Understanding Bonds: Lending Money for Interest

When you buy a bond, you’re lending money to a government or corporation. They promise to pay you interest regularly and return your money on a specific date.

Unlike stocks, where you’re an owner sharing in profits, bonds make you a lender collecting interest. This fundamental difference explains why bonds behave differently—and why they belong in most investment portfolios.

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The Simple Explanation

A bond is an IOU with specific terms:

• Principal: The amount you lend
• Coupon rate: The annual interest rate
• Maturity date: When they return your principal
• Issuer: Who’s borrowing (government or company)

Example: You buy a $1,000 bond with a 5% coupon and 10-year maturity.

• You lend $1,000 today
• You receive $50/year for 10 years ($500 total interest)
• You get your $1,000 back in 10 years
• Total return: $1,500 for a $1,000 investment

That’s the entire concept. Everything else is details.

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Why Bonds Exist

For Borrowers

Governments and companies need money for projects—building infrastructure, expanding businesses, funding operations during cash crunches.

Issuing bonds lets them raise money without:

• Going to banks (which may have stricter terms)
• Selling ownership shares (which dilutes existing owners)

For Lenders (You)

Bonds offer:

• Predictable income: Know exactly what you’ll receive
• Lower risk: Contractual payments, not dependent on profits
• Diversification: Behave differently than stocks
• Capital preservation: Return of principal at maturity

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Types of Bonds

Government Bonds

U.S. Treasury Securities (safest bonds in the world):

• Treasury Bills (T-Bills): Mature in less than 1 year
• Treasury Notes: Mature in 2-10 years
• Treasury Bonds: Mature in 20-30 years
• I Bonds: Inflation-protected savings bonds

Treasury bonds are backed by the U.S. government’s ability to tax and print money—default risk is essentially zero.

Municipal Bonds (“Munis”):

• Issued by states, cities, counties
• Interest often exempt from federal (sometimes state) taxes
• Fund schools, roads, hospitals, infrastructure

Corporate Bonds

Companies issue bonds to fund operations and growth.

Investment-grade: Issued by financially stable companies (lower yield, lower risk) High-yield (junk bonds): Issued by riskier companies (higher yield, higher default risk)

Credit rating agencies (Moody’s, S&P, Fitch) grade bonds from AAA (safest) to D (defaulted).

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How Bond Prices Move

This confuses many investors: bond prices and interest rates move in opposite directions.

When interest rates rise: Existing bond prices fall When interest rates fall: Existing bond prices rise

Why This Happens

Imagine you own a bond paying 4%. Then new bonds start paying 5%.

Nobody wants your 4% bond at full price when they can buy 5% bonds. Your bond’s price must drop until its effective yield matches market rates.

The good news: If you hold to maturity, price fluctuations don’t matter. You get your full principal back regardless of what happened to prices in between.

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Bond Yields Explained

Coupon rate: The stated interest rate when the bond was issued Current yield: Annual interest ÷ current price Yield to maturity (YTM): Total return if held to maturity, including price changes

For new investors, focus on yield to maturity—it’s the most complete picture of expected return.

Understanding the Yield Curve

The yield curve shows interest rates across different maturities.

Normal curve: Longer maturities pay higher yields (you’re compensated for tying up money longer) Inverted curve: Short-term rates exceed long-term (often signals recession concerns)

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Bonds vs. Stocks

Characteristic	Bonds	Stocks
You are	A lender	An owner
Income	Fixed interest payments	Variable dividends (if any)
Payment priority	Paid first	Paid last
Risk	Lower	Higher
Growth potential	Limited	Unlimited
Volatility	Lower	Higher
Historical return	4-6%	7-10%

Neither is “better”—they serve different purposes in a portfolio.

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The Role of Bonds in Your Portfolio

Stability

When stocks crash, high-quality bonds often hold value or even rise. This “flight to safety” reduces overall portfolio volatility.

During the 2008 financial crisis:

• Stocks fell ~50%
• Treasury bonds gained ~20%

A 60/40 stock/bond portfolio fell less severely than all-stock portfolios.

Income

Bonds provide reliable income regardless of what stocks do. Retirees often shift toward bonds for this predictable cash flow.

Diversification

Bonds and stocks don’t always move together. This “low correlation” means owning both reduces overall portfolio risk.

