Markets and economy

An advisor talks about bonds

A financial advisor discusses bond funds and how they can add diversification to investment portfolios.
6 minute read
  •  
October 07, 2022
Markets and economy
Market volatility
Market & economy insights
Article
Page
Asset mix
Bonds
Mutual funds

Answering common questions about bonds

When it comes to creating an investment portfolio, many of my clients want to diversify by adding bonds. But while most investors have heard of bonds, some may not be familiar with how they work and what their risks are. That's why I start conversations with new clients by discussing the ins and outs of bonds and how they can be beneficial in long-term investment portfolios.

Clients also contact me with their concerns when stories about changing interest rates and inflation dominate the news. They wonder if they should decrease their bond allocations or eliminate them from their portfolio altogether. During periods of market uncertainty, I address the current climate and remind clients of the benefits of diversifying with fixed income allocations.

How bonds work

To help clients better understand what fixed income or bond funds are, I like to start by making a comparison to loans. Bonds are debt-based investments issued by a government or corporation when they need to generate money. When you buy a bond, you're loaning money to these organizations with a set timeline for when you'll get your principal back (the maturity date). Bonds also usually pay interest (or coupons) throughout the term. When the bond reaches its maturity date, you get your principal back.

Mutual funds that invest in bonds provide additional portfolio diversification because they invest in hundreds to thousands of bonds. This means the maturity dates of the individual bonds are spread out even further—some may be in 6 months, some in 30 years. But a bond fund will never mature since it uses cash flow in the form of interest and principal payments to continue purchasing new bonds for the fund. 

Bond risks

Bonds tend to be much less volatile than stocks, but they still have risks:

  • Default risk. The risk that the issuing corporation could go bankrupt, and the investor won't receive their expected payments.
  • Reinvestment risk. The risk that the interest payments throughout the life of the loan will be invested into new bonds with lower yields.
  • Call risk. The risk that interest rates will fall, so the bond's issuer will cut the term short.
  • Inflation risk. The risk that a bond's interest rate won't keep pace with inflation.
  • Interest rate risk. The risk that the bond's value will fall because newer bonds have higher and more competitive interest rates.

Keep in mind that bond mutual funds invest in hundreds to thousands of bonds, so their built-in diversification helps lessen some of these risks.

Addressing client concerns about bonds

During volatile markets, my clients' most common concerns about bonds revolve around interest rate risk and inflation risk.

Rising interest rates tend to push yields higher and bond prices lower. Here's an example to demonstrate how this might affect an investor:

Example: A client bought a bond with a 1% yield last year, but current bond yields are 2%. If the client wants to sell the bond they own with the lesser yield, they'll have to discount the price to make it attractive to sell.

Inflation must be carefully balanced for bonds to perform well. If inflation is too high, the purchasing power decreases.

Example: A client buys a 30-year bond with a 2% yield, but the overall inflation rate at the time of purchase is more than 2%.

It's important for investors to remember that since bond funds have so many different bonds with different yields and maturities within the same investment, interest rate risk and inflation risk are lower than for individual bonds.

Unpack the challenges of rising bond-fund yields explains why investors should keep in mind that most of the returns from bonds and bond funds come from the income portion—not the price portion—for long-term goals. Price changes matter less over the long haul.

Read 3 bond questions that are top of mind for advised clients to learn more.

It still makes sense to include bonds in most portfolios

For most investors, it makes sense to invest a portion of their portfolio in bonds, specifically a bond mutual fund or ETF (exchange-traded fund), to add diversification. Investors need to align their overall portfolio with their goals and remember the market is cyclical—so be patient during times of volatility. If a client has a short-term need and plans on accessing the money they invest within 12 months, then investing in bonds may not be a good idea.

At times, we'll see both stock and bond prices dropping, raising the question: Why do I need bonds in my portfolio if they don't balance stock performance during times of market volatility?

Historically, we've seen bonds act as a hedge against stock market drops over the long term. So adding bonds to portfolios with long-term goals is usually appropriate. Bonds provide ordinary income and help provide stability to a portfolio, balancing out stocks.  

Questions? If you'd like to know more about bonds or learn more about how an advisor can help, contact us.

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All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

Past performance is not a guarantee of future results.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

For more information about Vanguard funds or Vanguard ETFs®, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

All ETF products are subject to risk, including the possible loss of the money you invest. Prices of mid- and small-cap ETFs often fluctuate more than those of large-cap ETFs. Investments in securities issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks can be especially high in emerging markets. Sector ETFs are subject to sector risks and nondiversification risks, which may result in performance fluctuations that are more extreme than fluctuations in the overall stock market. Bond ETFs are subject to interest rate, inflation, and credit risk. Diversification does not ensure a profit or protect against a loss.

Advisory services are provided by Vanguard Advisers, Inc. (VAI), a registered investment advisor, or by Vanguard National Trust Company, a federally chartered, limited-purpose trust company.

Certified Financial Planner Board of Standards Inc. owns the certification mark CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.