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Bond Basics: How Fixed Income Works

Bonds are the foundation of most conservative portfolios, but they're widely misunderstood. Understanding duration, yield, and credit risk lets you use fixed income the way professionals do.

Bond Basics: How Fixed Income Works

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What a Bond Actually Is

  • A bond is a loan you make to a government or corporation in exchange for regular interest payments (coupon) and return of principal at maturity
  • The coupon rate is fixed at issuance; the bond's price fluctuates in the secondary market as rates change
  • Yield to maturity (YTM) reflects the total return if you hold the bond to maturity, accounting for any premium or discount to face value
  • Bond prices and interest rates move in opposite directions, when rates rise, existing bond prices fall
  • Bonds are senior to equity in the capital structure, meaning bondholders get paid before stockholders in a default
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Full Guide

What a Bond Actually Is

  • A bond is a loan you make to a government or corporation in exchange for regular interest payments (coupon) and return of principal at maturity
  • The coupon rate is fixed at issuance; the bond's price fluctuates in the secondary market as rates change
  • Yield to maturity (YTM) reflects the total return if you hold the bond to maturity, accounting for any premium or discount to face value
  • Bond prices and interest rates move in opposite directions, when rates rise, existing bond prices fall
  • Bonds are senior to equity in the capital structure, meaning bondholders get paid before stockholders in a default

Understanding Duration

  • Duration measures a bond's sensitivity to interest rate changes, a duration of 7 means a 1% rate rise drops price by roughly 7%
  • Longer maturity bonds have higher duration and greater price volatility when rates change
  • Short-duration bonds (under 3 years) are relatively stable; long-duration bonds (10-30 years) can swing significantly
  • When you expect rates to fall, longer duration bonds outperform; when rates rise, short duration bonds are safer
  • The Bloomberg US Aggregate Bond Index has a duration of roughly 6-7 years, meaning a 1% rate move has a meaningful impact

Types of Bonds and Their Risk Profiles

  • US Treasury bonds: backed by the full faith and credit of the US government, considered risk-free for credit purposes
  • Investment-grade corporate bonds: rated BBB or above, higher yield than Treasuries with modest credit risk
  • High-yield (junk) bonds: rated below BBB, offer higher yields but significant credit and default risk
  • Municipal bonds: issued by state and local governments, interest often exempt from federal and state taxes, valuable for high earners
  • Agency bonds (GNMA, FNMA): issued by government-sponsored entities, slightly higher yield than Treasuries with implicit government backing

Bond Ladders: Managing Reinvestment Risk

  • A bond ladder holds bonds maturing at regular intervals, for example, bonds due in 1, 2, 3, 4, and 5 years
  • As each rung matures, you reinvest at current rates, smoothing out the impact of rate swings over time
  • Ladders provide predictable cash flows and eliminate the need to guess the direction of interest rates
  • Treasury ladders can be built directly through TreasuryDirect.gov with no management fees
  • CD ladders work similarly using FDIC-insured bank certificates of deposit for very conservative investors

TIPS and I-Bonds: Inflation Protection

  • Treasury Inflation-Protected Securities (TIPS) adjust their principal with inflation, protecting purchasing power
  • TIPS pay a real yield above inflation; the inflation adjustment is taxable as ordinary income even though you don't receive it until maturity
  • I-bonds are savings bonds whose rate resets every 6 months based on CPI, they cannot lose value in nominal terms
  • I-bonds are limited to $10,000 per person per year through TreasuryDirect.gov ($5,000 additional via tax refund)
  • Both TIPS and I-bonds make most sense when your primary concern is maintaining real purchasing power

Key Takeaways

  • Bonds provide income, capital preservation, and portfolio ballast against equity volatility, not just 'safe' returns
  • Match bond duration to your time horizon: short for near-term needs, longer for income-focused investors
  • Higher yield almost always means higher risk, understand whether that risk is duration, credit, or both
  • Bond ladders smooth reinvestment risk and provide predictable cash flows without guessing rate direction
  • TIPS and I-bonds add inflation protection that nominal bonds cannot provide
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