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FOR MANY INVESTORS, talking about bonds is about as interesting as watching paint dry. They aren’t nearly as interesting as stocks. But if you have a portion of your portfolio allocated to bonds, or plan to, it’s a topic worth some discussion.
The bond market is actually much larger and much more diverse than the stock market. For most investors, though, there are just a few types of bonds to consider. We can examine each in turn:
Total Bond Market
Perhaps the most well known type of bond investment is a total-market fund. All major fund providers, including Vanguard (ticker: BND) and iShares (ticker: AGG), offer funds tracking the total-bond market index.
The key advantage of funds like this is that they’re broadly diversified, holding a mix of U.S. Treasury bonds, for stability, and corporate bonds, for their higher yields. That’s why many people see this as the easiest and best way to invest in bonds.
The downside of total-market funds, though, stems from a metric known as duration. A bond’s duration is similar to its maturity and is an indicator of its riskiness. The intuition is that bonds are like IOUs. To the extent that an IOU will be paid back sooner rather than later, it inherently carries less risk. Similarly, bonds that require an investor to wait longer for repayment carry more risk.
More specifically, when interest rates rise, bonds can drop in value. That’s because older bonds, which were issued at lower rates, become relatively less attractive than newer bonds carrying higher rates. When this occurs, bonds with longer durations experience larger declines.
The problem with total-market funds is that their average duration is relatively long, and this makes them risky. We saw this most notably in 2022, when the Federal Reserve hiked interest rates in an effort to tamp down inflation. Total-market funds lost about 13%. While that type of loss wouldn’t be unheard of in the stock market, this is not what investors expect from bonds.
For that reason, while you might have some allocation to a fund like this, I generally avoid them.
What alternatives are there to total-market funds?
Corporate Bonds
You could opt for a fund that holds high-quality corporate bonds. These are bonds issued by large, solid companies like Microsoft and Bank of America.
These carry two potential advantages over total-market funds:
First, there’s the potential to earn more, since, on average, companies have to offer higher coupon rates than the government in order to entice buyers.
Also, when you move away from total-market funds, you can break free from the duration risk described above. Funds like Vanguard’s short-term corporate bond ETF (ticker: VCSH), for example, carry much shorter durations. That’s why funds like this fared much better in 2022, losing less than 6%.
Despite these advantages, corporate bonds aren’t ideal, because they carry another type of risk:
They tend to be positively correlated with the stock market, meaning that they often move in unison. That’s the opposite of what an investor would want.
We saw this dynamic most recently in the spring of 2020. In the early days of Covid, when the S&P 500 dropped more than 30%, corporate bonds sank as well. Even short-term corporate bonds lost more than 10%. In contrast, short-term Treasury bonds gained in value.
That brings us to the next category of bonds you might consider:
Treasury Bonds
U.S. Treasury bonds have historically been the most secure. With arguably only one exception, the U.S. government has never missed a bond payment. That’s why finance textbooks will refer to Treasurys as the “riskless asset.” And that’s why Treasurys would always be my first choice. But we should be careful about seeing them as truly riskless. There are two situations in which even Treasury bonds can pose risk.
First, Treasurys carry duration risk, just like any other bond. In 2022, intermediate-term Treasurys lost more than 10%, and long-term Treasurys lost nearly 30%. The solution? You might weight your holdings toward short-term issues. In 2022, short-term Treasurys lost an almost insignificant 4% of their value.
The second risk with Treasurys is harder to quantify, and that’s the risk posed by Congress.
More than once in recent years, the political parties have come to a stalemate in budgetary debates, and that’s taken us uncomfortably close to the so-called debt ceiling, beyond which the government might not have been able to pay its bills, including payments to bondholders.
How real is this risk? It’s hard to say, and personally, this is not a risk I worry a lot about.
The reality, though, is that there’s a first time for everything. That’s why you might consider diversifying beyond Treasurys into what I see as the next best thing:
State and Local Government Bonds (Municipals)
Municipal bonds are similar to Treasurys in that many cities and states have the authority to levy taxes, helping ensure that they’ll always have the funds available to make payments to bondholders. That makes municipals, in general, relatively low-risk. But two significant caveats apply:
First, the municipal market is very diverse, and while some bonds are backed by tax-collecting entities, others are not. And sometimes even seemingly safe municipal entities can face financial stress.
In 2020, at the outset of Covid, the New York City subway system saw ridership fall 92%. If the Federal Reserve Bank of New York hadn’t provided billions in emergency funding, the transit authority would have defaulted on its bonds.
Another way in which municipal bonds carry more risk than Treasurys: In colloquial terms, the federal government can print money. It’s more complicated than that, but the idea is that it would be very difficult for the Treasury to truly run out of money, and that’s why no municipal bond can ever be considered as secure as a Treasury bond. Taking a step back, though, highly-rated municipals rarely default, and especially if you stick with short-term issues, the risk is very low.
Municipal bonds carry another unique characteristic:
They are exempt from federal tax. And if you live in the state where a bond was issued, it’ll be free of state tax as well. In exchange for this benefit, though, the coupon payments on municipal bonds are generally lower than on comparable Treasurys. For those in marginal tax brackets over 30%, though, the tax savings can offset those lower coupon rates.
There are many other categories of bonds. For most investors, though, it doesn’t need to be more complicated.
To build a balanced portfolio, you might consider a simple mix of four Vanguard funds:
Short-Term Treasury (ticker: VGSH),
Short-Term Tax-Exempt (ticker: VTES),
Intermediate-Term Treasury (ticker: VGIT), and
Short-Term Inflation-Protected Securities (ticker: VTIP).
There was also a good discussion by a Forum member titled “Is now the time to go long in bonds?” that you might find interesting.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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Did you intend to lump ultra short term with short term? I keep my rainy day / emergency in SGOV an ETF of treasuries with 0-3 month duration.
