Bonds

Why it matters in retirement

Bonds cushion a portfolio during stock crashes, provide predictable income, and let retirees meet near-term spending needs without selling stocks at bad prices. The right bond allocation is the difference between riding out a bear market and being forced to sell low.

A Deeper Look

A bond is essentially an IOU. When you buy one, you are lending money to the issuer, whether that is the US Treasury, a state government, or a corporation like Apple or Johnson & Johnson. In return, the issuer agrees to pay you a fixed interest rate (called the coupon) at regular intervals, usually every six months, and to return your principal on a specific maturity date. If you buy a $10,000 Treasury bond paying 4.3%, you receive $215 every six months and get your $10,000 back when the bond matures.

There are several major types of bonds, and they differ in who is borrowing your money and how much risk you are taking. Treasury bonds are backed by the full faith and credit of the US government and are considered the safest bonds in the world. Municipal bonds are issued by state and local governments, and their interest is usually exempt from federal income tax, which makes them attractive for retirees in higher tax brackets. Corporate bonds pay higher yields than Treasuries but carry the risk that the company could default. High yield bonds, sometimes called junk bonds, are issued by companies with lower credit ratings and pay substantially more interest to compensate for the higher default risk.

The most important concept for bond investors to understand is duration, which measures how sensitive your bond's price is to changes in interest rates. A bond with a duration of 5 years will drop approximately 5% in price if interest rates rise by 1%. A bond with a duration of 15 years will drop about 15%. This is why long term bonds got crushed in 2022 and 2023 when the Federal Reserve raised rates aggressively. Some long term Treasury funds lost 30% or more, a reminder that "safe" bonds can deliver stock-like losses if you mismatch duration with your needs.

For retirees, bonds serve three distinct roles in a portfolio. First, they provide stability. When stocks drop 30% in a bear market, high quality bonds typically hold steady or rise, giving you a source of funds to draw from without selling stocks at depressed prices. Second, bonds generate predictable income. A portfolio of individual bonds or a bond ladder (bonds maturing in consecutive years) delivers known cash flows you can plan around. Third, bonds reduce the overall volatility of your portfolio, which matters psychologically. A portfolio that drops 15% instead of 30% is much easier to hold through a downturn.

Consider a practical example. You are 66, just retired, and you have $600,000. You build a bond ladder with $30,000 maturing each year for the next five years, using Treasury or high quality corporate bonds. That gives you $150,000 of near certain income over five years regardless of what the stock market does. The remaining $450,000 stays invested in a mix of stocks and intermediate bonds for growth. Each year, as the shortest rung matures and you spend it, you can extend the ladder by buying a new bond at the far end if stock returns have been positive.

When evaluating bonds, pay attention to four things. Credit quality tells you how likely you are to get paid back; stick with investment grade (BBB or higher) for core retirement holdings. Duration tells you how much price risk you are taking; match it to when you need the money. Yield to maturity is the total return you will earn if you hold to maturity, and it is more useful than the coupon rate. Finally, understand the tax treatment. Treasury interest is exempt from state tax, municipal interest is usually exempt from federal tax, and corporate bond interest is fully taxable. The right choice depends on your bracket and which accounts you hold the bonds in.

Common mistakes

• Buying long-duration bonds in a rising-rate environment
• Chasing yield into junk bonds without understanding default risk
• Using bond funds when you need a specific maturity date
• Forgetting that Treasuries are exempt from state income tax