Let’s Talk About Bonds: How to Add Fixed Income to Your Portfolio and Optimize Your Returns

The stock markets have been very volatile since the beginning of the year, with uncertainty about rising rates, high inflation, the potential for a recession, and continuing geopolitical risks.

Investors are concerned. So concerned, in fact, that many have left the equity markets in favor of bonds—a scenario we haven’t seen since the pandemic, and before that—the 2007-2009 recession. And bond yields are rising in response.

According to Ici.org, equity markets had estimated outflows of $7.39 billion last week, considerably higher than the outflows of $1.98 billion in the week before. On the other hand, bond funds also saw a small outflow last week—$284 million, but in the prior week, investors couldn’t get enough of them, adding $867 million.

That sure sounds to me like investors are seeking safety and yield. As you can see from the following graph, bond yields have been edging up, providing some nice alternatives for stocks.

Now, as an equity analyst, I am never totally out of the stock market. I love stocks, and over time, on average, stocks have significantly outperformed bonds. According to Morningstar, “since 1926, large stocks have returned an average of 10% per year; long-term government bonds have returned between 5% and 6%.”

However, there are times when bonds do outperform stocks, as you can see in the graph below.

This chart divides the S&P 500 by a Total Return Bond Index. What it means is this: When the ratio rises, stocks beat bonds. And when the ratio declines, bonds beat stocks. The graph only goes to 2020, but if you plotted it out through today, we would most likely be approaching another “bonds win” phase, if the uncertainty roiling the markets right now were to continue.

If you listen to the news media, the gurus are saying that the burning question for investors right now is this: Should they be buying bonds?

However, my question is this: Shouldn’t investors always have some bonds in their portfolios?

So, in this article, I’m going to delve into the whole stocks vs. bonds arena, beginning with the primary qualities that define stocks vs. bonds, going on to a comprehensive explanation of the characteristics of a bond, proceeding to bonds vs. bond funds, discussing the pros and cons of investing in bonds and bond funds at this time, and then recommending some specific investments for you.

Let’s get started.

What’s the Difference Between Stocks and Bonds?

The primary distinction is one of ownership versus debt. Buying a stock typically gives you partial ownership in a corporation. Corporations often issue equity to raise money for expansion. Investors buy the shares to benefit from potential growth and profits.

If you own voting shares, you get to vote on significant issues, such as electing directors. And equities are considered liquid investments—easy to turn them into cash (in most cases).

Alternatively, when you buy a bond, you are lending money to a company or government. You have no ownership of the company.

Another big difference is how shareholders/bondholders make money from their respective investments. With equities, you may receive monthly, quarterly, annual, or special dividends, but the big payoff/return is when the stocks appreciate from the original price you paid, and you cash in your shares. With bonds, holders earn interest over the time they hold the bond, and when the bond matures or the holder just decides to cash it in, they get a return of principal (more on that in a moment).

Here, in general, is how frequently bonds pay their interest to bondholders:

• Treasury bonds and notes: Every six months until maturity.
• Treasury bills: Only upon maturity.
• Corporate bonds: Semiannually, quarterly, monthly or at maturity.

You should know that both stocks and bonds carry risk. A stock’s price may drop from the amount you paid; the company could run into difficult times, suspend or eliminate its dividend, file bankruptcy, or even have its stock de-listed.

If you own a company’s bond and the company goes bankrupt, you could also lose your investment. And as the yield of a bond rises, its price deflates, so if you sell it prior to its maturity, you may not recoup all of your principal (more on this a bit later).

Lastly, one more way that stocks are different from bonds is in how the income from the investments is calculated.

If you own stocks for a year or more before you sell them, your gain will be taxed at the capital gains rates, which are currently 0%, 15% or 20%. If held less than a year, investor gains will be subject to ordinary tax rates of 0%, 12%, 22%, 24%, 32%, 35% or 37%. Ordinary dividends are taxed at ordinary tax rates while qualified dividends are capped at a tax rate of 20%.

In contrast, bond interest payments will be taxed at ordinary tax rates (dependent on type of bond; see more later), and if you have a gain on the principal when the bond is sold, that gain will be subject to capital gains tax rates.

