Investing

How bonds work, why they matter, and how to include them in your portfolio

Anna-Louise Jackson@aljax7
Twenty/20

Bonds, which historically offer lower returns along with lower risk, may sometimes seem like the boring counterpart to stocks, but these assets can play a valuable role — both in your portfolio and in terms of providing clues about the economy.

You may have heard about bond yields in the news recently because the so-called yield curve, a closely watched and historically accurate predictor of recessions, is flashing a warning sign.

The curve measures the difference in interest rates for two bonds with different maturity dates and shows what traders expect for U.S. economic growth in the near-term. Normally, the yield on longer-term Treasurys is higher than that of shorter-term Treasurys, because investors demand a higher return in exchange for surrendering their money for a longer period of time.

But when traders are worried about an economic slowdown or recession, many of them sell stocks to buy safer assets like Treasury bonds. Once the yield on longer-term Treasurys ends up lower than the yield on shorter-term Treasurys, the yield curve inverts — and can trigger even more concerns about the economy. After the yield curve inverted this week, the stock market had its worst day of 2019 so far.

How bonds work

When you invest in bonds, you loan money, either to governments or corporations, with the expectation of being repaid by a specific date in the future. In the meantime, you'll receive periodic interest payments — which is why bonds are referred to as a type of fixed-income security.

Instead of buying a stake in a company, as you do with stocks, investing in bonds means you're taking on part of that company's debt obligation. For example, a company might issue bonds to fund an expensive project, while the U.S. government issues Treasury bonds to help finance federal spending activities.

U.S. Treasury bonds are considered among the safest investments available because the federal government has never defaulted on its debt. Corporate bonds can be riskier, especially because a company could default on its debt. So-called junk bonds have higher risks and returns because analysts think there's a greater likelihood of default.

But many people prefer investing in bond funds managed by pros who choose a variety of bonds with some common element (such as corporate or Treasury bonds). This helps to balance out the risk of default from any one specific bond.

To understand bonds, you'll need to know a few basic terms:

  • Yield. This is the return you'll earn by buying a bond. Sometimes referred to as the coupon rate, this is based on the bond's price and annual interest payment.
  • Price. This is the amount you'll pay for the bond.
  • Maturity date. This is the date when the original sum loaned will be repaid in full.

When a bond's price increases, its yield falls. When a lot of people are eager to buy bonds, that will push the price higher and the yields lower. The yield on 30-year Treasurys, for example, fell below 2% for the first time ever, while yields on other duration bonds hit multiyear lows.

How to mix bonds into your portfolio

Since the 1990s, stocks and bonds have tended to move in opposite directions — and this means bonds can help balance out the risk from your stock investments. The right proportion depends on factors like your age and tolerance for risk. Baltimore-based money managers T. Rowe Price suggest these goals:

  • When you're in your 20s and 30s: 90% to 100% in stocks (because of your long investment timeline), with the remaining 10% or so in bonds.
  • In your 40s: 80% to 100% in stocks, up to 20% in bonds.
  • In your 50s: 60% to 80% in stocks, 20% to 30% in bonds, and up to 10% in cash.
  • In your 60s: 50% to 65% in stocks, 25% to 35% in bonds, and 5% to 15% in cash.

As discussed above, though, not all bonds are created equal. There's a wide range of risk and potential returns — along with plenty of options, because the bond market is larger than the stock market.

A popular way to invest in bonds is via index funds or exchange-traded funds, both of which are a low-cost way to easily invest in a variety of bonds. Many investors may be invested in bonds without realizing it. Bonds are a key component of target-date funds, in which the mix of stocks and bonds is adjusted automatically the closer you get to retirement age.

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