Week 16 Day 2: What a Bond Actually Is

A bond is a loan. You lend $1,000 to the U.S. government (Treasury bond), a corporation (corporate bond), or a municipality (municipal bond). They promise to pay you interest (the coupon) every six months and return your $1,000 at maturity. It is more predictable than stocks but offers lower returns.

Bonds serve three purposes in a portfolio. (1) Income: bonds pay regular interest, providing steady cash flow. A 10-year Treasury bond yielding 4.5% pays $45/year per $1,000. (2) Stability: when stocks crash, high-quality bonds often hold their value or rise (investors flee to safety). In 2008, while the S&P 500 fell 37%, long-term Treasuries gained 26%. (3) Preservation: if you need money in 1-5 years, bonds protect against stock market volatility. Types of bonds, ranked by safety: U.S. Treasuries (backed by the full faith of the U.S. government -- zero default risk), investment-grade corporate bonds (low default risk, higher yield), municipal bonds (tax-free interest, moderate safety), high-yield/junk bonds (higher default risk, much higher yield -- these behave more like stocks). The key risk: interest rate risk. When interest rates rise, existing bond prices fall (because new bonds offer higher rates, making old bonds less attractive). This is why 2022 was the worst year for bonds in modern history -- the Fed raised rates from near 0% to over 4% in one year.

Bond math centers on duration, a measure of price sensitivity to interest rate changes. Modified duration approximates the percentage change in bond price for a 1% change in yield: %Price Change = -Duration * Change in Yield. A bond with duration 7 loses approximately 7% for every 1% rise in rates. The Bloomberg U.S. Aggregate Bond Index had a duration of approximately 6.2 in early 2022. When rates rose roughly 2.5% that year, the index fell approximately 13% -- consistent with the duration prediction (-6.2 * 2.5 = -15.5% approximate, partially offset by coupon income). The yield curve (plotting yields against maturities) is normally upward-sloping (longer maturities yield more due to term premium). An inverted yield curve (short rates exceeding long rates) has preceded every U.S. recession since 1955 with only one false positive (1966). As of 2024, the 2-year/10-year spread was inverted for over 18 months -- the longest inversion on record. Despite bonds' reputation as boring, understanding their mechanics is essential for portfolio construction, especially as retirees become more dependent on fixed-income allocation.