While some investors do buy bonds and hold them until maturity, hoping for principal gains, most investors purchase them for the steady income and security during uncertain times.

I think you should own both stocks and bonds. Stocks can offer significant appreciation, helping you build your investment and retirement portfolios. And bonds can offer steady cash flow during times of uncertainty, and during the golden years of retirement.

But while stocks are fairly easy to understand, bonds have a few characteristics that require a different kind of knowledge. So, let’s break that down.

There’s a Bond Type for Everyone

Until the 1970s, the bond market was primarily a marketplace for governments and large companies to issue bonds in order to borrow money. And most bond investors were insurance companies, pension funds and individual investors who were looking for a stable, high-quality investment to hang onto for future needs.

In the 1970s, as more entities realized they were leaving money on the table, they began issuing bonds and bond-like investments, and the supply increased—across the globe.

Government bonds and corporate bonds make up the largest portion of available bonds.

Let’s look at each type:

Government bonds include “sovereign” debt, which is issued and generally backed by a central government. Government of Canada Bonds (GoCs), U.K. Gilts, U.S. Treasuries, German Bunds, Japanese Government Bonds (JGBs) and Brazilian Government Bonds are all examples of sovereign government bonds. The U.S., Japan and Europe have historically been the biggest issuers in the government bond market.

There are also sovereign bonds that are linked to inflation, known as inflation-linked bonds or, in the U.S., Treasury Inflation-Protected Securities (TIPS). With these bonds, the interest and/or principal are adjusted on a regular basis, according to the inflation rate. The downside is that if real interest rates are moving faster than nominal (advertised) interest rates, investors could sustain losses.

U.S. Treasury Bonds. These are treasury bills, notes, and bonds issued by the U.S. Treasury Department. They are guaranteed by the U.S. government; the guarantee is that interest and principal payments will be made on time. These instruments are used to set the rates for all other long-term, fixed-rate bonds. In the primary market—when the Treasurys are issued—they are sold at auction to fund the operations of the federal government. Treasurys are further broken down as follows:

• Treasury bills mature in 1 year or less. They do not pay interest; instead, they’re issued at a “discount"—you pay less than face value when you buy it but get the full face value back when the bond reaches its maturity date.
• Treasury notes mature between 2 years and 10 years.
• Treasury bonds mature in 10 years or more, usually 30 years.

As of 2022, the U.S. government had about $30.9 trillion in debt. The Federal Reserve and U.S. Department of the Treasury report that foreign countries held a total of $7.2 trillion in U.S. Treasury securities as of November 2022. The lion’s share was held by Japan and Mainland China, some $870 billion worth.

Treasurys are also resold on the secondary market.

Because they are guaranteed, the rates on Treasurys offer bondholders the lowest returns. Treasurys are owned by most institutional investors, corporations, individuals, and sovereign wealth funds.

Savings Bonds are also issued by the Treasury Department and are directed toward individual purchasers. They come in two flavors: EE Bonds and I Bonds, which are like savings bonds, except they are adjusted for inflation every six months. Here’s the difference:

EE Bonds
Guaranteed to double in value in 20 years.
Earn a fixed rate of interest.
Current Rate: 2.10%
Electronic only—they are kept in your TreasuryDirect account.
Buy for any amount from $25 up to $10,000
Maximum purchase each calendar year: $10,000
Can cash in after 1 year. (But if you cash before 5 years, you lose 3 months of interest.)

I Bonds
Protect against inflation. Earn both a fixed rate of interest and a rate based on inflation. The rate is reset twice a year.
Current Rate: 6.89%
Primarily electronic—kept in your TreasuryDirect account (minimum amount $25).
You can choose to use all or part of your IRS tax refund to buy paper I Bonds (minimum amount $50).
Maximum purchase each calendar year: $10,000 in electronic I Bonds + $5,000 in paper I Bonds
Can cash in after 1 year. (But if you cash before 5 years, you lose 3 months of interest.)

Before the advent of college savings plans, savings bonds were very popular with grandparents who wanted to sock away some money for future college educations. Today, their demand has been superseded by 529 plans, as well as Dividend Reinvestment Plans.

