Recently, bonds have received increased attention from media outlets. Long-term Treasury yields climbed to levels not seen in nearly two decades, with the 30-year Treasury yield rising above 5%. Some of the primary drivers have been inflation, the federal deficit, and increased corporate bond issuance by major technology companies, which has added to competition for investor capital and contributed to higher government bond yields.
With bonds in the headlines, this is a good time to explain what a bond is, why bond prices change, and why some investors—particularly retirees and those approaching retirement—should consider owning them despite the risks and volatility currently being portrayed in the media.
Key Takeaways
- A bond is generally a loan made to a government, corporation, or other borrower in exchange for interest payments and the return of principal at maturity.
- Bonds are typically less volatile and more predictable than stocks, but they are not risk-free.
- Bond prices generally move in the opposite direction of market yields. Longer-duration bonds experience larger price movements when yields change.
- High-quality bonds have historically helped reduce portfolio losses during many stock-market downturns, although this relationship does not hold in every market environment.
- With the 30-year Treasury yield now above 5%, bonds provide considerably more income than they did five years ago.
- Short-, intermediate-, and long-term bonds serve different purposes. The appropriate combination depends on an investor’s income needs, time horizon, risk tolerance, and financial plan.
What Is a Bond?
A bond is essentially a loan.
When you purchase a bond, you are lending money to a government, corporation, municipality, or another borrower. In exchange, the borrower agrees to pay you interest and return your principal at the end of a predetermined period.
The date on which your principal is scheduled to be returned is called the bond’s maturity date. Many traditional bonds pay interest semiannually.
For example, suppose you purchase a $100,000 bond with a 5% coupon that matures in 10 years. Assuming the borrower makes all the required payments, you would receive $5,000 of interest each year—often paid as two $2,500 payments—and receive your $100,000 investment back when the bond matures. (Bond Mutual Fund and Exchange Traded Funds usually spread out interest payments monthly instead of semi-annually).
This structure generally makes bonds more predictable than stocks. Bondholders typically know when they will receive interest payments, how much those payments will be, and when their principal is scheduled to be repaid, assuming the issuer remains in good standing.
Different Types of Bonds
The terms “bonds” and “fixed income” cover a broad group of investments with different characteristics and risks.
Common examples include:
- U.S. Treasury securities: Issued by the federal government and generally considered to have minimal credit risk.
- Municipal bonds: Issued by states, cities, counties, and other government entities. Most invest in these securities for tax-free income.
- Investment-grade corporate bonds: Issued by companies considered to have a relatively strong ability to meet their financial obligations.
- Bank loans: Loans generally made to companies with below-investment-grade credit ratings. Many bank loans have floating interest rates, meaning their interest payments adjust as short-term rates change.
These investments should not be expected to perform the same way and have different risk characteristics.
To keep the discussion straightforward, this article primarily focuses on U.S. Treasury securities.
What Are Treasury Securities?
Treasury securities are debt obligations issued by the United States government to finance federal spending and existing government obligations.
Investors lend money to the federal government, receive interest according to the bond’s terms, and receive their principal at maturity. Treasury securities are backed by the full faith and credit of the U.S. government and are generally considered to have minimal credit or default risk.
Treasury securities are commonly classified by their original maturity:
- Treasury bills generally mature in one year or less.
- Treasury notes generally mature in two to 10 years.
- Treasury bonds generally mature in 20 or 30 years.
What Are the Risks of Owning Bonds?
The primary risks include default risk, downgrade risk, inflation risk, and duration risk.
Default risk
Default risk is the possibility that the borrower will be unable or unwilling to make the promised interest or principal payments.
Historically, U.S. Treasury bonds have been considered to have very low default risk because they are backed by the full faith and credit of the U.S. government.
Downgrade risk
Credit-rating agencies evaluate a borrower’s ability to meet its obligations. If the borrower’s financial condition deteriorates, its bonds may be downgraded.
