An advisor talks about bonds

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.