Agency Bonds. These are bonds issued by government-sponsored enterprises (GSEs) like Fannie Mae, Ginnie Mae, and Freddie Mac, or federal agencies to support affordable housing or small businesses. GSEs do not lend money to the public directly; instead, they guarantee third-party loans and purchase loans in the secondary market, ensuring liquidity. Federal agency bonds are guaranteed by the federal government, but GSE bonds are not, although they do have the “implicit backing” of the U.S. government. Then there are supranational organizations, like the World Bank and the European Investment Bank, who may also borrow in the bond market to finance public projects and/or development.

Municipal Bonds are issued by various cities, states, or provinces. They are exempt from federal tax and usually from the state if you are a resident. However, their interest rates are usually lower than corporate bonds. They are also a bit riskier than bonds issued by the federal government.

Cities occasionally do default, such as New York City’s default in 1975 and Cleveland in 1978. However, they weren’t the biggest defaults. The winner of that prize is the Washington Public Power Supply System’s (WPPSS) 1983 default on $2.25 billion in bonds.

Funds borrowed via municipal bonds serve different uses:

General obligation bonds are backed by the full faith and credit of the issuing municipality. Their funds are not allocated to a specific project or asset. The issuer uses taxes to repay bondholders.

Revenue bonds are backed by revenue from a specific source such as a toll road or apartment complex. Most are “nonrecourse,” so bondholders can’t claim the underlying asset or project if the revenue stream dries up.

Conduit bonds are issued by municipalities on behalf of private entities, which are usually nonprofits, such as a hospital. The conduit borrower pays the municipality, which in turn pays bondholders. If the borrower defaults, the municipality is usually not required to step in and continue paying bondholders.

Corporate Bonds are sold by investment banks and issued by all different types of companies. They are riskier than government-backed bonds, so they offer higher rates of return.

There are two types of corporate bonds:

Junk, speculative, or high-yield bonds are issued by newer companies or corporations that don’t have the best credit ratings and have an above-average chance of defaulting. However, they also offer higher interest rates to compensate investors for the extra risk.

Investment-grade bonds receive a higher credit rating and have lower risk and lower returns than high-yield bonds.

Other bond types include:

Emerging market bonds are issued by developing countries, and may include both government and corporate bonds. They are issued in major external currencies, including the U.S. dollar and the euro, and local currencies (often referred to as emerging local market bonds). Emerging market bonds can be a great way to diversify your portfolio, and they pay better than corporate yields because they come with the regular rate and credit risk, as well as global and political risks.

Mortgage-backed securities (MBS) are created from the mortgage payments of homeowners. The cash flows from various mortgages are bundled together and resold to investors as bonds. They carry an interest rate similar to the homeowner’s mortgage rate.

They can be risky and were at the root of the subprime market explosion that set off the 2007-2009 recession. During that housing bubble, anyone who could breathe was able to obtain a mortgage. Those mortgages were bundled into MBS securities. When the buyers defaulted, the bondholders were literally left “holding the bag.”

Rate risk also comes into play, as rates drop, many homeowners will refinance, paying off those original mortgages, depleting the MBS. For this reason, MBS are often packaged into bonds with specific payment dates and characteristics, known as collateralized mortgage obligations (CMOs).

Asset-backed securities (ABS) are created from car payments, credit card payments or other loans. Similar to mortgage-backed securities, similar loans are bundled together and packaged as a security that is then sold to investors. ABS are usually “tranched,” with loans bundled together into high-quality and lower-quality classes of securities. Like, MBS, ABS also contain credit and interest rate risk.

Bond Ratings

Most bonds come with a rating that summarizes their credit quality—its strength and the company’s ability to pay its principal and interest.

These ratings are published by several different rating agencies, including Moody’s, S&P, and Fitch.

The following is a chart comparing the ratings from each of these three agencies.

This website from the SEC offers more bond rating agencies.

Investment-grade bonds are rated BBB to Baa, meaning they have low chances of default. Bonds that are rated BB to Ba or below are junk bonds where default and price volatility are more likely.

Not every firm has its bonds rated. If you decide to purchase an unrated bond, be aware that you will have to perform your own due diligence, which is a lengthy and complex operation. Personally, I would stay away from unrated bonds.

One last note, bond ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve. It is to your benefit to keep track of the ratings of any bonds you may own.