Credit ratings generally move from highest quality to more speculative. AAA is the highest rating, followed by AA, A, and BBB, which are typically considered investment grade. When a bond is downgraded, its price often falls and its yield rises because investors view it as riskier.
Even U.S. Treasury debt can be downgraded. Concerns about federal debt, deficits, and debt-ceiling uncertainty led major rating agencies to lower the U.S. credit rating from AAA to AA beginning in 2011. While this does not suggest missed Treasury payments are expected, it can affect investor confidence and required yields.
Inflation risk
Inflation reduces the purchasing power of a bond’s fixed payments.
If a bond pays 3% when inflation was initally 2%, but then increased to 4%, the bond is now not keeping up with purchasing power.
Duration risk
Duration estimates how sensitive a bond’s price is to changes in market yields. It is expressed in years, but it is not the same as the bond’s maturity.
Generally, the longer the duration, the more the bond’s price will move when yields change. A 30-year Treasury Bond will be more sensitive to interest rate movements than a 2-year Treasury Bill.
For example, a bond with a duration of five would be expected to decline by approximately 5% if its market yield increased by one percentage point. Conversely, the bond would be expected to increase by approximately 5% if its yield declined by one percentage point.
Why Do Bond Prices Fall When Yields Rise?
Why Do Bond Prices Fall When Yields Rise?
A bond’s coupon payment generally does not change after it is issued. What changes is the price investors are willing to pay for it.
Suppose a bond is issued for $100 and pays $5 of interest each year, giving it a 5% coupon rate.
Now assume interest rates rise and newly issued bonds paying $100 offer $6 of annual interest, or 6%. Investors would generally prefer the new bond paying $6 over the existing bond paying $5. As a result, the price of the older bond must fall to make it more competitive.
This is why bond prices and interest rates generally move in opposite directions. When market interest rates rise, the prices of existing bonds tend to fall. When market interest rates decline, existing bonds paying higher rates become more attractive and their prices tend to rise.
Importantly, a decline in a bond’s market price does not necessarily change what an investor ultimately receives. If an individual bond is held to maturity, the investor is still scheduled to receive the bond’s par value ($1,000), along with the stated coupon payments, assuming the issuer remains financially sound and makes all required payments.
A few terms are helpful to distinguish:
- Coupon rate: The bond’s stated interest rate, based on its par value.
- Current yield: The bond’s annual coupon payment divided by its current market price.
- Yield to maturity: The estimated annualized return if a bond is bought at its current price and held to maturity, assuming all payments are made. It also reflects any gain from buying below or above par value, which is $1,000.
For investors evaluating a bond, yield to maturity is generally more meaningful because it accounts for both the bond’s income payments and the difference between its current market price and the amount expected at maturity ($1000).
Why Diversification Matters
The goal of investing is to target the best return for the least amount of risk.
Diversification helps accomplish this by combining investments with different sources of risk and return. Stocks and high-quality bonds are a good example.
Stocks represent ownership in businesses and generally benefit from increasing profits and economic growth. High-quality bonds are contractual obligations and may perform better when economic growth weakens, inflation declines, or investors become more cautious.
When two assets do not consistently move in the same direction, they have less-than-perfect correlation. Combining them will likely reduce the overall volatility of a portfolio.
How Bonds Can Help During a Bear Market
A stock bear market is generally defined as a decline of at least 20% from it’s peak.
During many stock-market declines, investors become less willing to accept risk and move money toward Treasury securities. This is often called a flight to safety.
Economic weakness may also reduce inflation and cause investors to expect the Federal Reserve to lower short-term interest rates. When market yields decline, existing Treasury bonds generally increase in value. In this scenario, Treasury Bonds (20-30 years maturity schedule) will increase more than Treasury Bills (sub 1 year maturity schedule).
This can allow bonds to offset part of a stock portfolio’s decline.
For example, the global financial crisis: From its October 2007 peak through its March 2009 low, the S&P 500 declined by more than 50%.