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Bond Risks

Interest Rate Risk

When rates rise, existing bond prices fall. Longer-maturity bonds are more sensitive to rate changes.

Protection: Hold bonds to maturity, or use shorter-term bonds.

Credit/Default Risk

The borrower might fail to pay. Corporate bonds carry more default risk than government bonds.

Protection: Stick with investment-grade bonds or diversify through bond funds.

Inflation Risk

Fixed payments lose purchasing power as inflation rises. A 4% bond doesn’t help if inflation is 5%.

Protection: Consider I Bonds, TIPS (Treasury Inflation-Protected Securities), or shorter maturities.

Reinvestment Risk

When your bond matures, you might have to reinvest at lower rates.

Protection: Bond ladders (spreading maturities across multiple years).

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How to Invest in Bonds

Individual Bonds

Pros:

• Know exact maturity date and value
• Can hold to maturity, ignoring price swings
• Direct control over credit quality

Cons:

• Requires significant capital for diversification
• Research-intensive
• Less liquid than funds

Where to buy: TreasuryDirect.gov (Treasuries), brokerages (corporate/muni)

Bond Funds

Pros:

• Instant diversification across many bonds
• Professional management
• Easy to buy/sell
• Low minimums

Cons:

• No guaranteed maturity value
• Ongoing management fees
• Manager makes selection decisions

Popular bond funds:

• Total Bond Market Index: Broad U.S. bond exposure
• Treasury Funds: Government bonds only
• Short-Term Bond Funds: Lower interest rate risk
• Corporate Bond Funds: Higher yield, higher risk

Bond ETFs

Exchange-traded funds holding bonds. Trade like stocks throughout the day, often with lower fees than mutual funds.

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Building a Bond Allocation

Age-Based Guidelines

Traditional rule: “Own your age in bonds.”

• Age 30: 30% bonds, 70% stocks
• Age 50: 50% bonds, 50% stocks
• Age 70: 70% bonds, 30% stocks

Modern approach: Many financial advisors suggest more aggressive stock allocations for longer lifespans:

• Under 40: 10-20% bonds
• 40-60: 20-40% bonds
• 60+: 30-50% bonds

Risk Tolerance

If market drops make you panic, more bonds provide stability. If you’re comfortable with volatility, fewer bonds allow more growth potential.

Time Horizon

Money needed in:

• Less than 3 years: Mostly bonds or cash
• 3-10 years: Mix of stocks and bonds
• 10+ years: Mostly stocks, some bonds

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Treasury Bonds: The Foundation

U.S. Treasury securities deserve special mention as the safest bonds available.

How to Buy

TreasuryDirect.gov: Buy directly from the government with no fees Brokerages: Buy through any investment account

I Bonds (Inflation Savings Bonds)

Special Treasury bonds that adjust for inflation:

• Current rate: Fixed rate + inflation rate
• Protected against inflation eating returns
• $10,000/year purchase limit per person
• Must hold at least 1 year
• No state/local taxes on interest

I Bonds are excellent for emergency funds and near-term savings.

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Common Bond Mistakes

Reaching for Yield

High-yield bonds pay more because they’re riskier. Don’t chase yield without understanding the additional default risk.

Ignoring Interest Rate Sensitivity

Long-term bonds lose more when rates rise. Match bond duration to your time horizon.

Forgetting About Taxes

Bond interest is taxed as ordinary income. In taxable accounts, municipal bonds may offer better after-tax returns.

Selling in Panic

If you must sell bonds before maturity during rising rate periods, you’ll lock in losses. Only invest money you can leave invested.

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Your Action Plan

This week:

1. Learn the difference between Treasury, corporate, and municipal bonds
2. Check if your 401(k) or IRA offers bond fund options
3. Determine your appropriate stock/bond allocation

This month:

1. Consider I Bonds for inflation-protected savings (TreasuryDirect.gov)
2. Research total bond market index funds
3. Review your current portfolio’s bond allocation

Ongoing:

1. Rebalance annually to maintain target allocation
2. Gradually increase bond allocation as you age
3. Use bonds for goals within 5-10 year horizons

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Building wealth requires both growth (stocks) and stability (bonds). BUDGT helps you master daily spending so you have money left for both—see what’s safe to spend today.