Deciphering Bond Terminology

Both stocks and bonds have their own unique terminology. Here are a few terms that you may find useful when embarking upon your bond investing strategy:

Maturity is when the bond comes due, the date when the principal or par amount of the bond is paid to investors and the company’s bond obligation ends. Maturity is an important factor when analyzing whether a bond will fit into your investing strategy. Maturity can be further broken down:

• Short-term: Maturity within one to five years
• Medium-term: Maturity within five to 10 years
• Long-term: Maturity 10 - 30 years

Secured/Unsecured. A secured pledges collateral to bondholders in case the company cannot repay its obligation. If the bond issuer defaults, the investor receives the collateral. An example is a mortgage-backed security (MBS) that is backed by titles to the homes of the borrowers.

Alternatively, unsecured bonds are not backed by collateral. These bonds are also called debentures, and the risk is greater than secured bonds.

Liquidation Preference is the order in which a firm pays its investors should it go bankrupt. Holders of senior debt are paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.

Coupon is the interest paid to bondholders, normally annually or semiannually. The coupon is also called the coupon rate or nominal yield. It can be calculated by dividing the annual payments by the face value of the bond.

Tax Status, either taxable or tax-exempt.

Callability means the issuer of a bond can “call” it, or pay it off before maturity, usually at a premium to par or face value. This might happen if rates decline after a bond is issued so that the company could reissue it at a lower rate, thereby saving interest paid. Callable bonds usually offer higher coupon rates to make them more attractive to investors.

Bond Risk, as I mentioned earlier, is a factor to consider before investing. Here are a few of the risks you can expect when purchasing bonds:

Interest Rate Risk is the risk that rates could undergo significant changes. If they decline, prepayment of the bonds may occur and the investor’s expected cash flow declines. Or if rates rise, your bond may yield below market interest, so its price will decline as newer, higher-rate bonds come on the market. It’s important to note that the longer time period before your bond’s maturity, the greater the interest rate risk will be, as there will likely be many periods of interest rate changes through the years.

Credit/Default Risk is the risk that interest and principal payments will not be made as promised by the bond issuer. And that’s where bond ratings become very important.

Prepayment Risk arises if/when a bond is paid off earlier than expected, normally through a call provision.

Bond Yields are simply the measures of return, and include:

Yield to Maturity (YTM), most often used, measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate (for bond funds).

Current Yield is calculated by dividing the bond’s annual coupon by the bond’s current price. It is used to compare the interest income provided by a bond to the dividend income provided by a stock. Of course, this calculation says nothing about principal; it is only related to cash flow.

Nominal Yield is calculated by dividing the annual coupon payment by the par or face value of the bond. It equals the percentage of interest to be paid on the bond periodically.

Yield to Call (YTC) is used to calculate the yield if the bond is called at a particular call date, when it will most likely receive a higher premium. Investors want to know this so they can decide if the prepayment risk is worth a shot.

Realized Yield is the yield of a bond if an investor plans to hold a bond only for a certain period of time, instead of to maturity. This calculation involves an estimate of the future price the bond can be sold at so you can forecast an estimated return.

A few of these calculations are complex, but fortunately, your broker—or an Excel spreadsheet—can assist you.

What Is Duration?

Investors are often confused about the term duration, so I want to take a little extra time in explaining it. Duration is simply a measurement of how sensitive a bond’s price is to interest rate movements. As defined, duration is a weighted average of the present value of a bond’s cash flows, including a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid, as you can see in the graph below.

Duration is expressed in years, but it is typically less than the time to maturity. Duration will be affected by the size of the regular coupon payments and the bond’s face value. For example, in a zero-coupon bond, maturity and duration are equal since there are no regular coupon payments and the cash flows are paid when the bond matures. As you would expect, you’ll see a lot of price movement with zero-coupon bonds when interest rates change. Consequently, if investors believe rates are going down, that means the price of the bond should rise, making it attractive.

Duration allows investors to compare bonds with different maturities, coupons, and face values, as it shows the approximate change in price that any bond will experience in the event of a 100-basis-point (one percentage point) change in interest rates. The higher the duration, the more sensitive a bond’s price is to rate changes.