A hypothetical portfolio invested 60% in U.S. stocks and 40% in high-quality U.S. bonds would still have experienced a loss. However, its estimated peak-to-trough decline would have been approximately 30%.
Bonds did not prevent the portfolio from declining, but they helped reduce the loss.
Are Bonds Attractive Today?
Bond yields are considerably more attractive than they were five years ago. On August 31, 2021, the 30-year Treasury yielded about 1.92%; in August 2026, it moved above 5% and briefly reached levels not seen since 2007.
This matters because higher yields provide more income while a bond is held and may create greater potential for price appreciation if market yields eventually decline.
A 30-year U.S. Treasury yielding approximately 5.2% with an estimated duration of about 15 could rise roughly 15% in price if comparable yields fell by one percentage point, based on duration.
The same relationship works in reverse: if yields rose by one percentage point, the bond’s price could decline by roughly 15%. Even then, the bond would continue paying its scheduled coupon, and an investor who holds it to maturity would still be scheduled to receive the full principal amount. However, an investor who sells before maturity could realize a loss.
Who Should Consider Owning Bonds?
The role bonds play in a portfolio usually changes throughout an investor’s lifetime.
Someone early in a career who is regularly contributing to retirement accounts may have decades before needing the money. That investor generally has a greater ability to tolerate stock-market volatility and may own a higher percentage of stocks because stocks have historically provided greater long-term growth.
The priorities begin to change as retirement gets closer.
A retiree may need to withdraw money from a portfolio to supplement Social Security, and other sources of income. A stock-market decline becomes more consequential when the investor must sell investments to meet ongoing expenses.
Bonds can help by providing:
- A source of interest income
- Lower expected volatility than stocks
- More predictable cash flows
- Funds for near-term spending needs
- Diversification from stock-market risk
- A potential source of stability during certain economic downturns
This does not mean every retiree should hold a significant percentage of bonds. Someone whose pension and Social Security benefits cover nearly all living expenses may be able to own more stocks than someone who depends heavily on portfolio withdrawals.
Other factors that affect how much bonds should be held include an investor’s spending needs, other income sources, tax circumstances, time horizon, and comfort with market declines.
How We Currently Think About Bonds
We believe bonds are an important part of a diversified portfolio, particularly for investors who are risk-averse, approaching or in retirement, or dependent on their portfolios for income.
At today’s yields, bonds will generate more income than they have in recent years. They also have the potential to appreciate in price during a stock-market downturn.
Although this article has focused primarily on Treasury bonds, which we believe should generally serve as the cornerstone of a bond portfolio, other bond sectors should be considered, including but not limited to: investment-grade corporate bonds, mortgage-backed securities, and floating-rate bonds.
Different bond sectors respond differently to changes in interest rates and economic conditions. Corporate bonds and floating-rate bonds, for example, can typically produce higher yields than Treasuries and likely provide additional diversification. Floating-rate bonds are generally less sensitive to changes in long-term Treasury yields because their interest payments adjust more frequently. However, they usually carry more credit risk than high-quality government bonds.
The Bottom Line
Stocks and bonds serve different purposes.
Stocks remain an important source of long-term growth and can help a portfolio keep pace with inflation. Bonds can provide income, liquidity, stability, and diversification.
Higher yields are not necessarily negative. While rising rates can lower existing bond prices, they also allow investors to reinvest maturing short-term bonds into longer-term bonds at higher yields. For those comfortable with added price volatility, this may lock in higher income for longer.
The question is not simply whether bonds are a good investment today. The more useful question is what role bonds should play within your financial plan.
The answer depends on your spending needs, retirement timeline, risk tolerance, tax circumstances, and the other investments and income sources available to you.
Disclosure: This material is provided for general educational and informational purposes only and should not be considered individualized investment advice or a recommendation to buy or sell any security. Investment decisions should be based on your individual circumstances, objectives, risk tolerance, and financial plan. Past performance does not guarantee future results. Diversification does not ensure a profit or protect against loss.