The 10 Commandments of Bonds
Bonds are on my mind this month. For my own personal benefit, and maybe even for others, I felt I should write down my core beliefs about using bonds in a retirement portfolio.
In the simplest terms possible, here’s what I believe and what I use with clients, and I think this aligns with what the vast majority of unbiased economists and financial experts believe:
1. Asset Allocation Is The Key
The single most important decision in portfolio design—both pre- and post-retirement—is your stock-to-bond split (e.g., 50/50 vs. 100/0). It dictates your total risk, portfolio swings, and overall returns.
2. Bonds Are For Ballast and Behavioral Insurance
Bonds are defensive. They exist to protect capital and reduce portfolio drawdowns. By damping drawdowns, they prevent panic-selling stocks during market crashes and provide some peace of mind even when the stock market is doing poorly (i.e., you’re not going to lose everything).
3. Have Realistic Return Expectations
Stocks are the growth engine in a portfolio; Bonds provide safety. Bonds are meant to keep pace with inflation and deliver a small extra yield to cover interest rate and credit risk—not to act as high-growth engines. If you’re getting inflation plus 1-2%, you’re doing pretty well.
4. Protect Yourself from “Sequence-of-Returns” Risk
SOR Risk is a mathematical reality. Selling an asset while it’s down makes it hard to recover the equivalent value through later growth. In retirement, bonds provide a safe monthly paycheck. Selling your bonds to pay for groceries, instead of selling stocks, during downturns prevents permanent wealth loss.
5. Use Bonds for Rebalancing
Bonds provide safe "dry powder" needed to rebalance when the stock market falls. Without them, you have no dry powder to buy stocks when they’re on sale.
6. Match Cash Flows with Ladders
For known, fixed future expenses (like annual living costs in retirement), a bond ladder, using individual bonds or bullet bond ETFs, eliminates interest rate uncertainty by locking in exact maturity dates and values.
7. Keep Duration Sensible
Bonds fluctuate in value when interest rates change (duration measures this sensitivity). Limiting a bond portfolio’s effective duration helps insulate you against big swings. Generally, I recommend keeping a bond portfolio's effective duration <7 years.
8. Hedge Against Inflation
Since future inflation is unpredictable, it makes sense to insulate the bond portion of a portfolio against unexpected inflation by using Treasury Inflation-Protected Securities (TIPS). Blending nominal Treasuries and Inflation-Protected Treasuries makes sense because if actual inflation is higher than expected, the TIPS return will be higher than expected, but the nominal Treasury return will be lower. And vice versa if inflation comes in lower than expected. Splitting a bond ladder 50/50 between nominal Treasuries and TIPS hedges both outcomes!
9. Know When to Use a Bond Fund vs. an Individual Bond
Bond Funds are useful for perpetual asset allocation when you have no specific, fixed-date liabilities. Individual Bond Ladders or bullet bond ETFs make more sense when you must meet precise expense dates and want to minimize the risk of loss. I personally have 10 years of living expenses in a bond ladder.
10. Stick to Investment Grade Bonds
Avoid bonds or bond funds rated below Investment Grade (aka “Junk Bonds”). There are a lot of them. They have many of the downsides of stocks, but without the upsides. It's not an asset class most investors should be dabbling in.
Putting all this together into a proper asset allocation strategy isn't simple. Personally, I find the bond allocation, especially in retirement, can often be more complex than the stock allocation!
If you want to learn more about bonds, two books I recommend are:
Why Bother with Bonds by Rick Van Ness (a short, practical book).
A Fabulous Debt by Robin Wigglesworth (a fascinating history of bonds since ancient times)