For example, if interest rates rise by 1%, the price for a bond with a duration of four will fall by 4%, while a bond with a duration of six will fall by 6%.

Now, suppose that interest rates fall by 2%, causing yields on every bond in the market to fall by the same amount. In this case, the price of a bond with a duration of two years will rise 4% and the price of a five-year-duration bond will rise 10%.

The Inverse Relationship of Bonds and Stocks

One aspect of bonds that is often confusing for investors is the inverse relationship between bond and stock prices. Typically, when stock prices rise, bond prices fall, and vice versa. It’s a function of demand. As investors put more money into stocks, they will usually rise due to the demand, making them more attractive than bonds. But when the opposite occurs, and stocks fall, investors seek the security and income from bonds, making their prices rise.

The Inverse Relationship Between Bond Prices and Yields

But there’s another very important inverse relationship surrounding bonds. It’s this: Bond performance is also closely tied to interest rates. Let’s look at a couple of examples:

You buy a bond with a 3% yield. If rates rise, like they are doing now, new bond issues will command a higher yield, reducing the demand for your bond, and making the price fall. Or…

You buy a bond with a 3% yield, and interest rates fall. New bond issues will offer a lower rate, making your bond more valuable.

Now, this really becomes more important if you hold your bond to maturity, or if interest rates are shifting at the time you sell. They could be higher or lower than your bond yield, so the price you sell your bond for can be higher or lower than what you paid for it.

The Determinants of Bond Prices

Investors can buy bonds in the “secondary market” after they are issued. Some are publicly traded, but most trade over-the-counter between large broker-dealers acting on their clients’ or their own behalf.

The yield of the bond is the actual annual return an investor can expect if the bond is held to maturity. Yield is based on the purchase price of the bond and the coupon.

Bond prices are quoted as a percent of the bond’s face value. All you need to do to get the price is add a zero to the quoted price. So, a bond quoted at 99 is priced at $990 for every $1,000 of face value. It is considered to be trading at a discount. Alternatively, if the bond is trading at 101, it costs $1,010 for every $1,000 of face value and the bond is said to be trading at a premium. If the bond is trading at 100, it costs $1,000 for every $1,000 of face value and is said to be trading at par or face value.

Most bonds are issued slightly below par and can then trade in the secondary market above or below par, depending on interest rates, credit, or other factors.

Since bond prices and interest rates are inverse, generally, when interest rates are rising, new bonds will pay investors higher interest rates than old ones, so old bonds tend to drop in price.

However, if rates are declining, older bonds are paying higher interest rates than new bonds, and therefore, older bonds tend to sell at premiums in the market.

Bond Investing Strategies

As I said earlier, I think investors should own both stocks and bonds—for the diversification potential, as well as steady income from dividends and coupons.

Bonds have often been used as hedges against an economic slowdown or deflation, as they usually deliver a predetermined cash flow.

And although we are currently in an inflationary environment, the uncertainty of a possible recession is making bonds more appealing to investors.

Investors often ask me about portfolio allocation. The answer is; it depends. The proper allocation must be customized to you, relative to your age, risk profile, and personal investment strategy.

However, there are some guidelines. Some say the percentage of stocks in your portfolio should be equal to 100 minus your age. So, if you’re 30, your portfolio should contain 70% stocks and 30% bonds (or other safe investments). If you’re 60, it should be 40% stocks, 60% bonds.

But in the past few years, when people realized that expenses during retirement aren’t that different than during their working years, they realized that they needed to withdraw more money during their golden years, so they need to save more before retirement. Consequently, most advisors believe in a stock-heavy portfolio into your retirement years, as outlined below.

But, as you can see, bonds are an important part of almost every allocation model (except for very young folks), as they can help protect your retirement funds from crazy market volatility.

So, let’s talk about some specific investing strategies.

Passive investing includes buying and holding bonds until maturity and investing in bond funds or portfolios that track bond indexes. This strategy suits investors who are looking for capital preservation, income, and diversification.

Active investing is used by investors seeking to outperform bond indexes, trading bonds to take advantage of price movements. This is certainly a more speculative strategy, as you would be acting as your own economist, predicting rates and economic cycles, and potentially incurring significant risks.

