Bonds and Fixed Income

You're the Bank Now

Buy a stock and you own a sliver of a company. Buy a bond and you've done something different — you've lent someone money. Governments and corporations both need to borrow, and instead of walking into a bank, they issue bonds directly to investors: you hand over cash today, and in exchange they promise to pay you back later, with interest along the way. The U.S. government has leaned on this exact tool since before it was the U.S. government — the Continental Congress sold bonds to finance the Revolutionary War, and "war bonds" funded both World Wars a century and a half later.

Bonds don't get talked about nearly as much as stocks, but the bond market is actually larger — more money sits in fixed income globally than in equities. Every pension fund, every insurance company, every "safe" portion of a target-date retirement fund leans on bonds to do a job stocks can't: pay a predictable amount, on a predictable schedule.

The Anatomy of a Bond

Every bond, no matter who issued it, is described by the same four numbers:

• Face value (par value): what the bond pays back at maturity — usually $1,000 for an individual bond.
• Coupon rate: the fixed interest rate paid on the face value, almost always annually or semi-annually. A $1,000 bond with a 5% coupon pays $50 a year.
• Maturity: the date the issuer pays back the face value and the loan ends. Bonds range from a few months (T-bills) to 30 years (long bonds).
• Yield: the return you'd actually get buying the bond today — which is not the same as the coupon rate the moment the bond trades for anything other than its face value.

Why Bond Prices Move Opposite Rates

This is the one idea that makes the rest of fixed income click: when interest rates rise, existing bond prices fall — and when rates fall, existing bond prices rise. The mechanism is simpler than it sounds. Say you own a bond paying a fixed 3% coupon, and then rates in the broader market jump to 5%. Nobody wants to pay full price for your 3% bond anymore when brand-new bonds are paying 5% — so the price of your bond has to drop until its yield (what a buyer would actually earn from here) catches up to what's available elsewhere.

Bond price = PV(all future coupon payments) + PV(face value at maturity)

This is exactly why 2022 was one of the worst years on record for bond funds: the Fed raised rates aggressively to fight inflation, and every existing lower-coupon bond in the market got repriced downward all at once.

Types of Bonds, Ranked by Risk

• U.S. Treasuries: issued by the federal government, backed by its ability to tax and print money. About as close to "risk-free" as investing gets — which is exactly why the risk-free rate in CAPM (Lesson 1 of Quant Investing) is a Treasury rate.
• Municipal bonds ("munis"): issued by states and cities to fund roads, schools, hospitals. Often exempt from federal (and sometimes state) income tax, which matters more the higher your tax bracket.
• Investment-grade corporate bonds: issued by financially healthy companies. Higher yield than Treasuries to compensate for the (small) chance the company doesn't pay you back.
• High-yield ("junk") bonds: issued by companies with weaker credit. Meaningfully higher yield, meaningfully higher default risk. Credit rating agencies — Moody's, S&P, Fitch — grade every bond from AAA down to junk so investors can gauge that risk at a glance.

Duration: How Sensitive Is Your Bond?

Duration is a rough measure of how much a bond's price moves for a 1% change in rates — and the single biggest driver of it is time to maturity. A 30-year Treasury swings far more violently on a rate move than a 6-month T-bill does, because there are decades of future coupon payments getting repriced instead of just a few months' worth. If you're worried about rates rising, shorter-duration bonds are the more conservative place to hide; if you think rates are about to fall, longer duration is where the bigger gains sit.

Where Bonds Fit In Your Portfolio

Back in Lesson 6, the three-fund portfolio held a slice of BND — the U.S. bond market fund. Bonds aren't there to make you rich; stocks do that job better over the long run. They're there because bonds and stocks don't usually crash at the same time for the same reason, so holding both smooths out the ride. That's also exactly why the "hold your age in bonds" heuristic exists — the closer you are to needing the money, the less you can afford a stock-market gut punch right before you need to spend it.