Bonds, Explained: What They Are, How They Work, and Why They’re Not Always “Safe”

Bonds are often labeled as the “safe” part of a portfolio — but that’s not always the full story.

In this episode, I break down how bonds actually work in a way that’s simple and practical. We’ll cover what a bond really is (at its core, a loan), how interest rates and credit quality impact returns, and why not all bonds carry the same level of risk.

I also walk through what happens to bond prices when interest rates change, why longer-term bonds typically pay more than shorter-term bonds, and how bond ratings play a role in both risk and return.

We’ll then shift to bond funds — which tend to confuse a lot of people — and simplify what’s actually going on under the hood (hint: they’re just collections of individual bonds). I’ll also share why I generally prefer bond funds over individual bonds, and how I think about structuring the bond portion of a portfolio.

My approach is to keep bonds on the more conservative side and take risk where it’s better rewarded — in stocks. But as always, it comes down to understanding the trade-offs so you can make the best decision for your situation.

Transcript

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In today's episode, we're going to do a deep dive into understanding bonds, both at the individual bond level and understanding bond funds and how they work, because a lot of my clients get confused, feel they don't really understand bonds, particularly when it comes to bond funds. And I think it's really also important to understand that not all bonds are created equal. So lots of times people will hear the word bond and think that it is automatically a very conservative investment. And that is not necessarily the case. There is a spectrum in terms of risk and return that you can get from bonds from, you know, very low risk, low return to higher risk, higher return. So I wanted to explain all of that for you guys today. So let's start with the basic concept of what a bond is. A bond is a loan to either some sort of government entity, which could be federal, state, or local. It could also be foreign, doesn't have to be a US government entity, or some sort of corporation. Again, it could be a US corporation or an international corporation. And with that loan, there is a contract. So you are lending money to this entity, a certain amount of money for a certain amount of time, which is going to be the term of the bond. And in exchange for this loan, they are going to pay you interest, which is called the coupon rate. So quick example, I loan money to the US government. I buy a treasury bill, let's say for $1,000, and the government is going to pay me, say, 3% or $30 a year until the maturity date, let's say it's a five-year term. And at the end of the five years, I also get my $1,000 back. Easy, simple to understand. Now, bondholders get preference in terms of getting paid back before shareholders do. So if you own a stock of a company versus a bond, if that company goes bankrupt, bondholders get paid back first. So the company would have to liquidate the assets and hopefully the bondpayers could get paid back in full. But if not, they might get back, say, 70% of the amount that they lended. As the company is going through bankruptcy court, they have to pay the bondholders back. And because they get first preference and getting paid back, there is less risk and so lower return than investing in stocks. Now, within the whole bond category, of course, as I was mentioning, some bonds are more risky than other bonds. So let's dig into that a little bit. So why would one bond be more risky than another? Well, first off, it's going to have to do with how likely entity that you're lending money to is going to be able to pay you back. So the US government very highly rated all sorts of, there's a couple different rating agencies that rate bonds. So the more highly rated the entity is, the more likely you are to get your money back. So US Treasury bonds T bills are expected to be very safe. That the US government not only has a history of always repaying its bondholders, but they also have the power to print more money to be able to pay back the bondholders. Versus corporate entities. Some companies are in better financial shape than others. So a big, well-known company that's doing very well has a solid revenue stream, that's of course going to be lower risk than investing in a company that's not in great financial shape and of course is going to be getting a lower bond rating. And so, you know, if you're trying to decide between lending money to, say, a company like Apple in great financial shape versus a company not in great financial shape, you're not really sure that they're going to be able to pay you back at the end of the term. Well, if that company wants to borrow money from you, they're going to have to pay you a higher interest rate. Otherwise, there's no way you're going to lend money to them. And so those types of bonds are referred to as junk bonds or high yield bonds. So they're going to pay a higher interest rate, but they're much more risky. And again, this is on a spectrum, right? Companies, it's not black and white. Some companies are in great financial shape, some companies are in horrible financial shape. And then there's sort of everything in between. And similarly, there could be, you know, emerging market bonds where there's these government entities that are not in great financial shape and may not be able to pay you back, as say the US government. So right there