What bonds do and why people own them

A bond is a loan you make to a government or company. You lend them money, they promise to pay you back with interest on a set schedule, and you get that interest whether the stock market goes up or down. That predictability is the main reason people own bonds — they produce steady income and tend to move in the opposite direction from stocks, so holding both can reduce the overall swings in your account.

Whether bonds are right for you depends on three things: how much time you have before you need the money, how much risk you can tolerate, and what interest rates are doing. A bond that pays 5 percent looks different to someone who needs cash in two years than it does to someone who won't touch the money for twenty. The same bond also looks different depending on whether you might need to sell it before it matures — if rates go up after you buy, the bond's value drops, and you lock in a loss if you sell.

Bonds are not a single thing. Treasury bonds (issued by the federal government) are safer but pay less. Corporate bonds pay more but carry the risk that the company fails to pay. Bond funds and bond ETFs let you own many bonds at once, spreading that risk. Each type has a different job in a portfolio.

Key Takeaways

  • Bonds pay fixed interest on a schedule and typically move opposite to stocks, making them useful for reducing portfolio swings rather than for growth.
  • The longer you can hold a bond until it matures, the less it matters if interest rates rise and temporarily lower its value.
  • Treasury bonds are safer but pay less; corporate bonds pay more but carry company risk; bond funds spread risk across many bonds.
  • Bonds make more sense when interest rates are high, when you have money you won't need for several years, and when your other investments are volatile.

How interest rates affect whether a bond is worth buying

The interest rate a bond pays is set when it is issued and does not change. If you buy a bond paying 4 percent and interest rates later rise to 6 percent, your bond is now less attractive — if you tried to sell it, you would have to accept a lower price so the buyer's total return matches what they could get elsewhere. The opposite happens if rates fall: your bond becomes more valuable.

This matters most if you might need to sell before the bond matures. If you hold it to maturity, you get your full principal back regardless of what happened to rates in between. But if you need cash in five years and you bought a ten-year bond, you are selling early, and rising rates will have cost you money.

Right now, interest rates are higher than they were in 2020 and 2021, which means new bonds pay more. If you are considering bonds, compare what they pay to what you could earn in a high-yield savings account or money market fund — the gap tells you whether bonds are worth the extra complexity and risk.

Who should own bonds and who should not

Bonds work best for people who have money they will not need for at least two to three years. If you need the cash sooner, a savings account or money market fund is safer because the value does not fluctuate. Bonds also work better the older you are or the closer you are to retirement — younger investors with decades ahead can usually afford to own mostly stocks and accept bigger swings in exchange for higher long-term growth.

You might own bonds if you have a large amount in stocks and want to reduce how much your total portfolio moves up and down. You might also own them if you have a specific goal coming up — paying for a child's college in ten years, for example — and you want to lock in a known return rather than risk a stock market downturn right before you need the money.

Bonds usually do not make sense if you are in a low tax bracket and have a long time horizon, because the interest is taxed as ordinary income (not at the lower capital gains rate), and you would likely earn more by staying in stocks. They also do not make sense if you cannot tolerate the idea of your investment declining in value even temporarily, because bond prices do fall when rates rise — you just recover that loss if you hold to maturity.

Different types of bonds and what each one costs you

Treasury bonds are issued by the U.S. government and are considered the safest because they are backed by the government's ability to tax and print money. They pay less interest than other bonds. Treasury bonds are also exempt from state and local income tax, which can make them more attractive if you live in a high-tax state.

Corporate bonds are issued by companies and pay more than Treasuries because there is a real risk the company will not pay you back. The better the company's credit rating, the less it pays — a bond from a stable, profitable company pays less than a bond from a company with shaky finances. Corporate bonds are fully taxed as ordinary income at both federal and state levels.

Municipal bonds are issued by cities and states and are usually exempt from federal income tax (and sometimes state tax too if you live in the issuing state). They pay less than corporate bonds, but the tax break can make them worthwhile if you are in a high tax bracket. If you are in a low bracket, the tax savings do not help much and you are better off with a higher-paying bond.

Bond funds and ETFs own many bonds and let you own a piece of each. You pay a small annual fee (usually 0.05 to 0.50 percent per year), but you get when ready diversification and do not have to pick individual bonds. The trade-off is that bond funds do not have a maturity date — the value fluctuates with interest rates, and you could sell at a loss even if you hold for years.

