When Bonds Make Sense

The plain answer

Bonds make sense when you want part of your portfolio to be more stable than stocks. They can help protect money you expect to spend soon and can provide ballast when stock prices fall.

Bonds are not usually the part of a portfolio designed to maximize long-term returns. Their main jobs are to reduce volatility, preserve more of your money during stock market declines, and make planned withdrawals less dependent on what stocks happen to be doing.

The tradeoff is important: more bonds generally mean less risk, but also lower expected long-term growth. For a direct comparison, see Stocks vs. Bonds.

How it actually works

A bond is a loan to a government, company, or other borrower. In return, the borrower promises interest payments and repayment of principal according to the bond’s terms. Bond funds hold many bonds and are the most practical way for many investors to get broad diversification.

Bonds can serve three useful roles in a portfolio:

• Stability: High-quality bonds usually fluctuate less than stocks, although their prices can still fall.
• Spending soon: Money needed within the next several years may not have enough time to recover from a major stock decline. Short-term, high-quality bonds can reduce that risk.
• Ballast: When stocks fall sharply, bonds may hold up better. That can reduce the portfolio’s overall decline and provide assets to rebalance or spend.

Not every bond offers the same protection. Long-term bonds can move sharply when interest rates change. Lower-quality corporate bonds may fall alongside stocks during economic stress. A bond allocation intended for stability usually emphasizes high credit quality and a maturity range that fits when the money may be needed.

Cash and bonds also have different jobs. Cash is appropriate for emergencies and spending in the immediate future. Bonds can accept some price movement in exchange for potentially higher income and returns than cash over a longer period.

What this means for you

Consider bonds when a stock-heavy portfolio could interfere with a real goal or cause you to abandon your plan. They may be useful if you are approaching a major purchase, preparing for retirement withdrawals, already withdrawing from your portfolio, or uncomfortable with large swings in account value.

Match the bond allocation to the job it needs to do. Money needed very soon belongs in cash or similarly stable holdings. Money needed several years from now may fit short-term or intermediate-term, high-quality bonds. Money for goals decades away may support a larger stock allocation if you can tolerate the risk.

The right amount is the amount that lets the entire portfolio support your timeline while remaining tolerable during a bad market. Bonds earn their place by making the plan more dependable, not by winning every return comparison.

Common mistakes

• Treating bonds as risk-free. Bond prices can fall because of interest-rate changes, credit problems, and inflation.
• Buying long-term bonds for money needed soon. Their prices can be more sensitive to rate changes.
• Reaching for the highest yield. Higher yields often compensate investors for higher credit or interest-rate risk.
• Assuming all bond funds provide strong ballast. Lower-quality bond funds can behave more like stocks during a crisis.
• Avoiding bonds because stocks have higher expected returns. A portfolio only works if its risk fits your goals and behavior.
• Holding too many bonds for a distant goal without considering the cost of lower expected growth.

Related pages

• Stocks vs. Bonds
• Asset Allocation
• Choosing Your Risk Level