Bonds

A bond is a debt instrument: the investor lends a principal amount, the issuer pays interest called the coupon, and the principal comes back at maturity. A $1,000 corporate bond with a 4% coupon pays $40 a year and returns the $1,000 five or ten or thirty years out. Issuers divide into the US Treasury, states and cities issuing municipal bonds, and corporations issuing investment-grade or high-yield debt. Credit ratings from agencies like Moody's and S&P grade the default risk, with BBB-minus and above considered investment grade.

The risk is interest rates, not just defaults. Bond prices move inversely to yields: when rates rise, existing bonds paying the old coupon fall in price, and the longer the maturity, the harder the fall. The 2022 rate shock took the Bloomberg US Aggregate Bond Index down roughly 13%, its worst year on record, and long-term Treasury funds lost far more. Individual bonds held to maturity return principal regardless of the price path; bond funds never mature, so the drawdown has to be earned back.

The contract has three numbers. The face value, almost always $1,000, is what the issuer repays at maturity. The coupon is the annual interest, fixed or floating, paid in semiannual installments: 4% on $1,000 is $20 twice a year. The maturity is the repayment date, and together the three set the price. A bond's market price moves whenever prevailing yields move, because a 4% coupon is worth less if new bonds pay 6%, and the price falls until the old bond's yield matches the market.

The sensitivity is measurable and it is called duration. A bond with a duration of 7 years loses roughly 7% of its price for each 1-point rise in yields, and gains the same when yields fall. A 2-year Treasury has a duration near 2; a 30-year bond runs near 17 or higher, which is why the long end of the 2022 rate shock fell by a third while T-bills barely moved. Credit risk stacks on top: high-yield issuers pay more coupon precisely because default is a live possibility, and downgrades reprice the bond before any default.

The holding decision changes the risk. An individual bond held to maturity pays every coupon and the principal on schedule, default aside, and the interim price swings never have to be realized. A bond fund holds a rolling portfolio with no maturity date, so its net asset value reflects rate moves permanently until they reverse, which is why fund shareholders felt 2022 as a loss and T-bill ladders did not. Laddering maturities converts one sum into a schedule of known dates, the structure most retirement portfolios run on.

Bonds matter to an American portfolio as the asset that pays a known schedule. The coupon arrives twice a year, the principal returns on a date, and the volatility is a fraction of equities, which is why the standard retirement allocation holds 30% to 40% of them. The interest is taxable as ordinary income for corporates, exempt from federal tax for most municipals, and exempt from state tax for Treasuries, so the account the bonds live in matters as much as the issuer.

I watched a colleague named Brent (yes, that Brent) describe bonds as risk-free in early 2022 and buy a long-term Treasury fund for the yield. The fund fell roughly 31% that year as rates repriced two decades of assumptions. The principal was never at risk; the price was, and he had bought the price.

The highest-leverage thing most Americans can do is match bond maturities to when the money is needed, hold short durations where rates are uncertain, and keep the taxable bonds in tax-advantaged accounts where the ordinary income does not compound against the coupon. Compare yields with the bond yield calculator and project the income with the fixed income calculator.