Bonds Explained: Why the Boring Asset Got Interesting Again

Understanding bonds is one of the more neglected jobs in a portfolio, not only for people who skipped them in the 2010s when they paid next to nothing, but for anyone who watched 2022 and concluded the asset was broken. The work involves knowing that a bond is a loan with a coupon and a maturity date, seeing why the price drops when new bonds pay more, checking duration on a fund factsheet, and then using bonds for ballast, income, or a known future date, not for chasing yield.

On the other hand, the year that destroyed returns for people who already owned bonds is the same year that handed new buyers yields nobody had seen in a decade. A falling price and a rising yield are two names for one event. Hold to maturity and you get exactly what you were promised. Used as ballast against equity drops, they look a lot more sensible now that yields are back to something you can actually live on.

Here are some things you can do to read a bond, and to decide whether you need one.

What a bond actually is

A loan. You lend a government or company money. They pay fixed interest for a set period, then return the principal. Three numbers define it: face value (what you get back), coupon (the fixed interest), maturity (when you get it). Unlike a share, which pays out an uncertain slice of future profit, a bond promises specific amounts on specific dates. That certainty is the whole product.

Why prices fall when rates rise

The coupon on your bond is fixed. The market's required return is not. Buy a bond paying 2%, and a year later new bonds pay 5%, nobody pays full price for yours when they could buy the better one instead. So your bond's price drops until its effective return matches what is on offer elsewhere. Nothing has actually broken. Hold to maturity and you get exactly what you were promised. Sell before then, and that price drop is a real loss.

Two risks, and they behave completely differently

Interest-rate risk hits even the safest government bonds, and it is entirely a function of duration. That makes it the one bond risk you can measure precisely before buying: a fund's factsheet states its duration, and that number is your exposure. Duration 2 barely moves when rates shift, duration 15 moves violently. If a double-digit fall would be a problem, do not buy a long-duration fund, however safe the underlying issuer is.

Credit risk is the borrower failing to pay, and it is close to zero for developed-market government debt. Corporate bonds carry more, graded from investment-grade down to high-yield, which pays a higher coupon precisely because the risk is real. High-yield bonds behave like equities in a crisis, falling for the same reason stocks fall, since the recession that damages share prices is the same one that pushes marginal companies into default. If you are holding bonds for ballast, high-yield is not doing that job, and finding that out during a downturn is the expensive way to learn it.

Three jobs a bond can do, and matching yours

1. Ballast against equity drops. In many downturns, though notably not 2022, high-quality government bonds have risen while equities fell. This only works with high-quality debt at meaningful duration, not short-dated corporate bonds.

2. Income for anyone drawing on a portfolio rather than adding to it. Predictable payments on known dates, and this is where the return of normal yields changed the arithmetic most after a decade of near-zero rates.

3. A known sum on a known date, which equities cannot do. If you need a specific amount in five years, a bond maturing in five years matches that liability exactly. This is the most underrated use of the asset class.

How much of each to hold depends on your horizon rather than your age. Someone decades out has little need for ballast and far more exposure to inflation, which bonds are poor at beating. Someone a few years from needing the money has a real sequence-of-returns problem that bonds guard against directly, covered against your own horizon in asset allocation by age.

What not to do

Do not buy a bond fund without checking its duration first. Two funds both labelled "bond fund" can have completely different rate sensitivity, and the label alone tells you nothing about how much a fund will move when rates shift. Look up the number before you buy, not after a bad quarter explains it to you.

Where this leaves you

Check the duration on any bond fund you own or are considering, since that single number tells you what a rate move actually does to your holding. Decide which of the three jobs above you are buying for, because ballast and income point at different instruments. If you need a specific sum on a specific date, buy an individual bond that matures on it rather than a fund that never will, since a fund continuously rolls its holdings and never reaches a date where you simply get your principal back.

If you built your portfolio during the zero-rate years and are wondering whether to revisit it now, bring it to the Discord below. The duration question in particular is where most of the surprises live.

FAQ

Should I buy individual bonds or a fund? Government bonds work fine held individually. Hold to maturity and price swings never become a real loss. Corporate bonds are usually better in a fund, since spreading credit risk across hundreds of issuers removes most of it.

Do bond funds ever mature? No. A fund continuously rolls its holdings, so it always carries duration risk. You never reach a date where you just get your principal back.

Are bonds still worth holding after 2022? Yes, arguably more than during the zero-rate decade before it. The yields on offer now are the highest in years.

Not investment advice. Bond yields, credit ratings and tax treatment vary by country and change over time. Past performance does not guarantee future results.