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How Bonds Work And Their Place In A Portfolio

August 17, 2023

We have had a number of questions regarding bonds so it seemed like a good time to review this asset class. It is regularly referred to as Fixed Income.

A bond is a loan made to such entities as a company, a municipality, or the U.S. government. In return for the loan/principal/face value, interest is paid. At the end of the “term” of the loan, you are repaid your principal (loan amount).

Are there risks? Certainly. The primary ones are changes in interest rates; the quality of the bond; and when the loan/bond matures. The longer the duration of the bond, the more sensitive it is to interest rate changes.

Financial Connections tends to use bond mutual funds or Exchange Traded Funds (ETFs). They are a basket of bonds which we feel reduce the risk of any one bond defaulting (unable to pay back the principal). Each mutual fund or ETF has an average maturity such as 2 years or 5 years.

In most years, bonds don’t correlate closely to stocks meaning they don’t go up and down at the same time. 2022 was the exception. Why? The Federal Reserve (Fed) increased interest rates so rapidly and so quickly, bonds couldn’t maintain their value.

Bond prices are the inverse of the change in interest rates. Below is an example from the SEC Office of Investor Education and Advocacy on how the math works when interest rates rise and fall.

Rising interest rate of 1% (2022 the Fed raised interest rates 5%!)

DescriptionCurrent interest rateOne year later
Market rate interest3%4%
Coupon rate (interest on bond)3%3%
Face Value (principal)$1,000$1,000
Maturity10 years9 years remaining
Price$1,000$925

Some experts think interest rates might decline in 2024 or 2025. If so, bonds will have capital gains. Remember, inverse relationship. Interest rates declines, bond prices increase.

DescriptionCurrent interest rateOne year later
Market rate interest3%2%
Coupon rate (interest on bond)3%3%
Face Value (principal)$1,000$1,000
Maturity10 years9 years remaining
Price$1,000$1,082

While some correlation between bonds and stocks still exists, they have a place in your portfolio. Except for 2022, they have cushioned market declines. We continue to expect them to do so. The reason a bond price declines is very different (interest, credit quality, maturity) than a price decline of a stock (shares in the ownership of a company).

One of the ways Financial Connections approaches bond investing is to diversify bond holdings as we do stock holdings. We may hold short term bond maturities or intermediate. In taxable accounts we may hold municipal bonds because they are free from federal tax and maybe tax-free for state tax.

We may hold government bonds, corporate bonds and strategic bonds as part of the diversification. Much of the time they are in the form of mutual funds or ETFs.

If you have questions about your bond holdings, don’t hesitate to get in touch.

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