is one great example of the risk and return trade-off with bonds. Now, another area where there is more risk in bonds has to do with the term of the bond, right? So short-term bonds are less risky than long-term bonds. And when you think about it, this makes perfect sense. So I was talking about maybe lending money to Apple by buying a bond from Apple. If they're going to pay you back in a year, I'd say there's a pretty good chance that Apple is going to be able to pay you back that full amount versus lending money to Apple in the form of, again, buying an Apple bond. And it's, I don't know, I don't even know if they have these, but let's just say it's a 50-year bond. The term of the bond is 50 years. Well, what is Apple going to look like in 50 years? I have no idea. That sounds a lot more risky. We have no idea if Apple is still going to be around in 50 years. So if they want to borrow money from you for 50 years, they're going to have to pay you a much higher interest rate because who knows if they're going to be able to live up to their end of the bargain. It's just so far out in the future. So those are really the two main risks that we see in bonds is all having to do with is the entity that you are lending money to going to pay you back having to do with financial health of the entity currently, as well as just the length of the term of the bond. Who knows what things are going to look like further out than when we look at the short term? And actually, this is kind of a funny story. Back in the beginning of 2008, when I was in my early to mid-20s, starting off in this business, I bought a couple corporate bonds because they were paying higher rates than government bonds. I thought, okay, this is great. They were highly rated bonds. And then 2008 hit and I saw that the bond rating went down and that confused me. I thought, well, I bought really highly rated bonds. Why is the rating going down? And it took a while for me. I laugh now because it makes perfect sense years and years later. But just because you buy a highly rated bond right now doesn't mean that that company is going to stay in great shape throughout the term of the bond. Again, this has to do with the longer the term of the bond, the greater the risk. Now, with those bonds, not only did I notice that the rating fell, but what my what caught my attention first was that the value of the bonds changed. So I bought, I think it was two different bonds, each for $1,000. And so I saw, and that $1,000 is called par or face value. So when my loan gets paid back, I get $1,000. But it had the market value of the bond dip way below $1,000, maybe to $700 or $800. And that's what kind of worried me. So what's going on there is if I wanted to sell that bond, which makes sense. Oh my gosh, I want to get rid of this bond. It's no longer a highly rated bond. I'm not sure that the company is going to be able to pay me back when the term is up. Well, no one in their right mind is going to want to pay $1,000 for that bond because they're also thinking, who knows if I'll get my money back. So the market price of the bond is always changing. And so, you know, the market was valuing those bonds around $700 or $800. And, you know, I kept those bonds and I think I did get paid back in full. So that's great. Gosh, that was quite some time ago. But understanding that with bonds, the actual market price changes. Now, if you hold that bond until what's called maturity, when they return your loan to you and they're able to pay you back, you will always get that face value back as long as that company, that entity is fully solvent. But yes, in between that time where you're holding the bond and when you get paid back, if anything changes, either in terms of interest rates, which I'll talk about in just a moment, or the risk level of the bond, then the market price of the bond is going to change. And sometimes it doesn't always have to change downward. It can go upward. If it was a poorly rated bond that I bought and the company has increased in its financial standing, then people will be willing to pay above par value more than $1,000 for that bond because the interest rate is still going to be, you know, that same higher interest rate, because this is a contract. Just because the company is now in better financial shape, they signed that contract that they're going to pay me that interest rate for the full term of the bond. So if suddenly the company becomes in much better financial shape, they still have to pay that higher interest rate. And so anyone else out there looking to buy that bond on the market, they're going to be willing to pay more than hard for that bond because they're getting that higher interest payment, but with less risk. So let's talk a little bit about how changes in interest rates impact bonds. And what happens is interest rates are always changing. You probably hear this a lot in terms of mortgages, right? Mortgage rates are a lot higher in the past couple of years than they had been for over a decade following the Great Recession. You may hear about the Federal Reserve changing interest rates. And what the Federal Reserve does is they set interest rates for the rate that banks charge each other for overnight loans on reserves. And that indirectly impacts all other interest rates. But the Federal Reserve does not directly set mortgage rates or bond rates. They set this one very specific rate, which has this sort of ripple impact as to all other interest rates. They meet quarterly and they decide if they're going to keep interest rates where