Why they're still critical to your financial plan

The goal of understanding bonds in this blog is two-fold. First, to review how bonds work. Second, to argue that they play a crucial role in most people's financial plan.

A brief bond primer

Bonds are like loans: a promise to pay you a fixed amount of interest, usually 1-2 times / year, and to pay you back the principal at maturity.

What's a bit complicated is how bond prices move. Two factors impact bond prices:

1. Interest rates. When rates rise, the price of your bond goes down, because your bond is relatively less attractive. The longer the period before your bond matures, the more the price declines, as you are locked in for longer. The reverse is true when interest rates go down. Your bond becomes more attractive, so its price rises.
2. Credit. An investor expects higher interest for a less creditworthy bond. That's why US Treasury bonds offer low rates compared to other issuers. That's also why, if an issuer's financial prospects change for the better, its bonds should go up in value -- and vice versa. The impact is far less severe than with stocks, but it exists.

The interplay of bond prices and interest rates can cause confusion. They move in opposite directions. When bond prices go up, your effective interest rate, or yield, goes down, and vice versa.

For most of the past 40 years, interest rates have fallen and bond prices have risen. Over the last few months, the trend reversed, more sharply than it has since the late 1970s.

The Federal Reserve has announced plans to raise interest rates over the months ahead. But that does not mean bond prices will continue falling. More on that below.

Bonds are the opposite of stocks, but in one important way, they're the same

Owning stock lets you participate fully in the fortunes of the issuer. Over the past century, US stocks have risen about 10% annually -- a remarkable run. That attractive return, which is never guaranteed, is compensation for the risk you take. For example, the stock market dropped 50% in one 12-month period during the great recession.

Bonds have nowhere near that upside or downside potential. The most bonds have fallen in a 12-month period over the last 50 years is 9%.

But here's where stocks and bonds are alike. The worst time to sell stocks or bonds is when they have gone down. After stocks fall, your potential return is typically greater, because you are starting from a lower price. The same is true of bonds.

An example: today, 10-year bonds issued by the US Treasury pay about 2.9% annually. In August 2020, at their low, they paid 0.5%. Most bonds pay a higher rate than they have since 2018, making them more attractive today. Theoretically, you would still sell if you knew bond prices would continue to drop -- perhaps because of future interest rate increases or inflation. But every investor should already know about these risks. These risks should be reflected in today's prices. Before selling, ask yourself: what do you know that everyone else does not?

The role of bonds in your financial plan

Bonds serve two critical roles in your financial plan:

1. Immediate access to funds when you need them. You can sell high-quality bonds in almost any circumstance for a reasonable price. Compare that to stocks, which can fall dramatically in price. Cash can serve this role too but, over time, we expect bonds will provide a higher return than cash. It typically makes sense to keep no more than 1-2 years of expected needs in cash. Usually you should keep another 5+ years of expected needs in bonds.
2. Shock absorber for your investment mix. Because stocks can drop sharply, bonds reduce the overall volatility of your investments. That can make it easier to sleep at night -- and reduce the temptation to sell stock in a panic.

Even though bond prices have fallen recently, these two important roles remain.

Bonds are not exciting. Sometimes they surprise on the upside. Occasionally, they do poorly. But history has proven, time and again, that they serve a valuable role in your financial plan.

Suggested Reading

Factors Can Help in Bond Investing, but Choose Carefully, Dimensional Fund Advisors
The Fed is on the March, WSJ