The relationship between your age and how much to own in bonds

A common rule of thumb is to own a percentage in bonds equal to your age — so a 30-year-old might own 30 percent bonds and 70 percent stocks, while a 60-year-old might own 60 percent bonds and 40 percent stocks. This rule assumes you have decades to recover from stock market downturns when you are young, and that you need stability and income as you approach retirement.

This rule is a starting point, not a law. Some people are comfortable with more risk than their age suggests; others are not. Your actual situation matters more than the rule — if you have a pension that will cover your living expenses in retirement, you can afford more stocks at any age. If you have no pension and will depend entirely on your savings, you might want more bonds earlier.

The key is to pick a mix you can actually stick with. If you own 80 percent stocks and the market drops 30 percent, you lose nearly a quarter of your money in a few months. Some people can sleep through that; others panic and sell at the worst time. If bonds help you stay calm and keep investing, they are worth owning even if the math suggests you could earn more with all stocks.

What can go wrong when you own bonds

The most common mistake is buying a bond fund and expecting it to behave like a bond — to hold steady or go up. Bond funds fluctuate with interest rates just like individual bonds do, but because they have no maturity date, you can lose money even if you hold for years. If you buy a bond fund when rates are low and rates then rise, your fund's value drops and stays down until rates fall again.

Another mistake is buying bonds when interest rates are very low, locking in a small return for years, and then watching rates rise and wishing you had waited. There is no way to time this perfectly, but you can reduce the risk by buying shorter-term bonds (which are less sensitive to rate changes) or by spreading your purchases over time rather than putting all your money in at once.

A third mistake is holding too many bonds when you are young and have decades until retirement. Bonds are safe, but they do not grow much, and inflation slowly eats away at their value. If you own 60 percent bonds at age 30, you are probably giving up significant long-term growth for stability you do not yet need.

Bonds versus other ways to earn steady income

Before you buy a bond, compare it to a high-yield savings account or money market fund. These accounts are insured by the FDIC up to $250,000 per account, so there is no risk of losing principal. The interest rate changes with the market, but you can move your money without penalty. If you need the cash within a few years, one of these is usually simpler and safer than a bond.

Dividend-paying stocks are another alternative. They pay income like bonds do, but the payment can change and the stock price fluctuates more. Over long periods, dividend stocks have historically grown faster than bonds, but they are riskier in the short term. Some people own both — bonds for stability and dividend stocks for growth.

Certificates of deposit (CDs) are similar to savings accounts but lock your money away for a set period in exchange for a higher rate. If you know you will not need the money for two years, a two-year CD might pay more than a bond and with less risk, because it is FDIC-insured and the value does not fluctuate.

Frequently Asked Questions

Do I need bonds if I have a 401(k) or IRA?

Not necessarily. Many 401(k) and IRA plans already include bond funds as one of your investment choices. If your plan offers a target-date fund based on when you plan to retire, that fund already includes the right mix of bonds and stocks for your age. Check what you already own before buying more bonds.

What happens to my bond if the company goes bankrupt?

You lose money. Bondholders are paid before stockholders when a company fails, but there may not be enough to pay everyone back. This is why corporate bonds from stable companies pay less than bonds from risky companies — the market prices in the risk. Owning a bond fund spreads this risk across many companies so one failure does not wipe you out.

Should I buy individual bonds or a bond fund?

Bond funds are simpler for most people. You pay a small annual fee but get when ready diversification, automatic reinvestment of interest, and no need to pick individual bonds or worry about selling at the wrong time. Individual bonds make sense if you have a large amount to invest, want to hold to maturity and avoid price fluctuations, and are willing to research credit ratings and bond terms.

Can I lose money in a Treasury bond?

You cannot lose principal if you hold a Treasury bond to maturity — the government will pay you back in full. But if you sell before maturity and interest rates have risen, you will get less than you paid. Treasury bonds are the safest bonds, but they still carry interest rate risk if you need to sell early.

Are bonds a good investment right now?

That depends on your situation, not on what is happening in the market. Bonds make sense if you have money you will not need for several years, want to reduce how much your portfolio moves around, or are approaching retirement. They make less sense if you need the cash soon or if you have decades until retirement and can afford to stay mostly in stocks.