By now, you’re likely familiar with the concept of “diversification” and the role it plays in a well-balanced portfolio—remember the old adage, “Don’t put all your eggs in one basket.”
A diversified portfolio typically includes a mix of asset classes, namely equities (stocks), fixed income (bonds), and cash (or cash equivalents, like CDs). Each asset class plays a different, but important, role in your portfolio, based on its unique features and general risk levels.
All investment involves risk and may lose money (including principal). While stocks are volatile, they can help your portfolio gain significant value over time. Cash provides liquidity and stability, and bonds offer an opportunity to earn steady income. Your asset allocation (how much of your portfolio is in each asset class) will likely shift throughout your lifetime, particularly as you near retirement.
For example, you may have heard the common 60/40 asset allocation strategy, which suggests people keep 60% stocks and 40% bonds in a portfolio. This mix is designed, in theory, to provide ample opportunity for growth (via stocks) and protection from market downturns (thanks to the bonds).
Generally speaking, the closer you come to living off your investments, the more conservative you’ll want your portfolio to be. For that reason, people who are in or near retirement typically shift away from stocks, instead opting for a greater emphasis on cash and bonds.
But here’s something to consider: Bonds are still subject to risk. In fact, bonds have experienced some notable volatility over the past few years, and there’s always the chance we could see more of that instability in the future.
Do bonds actually offer the “safety net” sort of protection investors are looking for? Let’s take a closer look at the type of risk bonds are exposed to and the role they may play in your portfolio moving forward.
Bonds are essentially loans. Instead of borrowing from a bank, investors act as the lenders.
A certain entity, usually a company, municipality, or the federal government, issues bonds when it needs to raise money. Rather than take out a traditional bank loan, the entity allows individual investors (like you) to purchase these bonds. In return, the issuer promises to return your principal payment at a future date (called the maturity date). To further incentivize investors, bonds will typically pay out interest throughout the life of the bond, which can serve as regular, steady income.
Bonds can be purchased directly from an issuer (the corporation or government entity) on the bond market. Preexisting bonds can also be traded and sold on the bond market—meaning you don’t have to hold onto a bond until maturity.
Investors also have the option to purchase bond mutual funds (or bond funds) and bond ETFs. Rather than hold equities as the underlying securities, these funds purchase bonds. Just like regular mutual funds or ETFs, they allow an investor to diversify their bond holdings without having to partake in individual bond research and selection.
Bonds aren’t without risk, despite their reputation for some as “safe”. Remember, a bond is essentially a loan—you’re depending on the borrower to meet their obligation and pay you back, but there’s no guarantee they will and that they won’t default.
Some borrowers are considered more trustworthy than others. That’s why bond ratings exist, which are used by agencies to assess an issuer’s creditworthiness. The ratings range from AAA (the highest quality bond) to D (standing for “default”).
Typically, the higher the rating, the lesser the risk—which also means a lower potential payout.
During periods of economic expansion, corporate earnings are high, investor sentiment is positive, and stock performance is typically moving in a positive direction. To keep inflation from rising too quickly, the Federal Reserve has historically tightened its monetary policy during periods of growth.1
This often means higher interest rates, which makes borrowing money more expensive. Because interest rates are paramount to the bond market, higher interest rates have tended to drive prices down on the bond market (since newly issued bonds at the higher interest rates can earn investors more than preexisting ones).2
Now, the opposite has been true as well. During periods of economic contraction, corporations struggled, investor sentiment turned sour, and the rate of stock market growth declined. To help stimulate the economy, the Fed has often lowered interest rates, which in turn incentivized companies to borrow and spend more.1 When interest rates have gone down, bond market performance has tended to go up.2
While this has been generally true over time, it’s certainly not set in stone—and one market’s movements don’t guarantee an inverse reaction from the other. Both the stock market and bond market are influenced by macroeconomic factors. Bonds, in particular, can fluctuate in value based on things like:
When Covid hit, spending dropped, and the Federal Reserve cut interest rates in an effort to stimulate the economy. The Federal Funds target rate dropped to between 0% and 0.25% during two March 2020 emergency meetings.3 On the consumer side, you may recall seeing historically low mortgage rates between 2% and 3%.
But in 2022, inflation rose drastically, hitting a 40-year record high of 9.1%.4 To combat rising inflation and reduce spending, the Federal Reserve began hiking the Federal Funds rate. In total, we saw 14 rate hikes spread across two years, bringing the target rate from 0% up to 4.50%.3
The S&P 500 Bond Index dropped just over 100 basis points between January and October 2022—the same period in which the Federal Reserve began aggressively hiking those rates to combat high inflation. In fact, the bond market continued to slump throughout 2023 until rate hikes were put on pause and eventually reversed in 2024.5
For context, the bond market wasn’t the only one suffering during 2022. High inflation, rising interest rates, the war on Ukraine, and continued concerns over a possible recession had equity investors pulling back as well. The S&P 500 ended 2022 down 18% while the Nasdaq Composite fell 33.1%, notably the worst year for both indices since 2008.6
Despite market declines during periods of economic uncertainty, bonds can provide investors with a level of relative stability equities do not—in addition to a steady, fixed income component, which plays a critical role in many retirees’ portfolios.
The bond market is vulnerable to macroeconomic changes and volatility, particularly inflation and interest rates. But does that mean you should ditch it altogether? While they carry some risk, bonds can still play an important role in your portfolio and provide steady income at a time when you need it most.
As you continue reassessing your portfolio’s asset allocation and adjusting to meet your future financial needs, it can help to understand what factors can impact long-term bond performance and how that impacts your personal investment strategy and goals.