inflation loses purchasing power despite being paid in full.

The third one explains why bonds alone are a poor long-term strategy. They are excellent at preserving a number and mediocre at preserving what that number can buy, which is why they support a portfolio rather than replacing one.

Why they tend to hold up when stocks don't

Bond obligations are often backed by the borrower's assets, so lenders are typically prioritised for repayment if things go wrong. Bonds also tend to behave differently from stocks day to day. When investors get nervous about stocks, money often flows toward safer assets like bonds, which is part of why holding some can smooth out a portfolio's worst stretches.

The effect is strongest with high-quality government bonds during a growth scare or a crisis, and weakest when the problem is inflation, since that hurts both at once. Understanding which kind of bad period you are protecting against is what makes the allocation deliberate rather than habitual.

Protecting gains, not just chasing them

It's natural to focus entirely on growth and ignore the downside, but a portfolio with no stabilising component can be hit hard by a single bad period. Setting aside a modest portion in bonds isn't about maximising returns. It's about having something steady to lean on when everything else is moving against you.

There is a second, less obvious benefit. When stocks fall sharply, a bond allocation gives you something to sell that has not fallen, which means you can buy stocks at lower prices without touching your emergency fund. Rebalancing back to your target allocation forces exactly this behaviour, mechanically, at the moment it is hardest to do voluntarily.

How much to hold

There is no correct number, but the useful inputs are your time horizon and your honest tolerance for watching a balance fall. Someone thirty years from needing the money can hold very little in bonds, since they have time to recover from declines. Someone approaching the point of withdrawal usually wants substantially more, because a bad year at the wrong moment forces selling at depressed prices.

Temperament matters as much as arithmetic. An investor who would abandon a plan during a steep decline is better served by a more conservative allocation they can actually hold, since the return of a portfolio you sell at the bottom is worse than the return of a duller one you keep.

Funds over single bonds

The same reasoning behind stock index funds applies here: a bond fund holds many issuers at once instead of depending on any single borrower repaying its debt, spreading out the risk that one of them defaults.

Funds also solve a practical problem. Individual bonds can be awkward to buy in small amounts and require reinvesting the proceeds each time one matures. A fund handles that continuously, which is why a broad, low-cost bond fund with a duration matched to your horizon covers most needs without further complexity.