Everyone knows someone interested in the stock market. Entire movies are made about the stock market. How many people do you know that talk about the bond market? Probably zero.
Most people have heard the term "bond” before, but don’t really know what one is. We’re going to fix that. By the end of this post, you'll understand exactly what a bond is, how it differs from stocks and speculation, and when bonds make sense in a FI portfolio (spoiler: it's not just about your age).
What Is a Bond, Really?
A bond is a loan that you make to someone else.
That's it. When you buy a bond, you're lending money to a government, corporation, or other entity. They promise to pay you back the full amount (called the "principal") plus interest over a specific time period.
When you buy a $1,000 Treasury bond with a 4% interest rate and 10-year maturity, you're lending $1,000 to the U.S. government. They promise to pay you $40 per year for 10 years, then give you back your $1,000 at the end.
This is fundamentally different from stocks because you're a lender, not an owner.
Why Bond Prices Change
At first, bonds sound boring and easy because the payments are fixed. Instead, bond prices can be highly volatile because they fluctuate based on interest rates, credit risk, and time to maturity. Here's what affects your bond's value:
Interest Rate Changes: If you own a bond paying 4% and new bonds from the same issuer start paying 6%, your bond becomes less valuable. Who wants 4% when they can get 6%? Conversely, if new bonds only pay 2%, your 4% bond becomes more valuable. (You make a profit if interest rates fall after you purchased it and you decide to sell to someone else for more than you originally paid.)
Credit Risk: If the borrower becomes more likely to default, the bond price falls. If their financial condition improves, the price rises. (This makes sense. If someone declares bankruptcy, they may not be able to pay back anything and your bond could be worthless.)
Time to Maturity: The closer you get to the repayment date, the closer the bond price moves toward its face value. (This is also logical. If the bond matures tomorrow for $100, it’s going to be worth nearly $100 today. It would be hard for it to be worth more or less with just one day until maturity.)
Supply and Demand: If more people want to buy bonds than sell them, prices rise. If more want to sell than buy, prices fall. (This is true of anything for sale.)
The key insight: Bond prices move opposite to interest rates. When rates go up, existing bond prices go down. When rates go down, existing bond prices go up.
Note: this is really important! Bonds generate income (interest payments) but they can also generate capital gains by appreciating in value (if interest rates decline).
Bonds vs. Stocks: The Critical Differences
Bonds (Lending):
Fixed claim to interest payments
No ownership stake in the business
Limited upside potential (you get the agreed interest, nothing more)
Priority in bankruptcy (lenders get paid before owners)
Generally less volatile than stocks
Stocks (Ownership):
Variable claim to business profits
Ownership stake with voting rights
Unlimited upside potential if business grows
Last to get paid in bankruptcy
Generally more volatile than bonds
The bottom line: Bonds give you predictable income with limited upside. Stocks give you unlimited upside with higher volatility.
How Governments and Corporations Create Bond Value
Here's why bond investing works: borrowers need capital and are willing to pay for it.
Every day, governments and corporations need to fund operations:
The U.S. government funds infrastructure, defense, and social programs
Corporations fund expansion, research, and operations
They're willing to pay interest to access capital now rather than wait
When you own bonds, you're participating in this capital allocation system. You're providing needed funding and getting compensated with interest payments.
This is why bonds have historically provided positive real returns. Not because of speculation, but because there's genuine demand for capital.
The 40-Year Bond Bull Market (And Why It's Over)
Now we have to address something unfortunate for investors in 2025. Traditional investing advice was to put 60% in stocks and 40% in bonds. That doesn’t work anymore.
From 1981 to 2020, interest rates fell almost continuously. This created an incredible environment for bonds:
In 1981, 10-year Treasury bonds yielded over 15%
By 2020, they yielded under 1%
As rates fell, existing bonds became more valuable
If you bought bonds at any point during this 40-year period, you likely experienced both steady income and capital appreciation. Bonds looked like magic.
Unfortunately, the magician has gone home and the party is over. As of today, 10-year Treasury bonds yield around 4-5%. Going back to 15% rates would require massive inflation, and going back to 1% rates would require inflation to fall below the 2% Fed target and that also seems unlikely at the moment.
What this means for you:
Bond returns going forward will likely come from interest payments, not price appreciation
The "bonds always go up" experience is extremely unlikely to repeat
4-5% yields are somewhat attractive compared to the 2010s
Types of Bonds (Keep It Simple)
There are many types of bonds, but here are the main categories:
U.S. Treasury Bonds: Issued by the federal government. Considered the safest bonds because the government can print money to pay them back. Most common types:
Treasury Bills (1 year or less)
Treasury Notes (2-10 years)
Treasury Bonds (20-30 years)
Corporate Bonds: Issued by companies. Higher risk than Treasuries but typically higher yields. Companies can go bankrupt, so there's credit risk.
Municipal Bonds: Issued by state and local governments. Often tax-free for residents of the issuing state.
There are also bonds issued by government agencies, foreign governments, and other types of entities like tollway authorities and Federal Home Loan Banks.
For most FI investors, you don't need to understand all the nuances. A total bond market fund owns thousands of different bonds and handles the complexity for you.
Bond Funds: The Index Fund Approach
Just like with stocks, most people shouldn't pick individual bonds. Instead, use bond funds.
A bond fund lets you own pieces of thousands of bonds with a single purchase.
