Investing in Bonds
Learn how bonds work: the main types, how yields pay you, the risks that move prices, and simple ways to hold them.
TL;DR
- A bond is a loan you make to a government or company in return for scheduled
coupons. durationtells you how far a bond's price will move when interest rates change.- When rates rise, existing bond prices fall; that inverse link is the key thing to remember.
Types of Bonds
Treasury BondsLoans to the US government, the safest bonds you can buy.
Backed by the US governmentCorporate BondsLoans to companies that pay more yield for more risk.
Corp yield - Treasury yield = extra payMunicipal BondsLoans to states and cities, often free of federal tax.
Tax-free interest for many holdersBond Funds and ETFsOwn thousands of bonds in a single, easy purchase.
BND holds the whole bond marketYields and How You Get Paid
CouponThe fixed yearly interest, based on the $1,000 face value.
5% coupon = $50/yr per bondCurrent YieldThe coupon divided by the price you actually paid.
$50 / $950 paid = 5.3%Yield to MaturityYour true annual return if you hold it to the end.
Blends coupon plus price gain or lossPar vs PriceBonds trade above or below their $1,000 face value.
Buy at $950, collect $1,000 at maturityThe Main Risks
Interest Rate RiskWhen market rates rise, the price of existing bonds falls.
Rates up -> older bond prices downDurationMeasures how far the price moves per 1% change in rates.
6-yr duration -> about 6% drop if +1%Credit RiskThe issuer might miss payments or default entirely.
AAA safest ... BBB ... junk riskiestInflation RiskFixed payments buy less as prices climb over time.
5% coupon - 3% inflation = 2% realSimple Bond Strategies
Match Duration to TimelinePick maturities near the date you will need the cash.
Need it in 5 yrs? Use ~5-yr bondsBuild a LadderStagger maturities so money returns to you every year.
1,2,3,4,5-yr rungs, reinvest yearlyUse a Total Bond FundGet instant diversification with a hands-off single fund.
One fund = thousands of bondsTIPS for InflationTreasury Inflation-Protected Securities raise principal with prices.
TIPS adjust upward with inflationTips
- Match a bond's
durationto when you will spend the money; a 5-year need pairs well with about 5-year bonds so rate swings barely touch you. - Build a
bondLadderwith staggered maturities so cash comes back each year to spend or reinvest at whatever rates exist then.
Warnings
- Do not chase high yields blind to
creditRating; junk bonds pay more precisely because they are more likely to default in a downturn. - Remember long bonds swing hard; when
interestRatesjump, a long-duration bond can lose more value than a year of its interest pays back.
In Practice
See how duration turns a 1.5% rate rise into a real dollar change on a bond fund.
You hold $50,000 in a total bond fund with an average duration of 6.5 years. Rates rise 1.5%.
- Price drop from duration: -6.5 x 1.5% = about -9.75%.
- Dollar drop in value: $50,000 x -0.0975 = about -$4,875.
- But new money now earns more: a 4.5% yield pays about $2,250 in interest that year.
- Net one-year result: -$4,875 price + $2,250 interest = about -$2,625.
Your fund falls about 9.75% in price, softened by the higher interest it now pays.
Shorter-duration bonds ride out rate hikes far more gently; pick duration to fit your timeline.
FAQ
Duration measures how much a bond's price moves when interest rates change. A bond with a 6-year duration falls about 6% in price if rates rise 1%, and rises about 6% if rates fall 1%. Shorter duration means a smoother, steadier ride.
They carry essentially no default risk because they are backed by the US government, which is why they anchor safe portfolios. But they still lose value if rates rise before you sell, and their fixed payments lose buying power when inflation runs high.
A bond ladder splits your money across bonds that mature in different years, such as 1, 2, 3, 4, and 5 years out. Each year a rung matures and you reinvest it at the far end, giving you steady cash flow without betting on where rates go next.
It depends on your timeline and nerves, not a single formula. A young investor decades from retirement might hold little in bonds, while someone near or in retirement often holds much more for stability. A common starting point is to raise your bond share as your time horizon shrinks.