they are, increase them by maybe a quarter of a point, sometimes half a point, or decrease them by a quarter point or half a point. And in response, newly issued bonds are going to reflect some version of that interest rate change. So it doesn't have to be a direct if the Federal Reserve increases their rates by a quarter of a percent, that all bonds that are going to be newly issued are increased by a quarter of a percent. But it does have some impact, usually in the same direction. Okay. So when interest rates go up, bond prices go down. And when interest rates go down, bond prices go up. Now this sounds very counterintuitive at first, but once you think about it, it actually makes total sense. So let's say I have a bond that I currently hold that is paying 3%. I have a bond for $1,000, it pays $3%, $30 a year. Now, again, this is a contract. I agreed to lend money to an entity for a 3% rate. Now, let's say the Federal Reserve, let's just make it a drastic case, goes ahead and increases interest rates by a lot. And suddenly new bonds issued by the entity that I already have a bond for are paying a 10% interest rate. So you buy a bond for $1,000 and you're going to get $100 a year until the bond matures. Now remember, I have this contract. So even though the same entity is issuing new bonds at a really high rate, I'm stuck with this bond that is paying 3%. So I might say, hey, I want to sell this bond. Maybe I need the money, or maybe I just want to buy a bond that's paying a higher rate. Now someone else comes to the market and they're looking to buy a bond. So they could either buy my bond for $1,000 that pays $30 a year, or they could buy a newly issued bond that pays 10% a year. Well, obviously they're going to choose the 10% bond over my 3% bond. That's a no-brainer. So if I really want to sell my bond, I've got to be willing to sell it for a lower price. And how much lower that's going to be is going to depend on the term of the bond. And, you know, it's this sort of calculation so that at the end of the day, that person that buys the bond is essentially still getting a 10% annualized return on their bond for when they get the $30 in interest plus the full $1,000 paid back to them at the end of the term. So interest rates went up, the value of my bond went down. Now again, if I keep that bond until it matures, I'm still getting that $1,000 back. But if I wanted to sell it, I have to be willing to sell it at a lower price than that $1,000 that I paid for it. Conversely, when interest rates go down, bond prices go up. So let's talk about the reverse scenario. I have this wonderful bond. I paid $1,000 for it and it's paying 10%. Now the Fed makes a drastic move, really decreasing interest rates, and now bonds are selling and paying a 3% interest rate. So again, you come to the market, you want to buy a bond. I'm looking to sell my bond. Wonderful. Well, everyone on earth is going to want to buy my bond that's paying 10% if I'm willing to sell it for $1,000 versus buying a newly issued bond that only pays 3%. So what I can and would certainly do is I would raise the price of what I'm selling the bond for. So I would no doubt be able to sell that bond for over $1,000, all else being equal with that newly issued bond that is paying 3%. And so again, if I keep that bond until maturity, I'm going to get that $1,000 back. But if I wanted to sell it now, while newly issued bonds are paying a lower rate, I can get over $1,000 for it. Okay. And so when you own a portfolio of individual bonds, you're going to be seeing the market price change. But I think mentally it's a lot easier to understand that, especially when bond prices are going down and no one likes to see the value of their portfolio going down because you still see that par value of $1,000 for your bonds. And so you kind of typically ignore the current market price. At least that's that's my experience. But when you buy a bond fund, it's a very different feeling because when you think about it, of course, a bond fund is just an ETF or mutual fund that is invested in thousands of individual bonds. So we're not seeing the par value of all those underlying bonds in the portfolio. What we're just seeing is the value of the amount I have invested in the bond market changing. You know, if it's an ETF, you're going to see it changing constantly throughout the day, much like stock is constantly changing price, although you would see less volatility than stocks do. Or if it's a mutual fund, you're going to see that price change on a daily basis. But with bond funds, we're not really looking to make money on the actual price of the fund. We're making money by the interest that the fund is paying out. Now, of course, it is disheartening when you invest a bunch of money in a bond fund and then you see the value of your bond fund going down. It's of course more fun to see price of the bond fund go up. And it is just really confusing to see and understand that. But you always just have to remember that within that bond fund, what's really going on is you are owning thousands, if not 10,000 plus bonds within that fund. And the price of those bonds is constantly changing based on factors like interest rate changes and the financial stability of the entities that you are lending money to by buying those individual bonds. Now, as we're talking about how bond prices change as interest rates change, it's important to understand that longer-term bonds are going to be more volatile than shorter-term bonds. Okay, so the price is going to be much more impacted by