Examples of solid bond funds:
BND (Vanguard Total Bond Market ETF): Owns over 10,000 U.S. bonds
FXNAX (Fidelity U.S. Bond Index): Similar broad exposure to U.S. bond market
Both include government and corporate bonds with different maturities
Why bond funds beat individual bonds for most people:
Instant diversification: You own thousands of bonds instead of one
Professional management: No need to research individual issuers
Liquidity: You can sell anytime during market hours
Reinvestment: Interest payments automatically buy more bonds
Lower minimums: Start with any amount instead of typical $1,000 bond minimums
When Bonds Make Sense in Your FI Portfolio
This isn't about your age. It's about your situation and risk tolerance. I generally recommend stocks above bonds in most situations, but there are a few exceptions.
Bonds make sense when:
You're close to or in early retirement: If you're planning to withdraw from your portfolio within the next 5 years, bonds provide stability. When stocks crash 40%, your bond allocation helps you avoid selling stocks at the bottom. Instead, you draw from bonds while stocks recover. (This is the only real reason for bonds in my opinion.)
You want to reduce portfolio volatility: A 90% stock portfolio might swing 60% in a bad year. An 80% stock/20% bond portfolio might only swing 45%. Less volatility might mean better sleep for you even if the total return is slightly less.
You want guaranteed income: Bonds provide predictable income streams. A $100,000 bond allocation yielding 4% generates $4,000 annually regardless of stock market performance.
Bonds don't make sense when:
You're 25 and accumulating: If you won't touch your investments for 40 years, stocks will likely outperform bonds dramatically. The volatility doesn't matter over such long periods.
You have stable employment: If you have a reliable paycheck and won't need portfolio withdrawals, you can afford the stock market's volatility for higher long-term returns.
You're comfortable with 100% stock volatility: Some people genuinely don't lose sleep over portfolio swings. If that's you, why accept lower expected returns?
Sequence of Returns Risk: The Real Reason Bonds Matter
Let’s come back to the one reason I said was valid. I want to explain this a bit more. There is an important concept called: sequence of returns risk.
Imagine two people retire with $1 million portfolios and plan to withdraw $40,000 annually (4% rule):
Person A retires right before a 10-year bull market Person B retires right before a major crash followed by recovery
Even if both experience the same average returns over 30 years, Person B is much more likely to run out of money because they had to sell stocks at low prices early in retirement. In other words, while the next 30 years returned the same for both people, Person B didn’t see those gains because he sold his stocks for food in the first few years!
Bonds help solve this problem:
Keep 1-2 years of expenses in bonds
During market crashes, spend from bonds instead of selling stocks
Let stocks recover while living off bond income
Rebalance back to your target allocation when stocks recover
Adding bonds won’t maximize your returns, but they might reduce your risk of financial ruin due to bad market timing.
Sample Bond Allocations by FI Stage
Accumulation Phase (Building toward FI):
100% stocks
Focus on growth over stability
Long time horizon allows recovery from crashes
Pre-FI Phase (2-5 years from FI):
90% stocks, 10% bonds
Start building stability without sacrificing much growth
Test your risk tolerance with some bond exposure
Early Retirement Phase (Living off portfolio):
80% stocks, 20% bonds
Balance growth needs with stability requirements
Bonds provide spending money during stock market downturns
Later Retirement (75+ years old):
70% stocks, 30% bonds
Higher bond allocation for stability and income (because you may not have a decade for stocks to recover)
Still need some stock exposure for inflation protection
Remember: These are guidelines, not rules. Your specific allocation depends on your risk tolerance, backup plans, and financial situation. There is nothing wrong with being 100% stocks at any age and I could probably accept a 60/40 split for the most conservative among us who prioritize stability over growth. Below 60/40 and you’re usually constructing an inferior portfolio.
Common Bond Investing Mistakes
Trying to time interest rates: Nobody can consistently predict whether rates will rise or fall. Focus on bonds' role in your portfolio, not trying to optimize timing.
Buying individual bonds without expertise: Credit analysis and duration management are complex. Let professional fund managers handle this.
Ignoring inflation: In high inflation periods, fixed bond payments lose purchasing power. This is bonds' biggest weakness.
Expecting stock-like returns: Bonds are defensive assets. Don't expect 10% annual returns from a 4% yielding bond.
Going 100% bonds: Bonds alone won't build wealth or protect against inflation over long periods. You need stocks for growth.
The Bottom Line
Bonds aren't exciting, and they won't make you rich. But they serve a crucial role in FI portfolios: providing stability and income when stocks are struggling. (Historically stocks and bonds moved inversely. More recently this relationship has been less clear.)
The goal isn't to maximize returns with bonds. It's to create a more sustainable withdrawal strategy that reduces the risk of running out of money due to bad market timing. (e.g. retiring into the Great Depression)
For most FI investors, the right approach is:
Build wealth with stocks during accumulation
Add bonds as you approach and enter retirement
Use bonds for stability and spending money during market downturns
Keep high stock exposure throughout retirement for inflation protection
Bonds are the financial equivalent of wearing a seatbelt. You hope you never need them, but you'll be glad they're there when the crash happens.
Start simple: If you decide bonds belong in your portfolio, begin with a total bond market fund like BND or FXNAX. Don't overthink it. The most important decision is the stock/bond split, not which specific bond fund you choose.
Until next time,
Max