What to know about bonds and fixed income investing

Find out the role that bonds can play in bringing steady income and more stability to your portfolio.

A mature man reviewing his investments on his laptop.

Due to their lower-risk, low-return reputation, bonds can sometimes be overlooked as an asset class by investors. However, when part of a thoughtful investment strategy, bonds can help create a balanced portfolio and offer a steady stream of income.

We can work with you to decide how bonds fit into your personalized investment strategy, one that reflects your unique needs and financial goals.

Here’s what to know about bonds and fixed income investments:

How bonds work

Bonds are debt contracts that the issuer — typically governments or companies — use as a way of raising money. Unlike stockholders, bondholders don’t have an ownership interest in the company or organization that issues the bond, nor do they stand to profit from its growth and success. Instead, a bond is essentially a loan, with the issuer promising to pay a specified rate of interest, known as yield, during the life of the bond and repay the face value of the bond — the principal — when it matures.

Learn more: Asset classes: The building blocks of an investment portfolio

Why have bonds in your portfolio?

Generally considered to be conservative investments, bonds are lower-risk investments that can provide investors with the following benefits:

Predictable income stream: Bonds typically pay a relatively low but fixed rate of interest, with payments made to bondholders once or twice a year during the length of the bond.
Diversification: Because bonds tend to have more stable returns than stocks, they can help to create a diversified, balanced portfolio with a healthy mix of assets.
Low risk: Because some bond types are less dependent on market performance than stocks, they can often be a good option for investors who are more risk averse, including those who are about to retire or who have already retired.
Tax benefits: Certain bonds issued by the U.S. government can provide unique tax benefits to the issuer.

Learn more: Why should an investor consider diversification and asset allocation?

The risks of investing in bonds

Though bonds are considered among the lowest-risk investments available, they also have risks:

Interest rate risk: The risk that interest rates will rise above the rate locked in at the time of the purchase of a bond. That is why when market interest rates rise, bond prices tend to fall; and vice versa. The longer a bond's maturity, the greater the bond’s interest rate risk.
Inflationary risk: The risk that unanticipated inflation will undermine the purchasing power of a bond’s return.
Default risk: If an issuer is unable to pay off the bond, a default could result in the loss of an investor’s principal, interest or both.

Advice spotlight

Consider how your bond allocation may change as you get closer to retirement. Due to their lower risk, increased stability and predictability, bonds can be a smart choice for those who want less exposure to potentially volatile markets and ready access to their investments for expenses in retirement.

What types of bonds can you invest in?

Bonds offer different features depending on the issuer and how they’re structured. Here are some of the most common:

U.S. government bonds: Backed by the federal government, U.S. government bonds are considered a very low-risk investment option, though the lack of risk also comes with a relatively low rate of return (interest income from U.S. government bonds is typically exempt from state and local taxes).
- Treasury bills, or T-bills, are short-term bonds with maturities ranging from four to 52 weeks. They do not have regular interest payments but instead are issued at a discount from the face value (known as the par value). The bondholder is then paid the face value when the bill matures.
- Treasury notes are intermediate-term investments that offer a fixed rate of interest, and have maturities of two, three, five, seven and 10 years.
- Treasury bonds are long-term, fixed-income instruments that have maturities from 10 to 30 years.
- Treasury inflation-protected securities (TIPS) are bonds that have a unique structure allowing the bond principal to mirror the Consumer Price Index, which means your interest payments can adjust with inflation.
Municipal bonds: Municipal bonds are issued by states, counties or municipalities. Typically exempt from federal income tax, they can also be exempt from state income tax under certain conditions, and some investors use them as a relatively low-risk way to manage their state and federal tax liability.
Corporate bonds: Corporate bonds are issued by private companies, and come with varying interest rates, maturity dates and credit quality. They are typically categorized as either investment grade bonds or high-yield bonds.
- Investment grade bonds are bonds that offer a low risk of default and typically come with a lower interest rate.
- High-yield bonds typically pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they must pay a higher yield than investment-grade bonds to compensate investors.
Foreign and emerging market bonds: Investors can also buy bonds issued by foreign governments and corporations. As with U.S. corporate bonds, international and emerging market bonds have a variety of interest rates, maturity dates and credit quality. However, there is an added level of foreign risk, as reliable information about some of these bonds can be harder to acquire.

How the bond market works

Though many investors buy a bond at issuance and keep it to maturity, bonds can also be bought and sold to other investors on the secondary market, where various economic factors will affect prices, rates, and yields. Here are some key considerations:

Bond prices are affected by the Federal Reserve: Monetary policy, especially interest rate management, can have a major effect on bond prices. In the U.S., this means when the Federal Reserve increases or reduces interest rates, the price of bonds often moves too. When interest rates go down, the price of outstanding bonds typically goes up, as investors are willing to pay a premium for a bond with a higher interest payment (also known as a coupon). Conversely, when interest rates go up, bond prices typically go down, since investors will be able to buy new bonds with higher coupon rates.
The relationship between yield and price: Yield is simply the anticipated return on an investment, expressed as an annual percentage. For example, a 5% yield on a bond means that it’s designed to average a 5% return each year. Generally, the higher the price you pay for a bond, the lower the yield, and vice versa.

Bond ladders

While there are different bond strategies, one of the most common is what’s known as a bond ladder. With a bond ladder, an investor purchases bonds that have staggered maturity dates to help reduce their portfolio’s susceptibly to interest rate fluctuations. As the different bonds mature, you reinvest the proceeds into new bonds with longer maturities.

With a five-year bond ladder, for example, five different bonds are purchased, each with a different maturity date of one, two, three, four and five years. When the first bond matures after one year, a new five-year bond is purchased to keep the ladder rolling. If interest rates have risen, a bond ladder allows you to have cash available to invest into a new bond at the higher rate. If interest rates have fallen, only a portion of your investment is subject to the lower rate.

A bond laddering strategy tends to be well-suited for investors who want to manage interest rate risk while maintaining a steady income stream, since it can allow you to benefit when interest rates are high and reduce your exposure to investment rate risk when rates are low. It also can work well for investors with specific future cash needs, such as funding retirement expenses.

By investing in a bond ladder instead of a single bond, you keep your money in motion and have access to a portion of your investment on a regular basis. This may help you structure your portfolio to withstand the inevitability of interest-rate fluctuations.