longer-term bonds than short-term bonds. And it makes sense again if you think about what is going on. So let's just say a drastic case, I have a short-term bond that is going to mature next week and it's paying 3%. And now interest rates have really gone up. And if I buy a newly issued bond, it'll pay 10%. Well, bummer that I have another week of this lower paying bond, but I only have a week left. And then I can take that money and reinvest it into a higher interest bond. Whereas if I have a say 10-year bond that's only paying 3% and interest rates have gone up, newly issued long-term bonds are paying 10%. Oh my gosh, I am either stuck for another 10 years with this bond that is paying way lower than the newly issued bonds. Or if I want to sell it, of course, I'm going to have to sell it for a lot less money. And so there's just going to be bigger swings in the prices of longer-term bonds because there's a bigger risk. Now, that being said, if you buy a long-term bond with a really great interest rate, just again, I'll use that 10% example, and then interest rates go down for a long period of time, that is going to really increase the value of your bond by a lot more than you know a bond paying 10% that's going to mature next week when interest rates just dropped. So understanding that longer-term bonds have bigger swings in price, more risk due to interest rate changes than short-term bonds. Now, just to be clear, bonds are really almost never changing from 3% all the way to 10% and vice versa regularly. I'm just trying to give you some drastic changes to really illustrate my point here. So, in terms of the financial state of the entities that you are buying bonds from and changing interest rates, this all impacts the price and interest rate that you are getting from a bond. And, you know, there's more conservative bonds that are going to be less risky, pay lower rate of return to your higher risk bonds that are going to pay a higher interest rate and everything in between. And so you may be asking, like, hey, thanks for this information. What do I do with that? So I really like to keep the bond portion of my portfolios very conservative and really focus on taking the risk in the equity part of the portfolio. So the bond portion is there for stability. And given that, what I like to do with the bond portion of my portfolios is invest 50% of it in a highly rated intermediate term bond fund and 50% in a highly rated short term bond fund. So I'm going a little bit more on the conservative side. Again, I'm not talking 100% super short term, highly rated bonds. I do like to capture sort of the middle market as part of it and then the shorter term. End of it to overall keep the bond portion fairly conservative while still getting a decent rate of return relative to cash. I by no means think it's a mistake to just buy a total U.S. bond fund that's going to capture the bond market as a whole. I personally am not a fan of doing longer-term bonds, junk bond funds, emerging market bond funds. To me, that is a higher level of risk than I like to have in the bond portion of the portfolio. Like I said, I like to keep the risky part of the portfolio in the stocks. And so that's what I do. And here's a great example of that. So 2022 was the worst bond market since 1841. Now, the bond market as a whole, the US bond market as a whole, was down over 13%, which for bonds is terrible. Like I said, it's the worst we've seen since 1841. And why that was, what was going on, was that the Federal Reserve was rapidly raising interest rates. Interest rates had been very, very low for quite some time following the Great Recession that started in 2008, and they were finally starting to raise interest rates multiple times that year. And again, with interest rates going up, that pushes bond prices down. So we saw bond funds really dropping in value, individual bonds, of course, that face value is always going to stay the same, but the market value for people looking to sell drops. So the intermediate term bond fund that my clients held was down again, roughly 13%. The short-term bond fund was down closer to 6%. And so it just gives a little bit less volatility to that portfolio than being fully invested in bonds, especially for my clients that are retirees where they have a larger portion of their portfolio in bonds because they want to reduce the risk in their portfolios. So that's what I like to do. I don't think that there's anything totally right or wrong with what you choose to do with a bond portion of your portfolio if you have bonds in your portfolio, as long as you understand that there is a trade-off between risk and return and understanding where you want to be on that continuum of low risk, low return to higher risk, high return, understanding the pros and cons of each side. And hopefully you have learned something today that can help you through these decisions. That being said, I do always recommend I'm a big fan of bond funds because you are protected so much more through this diversification of not putting all of your eggs in one basket, not having all of your bonds into, you know, one or two companies that even if they are in great financial shape now when you bought them, that they may no longer be in the good financial shape. So understanding that diversification is always going to help you in the end. And so again, I'm a huge fan of choosing bond funds over individual bonds, even though it is a little bit harder to wrap your mind around. So I hope you all have a better understanding of bonds today. Catch you next time.