Bond Basics: Why Every Portfolio Needs Fixed Income

Bonds are the part of personal finance that gets the least attention and the most muddled writing. Equity gets all the glamour — but in 2008, while stocks fell 37%, US Treasuries gained 14%. That kind of diversification is what bonds are for.

What a bond actually is

A bond is a loan you make to a borrower (government, corporation, municipality) in exchange for two things:

Periodic interest payments (the "coupon") for a fixed term.
Return of principal at maturity.

Buy a $1,000 5-year Treasury at 4.5% coupon: you receive $45/year for 5 years and $1,000 back at the end. Total: $1,225 from a $1,000 investment. Predictable in a way stocks aren't.

The two main risks

1. Interest rate risk (duration)

Bond prices move inversely to interest rates. If you hold a 4% bond and rates rise to 5%, your bond is worth less because new bonds offer better terms. The longer the bond's duration, the more sensitive it is.

Rule of thumb: a 1% rate increase causes a roughly 1% price drop per year of duration. A 10-year bond loses about 10% in value when rates rise 1%; a 1-year bond loses about 1%.

2022 was a duration disaster

The Fed raised rates from 0% to 4.5% in one year. The Vanguard Total Bond ETF (BND) fell 13% — its worst year ever. Long-Treasury ETFs (TLT) fell 31%. Investors who thought bonds were "safe" learned about duration risk the hard way.

2. Credit risk

The borrower might default. US Treasury bonds are essentially default-free (the government can print money to pay them). Corporate bonds, junk bonds, and municipal bonds vary widely in default risk:

Investment-grade (BBB- or higher): ~0.1–1% annual default rate.
High-yield/junk (BB+ or lower): ~3–10% annual default rate, varies with economy.

Higher credit risk = higher yield, but also higher correlation with stocks during recessions. Junk bonds often crash with the stock market — failing at the diversification job bonds are supposed to do.

The bond types you'll encounter

US Treasury bonds

T-bills: 4-week to 52-week maturity. Used for short-term cash management.
T-notes: 2 to 10 years.
T-bonds: 20 to 30 years.
TIPS (Treasury Inflation-Protected Securities): principal adjusts with CPI inflation. Real-yield instrument.
I bonds: retail-only, inflation-adjusted, max $10k/year. Held at TreasuryDirect.

Treasury interest is exempt from state income tax — meaningful in California, New York, etc. Worth comparing yields on an after-state-tax basis.

Corporate bonds

Loans to companies. Higher yield than Treasuries to compensate for credit risk. Most retail investors access via funds (LQD for investment grade, HYG for high yield) rather than buying individual bonds.

Municipal bonds ("munis")

Loans to state and local governments. Federal tax-exempt; sometimes state-tax-exempt if you live in the issuer's state. Worth considering for high-bracket investors in taxable accounts. Calculate equivalent taxable yield: muni yield ÷ (1 - your marginal tax rate).

International bonds

Government and corporate debt from foreign issuers. Adds currency risk on top of credit and duration risk. Vanguard's research suggests diversification benefit is modest; many simple portfolios skip them.

How much bond exposure?

The classic rule was "your age in bonds." That's probably too conservative now given longer life expectancy and higher historical equity returns. Modern guidance:

Accumulation phase (20s–40s): 0–20% bonds. Time horizon is long; sequence risk doesn't apply.
Pre-retirement (50s): 20–40% bonds. Begin reducing equity to manage sequence risk.
Early retirement: 30–50% bonds. The danger zone for sequence risk.
Late retirement (75+): 30–60% bonds. Spending stability matters more than growth.

Personal factors that should adjust these:

Pension or Social Security covering essentials → can hold more equity.
Variable income or no pension → hold more bonds.
Long expected longevity (family history) → hold more equity.
Strong stomach for volatility → hold more equity.

Individual bonds vs bond funds

Bond funds are continually rolled — never "mature." Their value fluctuates daily with interest rates. Convenient but exposes you fully to duration risk.

Individual bonds, if held to maturity, return your principal regardless of interim price changes. You know exactly what you'll get.

For bond ladders (buying bonds maturing in successive years to fund expenses), individual Treasuries can be superior. For broad diversification with low effort, bond funds win.

The bond ladder for retirement

Buy 5 individual Treasuries maturing in years 1, 2, 3, 4, 5. Each year, one matures and you spend it. Re-invest the others into a new 5-year. This locks in known income for 5 years regardless of interest rate movements — a powerful sequence-risk defense.

The yield curve and what it tells you

The yield curve plots Treasury yields against maturity. Normally upward-sloping: longer terms pay more because you're locking up money for longer.

Steep upward curve: typical, healthy economy.
Flat curve: uncertainty about future growth or inflation.
Inverted curve (short rates higher than long): historically a recession signal. The 2022–2023 inversion preceded predicted but slow-arriving slowdown.

For investing decisions, the yield curve doesn't need to drive your strategy — but it explains why sometimes a 1-year T-bill yields more than a 10-year bond.

TIPS and I-bonds: the inflation hedges

Both adjust principal or interest with inflation. Critical when inflation is volatile.

TIPS: trade like regular bonds but principal adjusts with CPI. Held in a brokerage account or via TIPS funds (SCHP, VTIP).
I-bonds: retail-only, $10k/year limit per person. Yield resets every 6 months based on CPI. Tax-deferred federal interest, exempt from state. Cannot be sold in first year, partial penalty for years 1–5.

For retirees worried about high inflation eroding fixed bond income, a 10–20% TIPS allocation within the bond portion is a reasonable hedge.

Common bond mistakes

Chasing yield in junk bonds. The extra yield disappears in recessions when you need bonds to be safe.
Holding long-duration bonds for stability. Counterintuitive but true: long bonds are more volatile than short bonds.
Avoiding bonds entirely "because they don't earn anything." Even a 4% bond return reduces overall portfolio volatility — meaning higher risk-adjusted return.
Treating bond funds like savings accounts. They lose value when rates rise. Don't hold money you'll need in 1 year in BND.
Forgetting taxes. Treasury interest is federal-only; corporate bond interest is fully taxable. Munis can be tax-free. The right bond for taxable account differs by bracket.

Key Takeaways

Bonds = predictable income + return of principal at maturity. Two risks: interest rate (duration) and credit.
Treasuries are state-tax-exempt and effectively default-free. Corporate bonds carry credit risk that can correlate with stocks.
"Age in bonds" is too conservative; modern guidance is 0–20% accumulation, ramping to 30–50% in retirement.
Individual bonds + ladder strategy can outperform bond funds for retirement income because hold-to-maturity returns principal regardless of rate moves.
TIPS and I-bonds defend against inflation; useful in 10–20% of bond allocation for retirees worried about purchasing power.

Stress-test your bond allocation against your expected retirement timeline using our FIRE Calculator.