Great discussion about bonds. Although they are a ballast for many, including me 10 years ago, I no longer go with bonds. Now, I am following the Buffet view, 80% S&P 500 and although he said 20% treasuries, I am doing 20% Cash savings in internet banks. Has worked very well over the last 10 years, and helps with the erosion of our investments, due to inflation. Just think about 2.5% inflation over a 30 year period, that is a lot of loss, that dollar is worth only about 52¢ and we have to make up for it somehow. Based on our long term overall record of S&P 500 around 11% over that last 30 years, we should all be in good shape.
I am curious that you didn’t mention high yield bonds. Yes, they are positively correlated to equities, but if you are willing to buy them when they are cyclically cheap and sell when they begin to look a bit pricey, you can generate some capital gains, with a healthy current income stream.
Thanks Adam for the overview. I did not see TIPS in your article. Why is that?
With bonds (as with stocks) there is always the temptation to make things more complicated than needed. Nothing wrong with avoiding BND/AGG in favor of the 4 etfs listed. However, I’m not sure the complication adds anything. As a test, I ran the total returns for the period of 1/1/21-9/19/25 (4.75 years) for each etf. This includes the start of the recent high inflation period until today. Then I ran, for comparison, the period 1/1/16-12/31/20 (5 years). This is the 5 years just prior to the recent inflation run. I had to substitute etf SUB for VTES as VTES only began in 2023.
1/1/21-9/19/25 Total Returns
VGSH 7.7%
SUB 6.4%
VGIT -2.1%
VTIP 18.5%
Average 7.6%
BND -2.9%
Advantage 4 funds by 10.5%
1/1/16-12/31/2020 Total Returns
VGSH 9.6%
SUB 8.3%
VGIT 18.8%
VTIP 14.5%
Average 12.8%
BND 24.4%
Advantage BND by 11.6%
The next 5 years?? No one knows.
Vanguard focuses on Intermediate term “total market” bonds (BND) for their target date and lifestrategy funds (with a little bit of “total market” international intermediate bonds as well). For the target date funds, they add some exposure to TIPS once you move into retirement. I believe they pick intermediate term “total market” bonds (vs short or long term bonds) as the proper balance of accepting some interest rate sensitivity in order to achieve higher returns in the longer term. As always, your age and circumstances may bring you to different conclusions. Just don’t overcomplicate it.
This article reminded me that I don’t know everything about debt securities.
Good discussion! To that list of total bond market funds, corporates, treasuries, and municipals, I’d add CD’s, Multi-Year Guaranteed Annuities (think: CDs from insurance companies), and if you have access to one–a stable value fund (think: G-fund for the federal Thrift Savings Plan). This last can simplify your life considerably, especially when you are in the draw-down phase of your retirement.
Also, another important distinction: One’s overall bond allocation should be broken down to include both short-term and long-term holdings, especially when one is taking account distributions. For example, funds like BND might not be the best for the short-term bucket, but generally can fit pretty good in longer-term holdings. I also tend to avoid most anything with a duration of longer than 10 years, since within recent memory I don’t feel investors are being adequately compensated for the (considerable) risk that entails. And of course, muni’s should generally be avoided for retirement accounts, as their tax advantages are mostly negated there, and their generally lower return doesn’t usually make up for that.
While it makes sense to use indexes for stocks, it doesn’t for bond funds.
BND 10-year average annual performance is at 2%. BND lost money in the last 5 years.
One can select higher % in bond funds using other bond categories and lower their stock %.
I have held a huge % in PIMIX from 2010 to 2018. PIMIX is still a good fund.
There are several bond funds with much better risk/reward.
See a 5-year chart of BND,PIMIX…and CBLDX.
https://schrts.co/HfzHJjgF
Disclaimer: 95% of my portfolio performance since retirement in 2018 has been made by investing in bond OEFs.
https://ibb.co/zT6QGzSs
I will probably rebalance next month, if the stock market hasn’t tanked, so this is of particular interest to me. I have held Vanguard’s intermediate muni fund in taxable for many years and will continue to do so. I have a large position in their intermediate TIPs fund in my IRA which I also have no plans to change, but my remaining bonds, in my IRA, are split unequally between short and intermediate Treasury and corporate Vanguard funds (more in short and Treasury). I used to have a small position in Vanguard’s junk bond fund, but sold out a few years back.
Since I am only 50% in stocks, I am not overly concerned about holding high grade corporates. I do wonder about adding short term TIPs, or even individual TIPs.
I confess, I find the subject of purchasing individual TIPs on the secondary market to be a somewhat confusing endeavor, and something I hesitate to recommend. But since durations of some issues have gotten more attractive in the last few years, it might be worth the effort, if one is willing to put in the time to do some research. I definitely feel there is more potential for satisfactory performance with individual issues, as opposed to TIPs funds.
Adam, you’re right: bonds aren’t exciting until we start looking for a down-market way to fund retirement. Or, until we hold longer-term bond funds when interest rates start climbing. Thanks for sifting this information and isolating the best choices, along with the risks they carry.
Thank you Adam for leading HumbleDollar during Jonathan’s decline. I can tell you are a good friend to Jonathan.
If you did have $100,000 in a Total bond market fund, like BND (IRA) in 2022 and you reinvested all dividends, who long would it take to get your original investment of $100,000 back?
If interest rates continue to fall will BND recover faster?
Thanks. How do you feel about actively managed bond funds Adam? Like so-called core-plus funds. They might overweight mortgage-backed securities, or they might have modest allocations to emerging markets and high yield bonds. Yes, they will get whacked in certain market conditions but have the potential to outperform significantly long term.
Thank you for this!