Laddering bonds. This strategy came about to help buy-and-hold investors manage interest rate risk. You invest equally in bonds maturing periodically, usually every year or every other year. As the bonds mature, you would reinvest funds to maintain the maturity ladder.

Here’s an example:

Barbell approach. This strategy is also directed toward buy-and-hold investors. You would invest in a range of short-term and long-term bonds. When the short-term bonds mature, you would reinvest to take advantage of market opportunities, while your long-term bonds offer attractive coupon rates.

Bond funds or ETFs can either be passive or active. Some funds invest in the same or similar securities held in bond indexes and thus closely track the indexes’ performances. The mix is directed by portfolio managers, as the indexes change, not according to their personal investing strategies.

Alternatively, there are plenty of mutual funds and ETFs that provide a wide variety of bond strategies, including:

Utilizing fundamental and credit analysis to find bonds that may rise in price due to an improvement in the credit standing of the issuer.

Macroeconomic analysis, a top-down analysis to identify bonds that may rise in price due to economic conditions, a favorable interest rate environment or global socioeconomic factors. These may include, sector rotation, market analysis, duration management, yield curve positioning or risk management.

There’s a case to be made for owning individual bonds and for owning bond funds. Let’s compare the pros and cons.

Individual bonds

Pros:

• Steady and reliable cash flows that help you plan your income streams.
• A predictable value at maturity.
• Your own cost basis, which is the combination of the price you pay to purchase the bond, and the amortization of any premium or discount for the bond.

Cons:

• To diversify a bond portfolio, you must own quite a few bonds, which are very costly. And since there are a wide variety of sub-asset classes within the fixed-income market, diversification may be tough to accomplish.
• Institutional bond investors get better prices than individuals.
• Researching bonds takes a lot of time, as there are thousands of issues.

Bond funds

Pros:

• Diversification is much easier.
• You’ll benefit from institutional pricing.
• Your fund will be professionally managed.

Cons:

• You’ll pay a management fee, although they have been declining for years. According to ICI, bond mutual fund expense ratios averaged 0.84% in 1996, compared with 0.39% in 2021. Active funds have higher management fees.
• The net asset value (NAV) will fluctuate with the market, making bond funds less attractive than individual bonds when planning for future liabilities.
• Different cost basis and tax consequences: With pooled funds, your cost basis for tax purposes won’t be as simple as if you had purchased an individual bond and held it to maturity. Also, the manager of the fund makes the buying and selling decisions and they won’t always line up with your capital gain strategies, especially at the end of the year.
• Bond funds are riskier than individual bonds, due to the number of bonds included in the funds.

Here’s a table for a quick comparison:

Source: Schwab.com

The bottom line is this: when investing in bonds or funds, decide upon your goal. If you are investing for a specific cash flow need—such as funding your retirement—look to buy safer bonds.

If you are looking to cut your tax nut, consider municipal bonds.

If you want to easily diversify, try bond funds, which also come in short-, intermediate-, or long-term varieties.

Here’s a pictorial from Morningstar that shows returns for major bond fund categories in recent years:

Most investors should have a “core” group of bonds or funds, with maybe a few high-yield instruments if they can afford the risk of default. Those yields will spice up your portfolio returns.

Of course, yield is important and there are several websites that will help you compare bond yields, such as MortgageCalculator.org, OmniCalculator.com and MoneyChimp.com.

I said at the beginning of this article that I am an equity analyst. I do not regularly trade bonds, so I’m not going to give you individual bond recommendations. For those, please work with your financial advisor. However, I am a fan of diversifying by using bond funds, or ETFs, in this case. I love ETFs over mutual funds for a variety of reasons, but mostly because they trade like stocks. So, I’m going to offer you a couple of bond ETFs to consider.

I’ve looked at about 35 different bond ETFs—their yields, durations, and expenses. I winnowed that list down to these three, based on their fundamental and technical characteristics.

I hope this bond primer will take some of the mystery out of the bond markets and open up a new avenue of investing that you may not have considered in the past.

As for the recommendations, these ETFs are just a few out of hundreds available. I would heartily recommend that you take a look at a website such as ETF Databse to get some more ideas, and then use tools available at sites like Morningstar to research and evaluate them further to determine which ones are best suited to your individual investing strategy and risk profile.