There are many types of bonds available to investors, and they come with different risks and benefits. This section describes the typical bond investor in general terms.
Unlike stocks, bonds are often associated with older, more conservative investors. Because bonds typically promise scheduled interest payments and repayment of principal at maturity (assuming no default), they’re generally considered less risky than stocks. That lower risk usually comes with a trade-off: lower expected returns. Investors who want safer, more predictable income often choose debt securities (bonds) over equity (stock) securities.
Remember the Rule of 100? As an investor gets older, they generally allocate more of their portfolio to fixed-income securities like bonds. Here’s the table from the suitability section of common stock:
| Age | Stock % | Bond % |
|---|---|---|
| 30 | 70% | 30% |
| 45 | 55% | 45% |
| 60 | 40% | 60% |
| 70 | 30% | 70% |
The Rule of 100 is often applied to bonds like this: an investor’s age roughly equals the percentage of bonds in their portfolio.
Keep in mind this is a general guideline, not a rule that fits everyone. Some older investors can afford to take more risk because they have substantial assets. For example, an 80-year-old billionaire could choose to hold a large portion of their portfolio in more volatile investments like common stock. On the other hand, some younger investors are more risk-averse and may prefer a higher bond allocation. Bottom line: use the Rule of 100 as a generality, but expect exceptions.
We’ll also look at the different risks that specific types of bonds can carry. Even though bonds are often viewed as “safe,” some bonds are quite risky. Junk bonds, which are typically issued by unproven or financially distressed companies, offer higher yields to compensate investors for that risk. If a default occurs, the investor could lose a significant amount of money.
Interest income is the primary benefit bonds provide. If an investor isn’t seeking income, another asset class may be a better fit. One common exception is zero coupon bonds, which pay interest only at maturity. If an investor wants a predictable payout years in the future but doesn’t need income along the way, a long-term zero coupon bond could be suitable.
Investors who use bonds as part of a long-term portfolio strategy may use one of several approaches. The most popular are:
Bond ladders
A bond ladder is easiest to picture as the rungs of a ladder. In this strategy, the investor buys multiple bonds with a range of maturities.
For example, assume an investor wants to purchase $10,000 of bonds with varying maturities. They could build a ladder like this (assume each bond is $1,000 par):
By spacing maturities evenly (every 3 years in this example), the investor gains maturity diversification. Longer-term bonds are typically more exposed to interest rate and inflation risk, while shorter-term bonds are less exposed. Because longer-term bonds generally carry more risk, they often offer higher yields than shorter-term bonds.
Investors who use ladders often follow a “revolving door” approach. When a bond matures, the proceeds are reinvested into a new long-term bond. Using the example above, after 3 years the 3-year bond matures. The investor could then use those proceeds to buy a new 30-year bond. That’s the “ladder” idea: as one rung is completed (a short-term bond matures), another rung is added (a new long-term bond is purchased).
Bond barbells
A barbell strategy is named after a barbell: weight on both ends and little in the middle. In a bond barbell, the investor buys short-term and long-term bonds, but avoids intermediate-term maturities.
For example, assume an investor wants to purchase $10,000 of bonds with varying maturities (assume each bond is $1,000 par):
This approach is often described as combining the features of both ends of the maturity spectrum:
The long-term bonds typically provide higher yields, but they also involve higher levels of risk. In a barbell, that risk is balanced by the short-term portion of the portfolio.
Bond bullets
A bond bullet strategy refers to a bullseye. Investors using this strategy usually have a specific future date when they want a large payout.
For example, assume an investor is saving for a dream home over a 10-year period. Each year, the investor purchases $100,000 of bonds that will all mature at the 10-year mark:
By the time the investor reaches the 10-year mark, they’ve purchased $1 million of bonds, and all of them mature that year.
Sign up for free to take 7 quiz questions on this topic