What is a Bond?

At a high level, bonds are easy to understand.  A bond is simply a promise to repay a sum of money at a certain point in the future.  These can take the form of loans to governments, companies or other entities.  Some key terms relating to bonds include:

• Face Value/Par Value: This represents the amount that is owed by the issuer to the bond-holder at maturity.

• Coupon: The interest payments made on a bond.  These are generally made semi-annually, quarterly or monthly.  Not all bonds pay a coupon, and these payments can be either fixed or variable.

• Issuer: The borrower that issued the bond, such as the US government, a municipality or a company.

• Maturity: The date at which the issuer repays the face value of the bond to the bondholder.

• Yield: This is the calculation of the annual expected rate of return earned from a bond, assuming the issuer doesn’t default on the obligation.  This metric is more holistic than the coupon, as it also captures the gradual movement of the bond’s price towards its par value as it nears maturity.

The Bond Lifecycle

Now that we’ve established some basic terminology, let’s walk through the life of a bond investment.  Investors typically buy bonds after they’ve been issued, meaning that they generally purchase them from other investors rather than from the issuer.  If the investor is purchasing a coupon-paying bond between payments, they compensate the bond’s previous owner with a pro-rated amount for the accrued interest due for the days that the prior owner held the bond.  This is known as “purchased interest”.  The investor then collects the coupon payments for the remainder of the bond’s life or until the investor sells the bond.  If held to maturity, the investor collects the par value, assuming the issuer has not defaulted in the meantime.   We often see the discussion around fixed income complicated by analysis of duration, the shape of the yield curve and other intricacies.  However, at its core, fixed income investing is conceptually simple.

 

What Types of Bonds are There?

There are a wide variety of bonds within the investable universe.  Let’s break down some characteristics of a few of the most common ones:

• US Treasuries: These bonds are issued by the US government and range in maturity from 4 weeks to 30 years.  The coupon payments are typically either a fixed rate or zero. These bonds are exempt from state and local income tax but are subject to federal income tax.  Given the credit-worthiness of the US government, these bonds are typically very liquid and generally offer lower yields than some other categories.
• Corporate Bonds: These debt securities are issued by corporations and the interest earned from these bonds is fully taxable.  Maturities can range widely.  However, most corporate bonds are callable, meaning that the corporation can refund the face value of the bond to investors prior to maturity.  This benefits the issuer, as they can issue long-term debt, while retaining the flexibility to refinance if interest rates decline.  Call features should play a role in weighing the relative appeal of various bonds.  The credit quality of corporate bonds varies depending on the issuer.
• Asset-Backed/Mortgage-Backed Securities: ABS & MBS are bonds whose cash flows are derived from a pool of underlying assets.  For example, mortgage-backed securities represent a portion of ownership in a pool of mortgages that are then securitized.  Investors can then purchase a security representing a diverse sleeve of mortgages.  The cash flows from these securities are more complex than those of traditional bonds, as each payment includes a portion that is both principal and interest (think of the opposite side of your own mortgage payments).  Unlike traditional bonds, the principal value is reduced over time as mortgage-holders pay down their principal balances. 
• Municipal Bonds: Municipal bonds are issued by state or local government entities and generally finance education or infrastructure projects.  These bonds tend to look a lot like corporate bonds, with fixed coupon payments and are often callable prior to maturity.  These bonds are generally federally tax exempt and are also usually exempt from state income tax if the investor is a resident of the state where the bond was issued.  These bonds are less liquid than treasuries, with liquidity varying widely depending on the issuer.

What Role do Bonds Play in Your Portfolio?

Historically, the conventional wisdom has been that investors buy bonds to generate income, particularly in their retirement years.  While income is an important part of the equation, volatility mitigation is even more significant, especially when investors begin drawing on their portfolio to fund living expenses.  In fact, one of the great fallacies in investing is the mental segregation of income from “principal”.  One of the fundamental tenets of total return investing is that the ultimate objective is to maximize return while minimizing risk.  Return is the aggregation of both market value changes and income.  The breakdown between the income and appreciation portion is largely irrelevant.  In fact, it is often more tax efficient to earn a greater proportion of the total return from capital appreciation as opposed to coupon payments.

 

The real benefit of allocating to fixed income is risk mitigation.  Although equity-heavy portfolios have provided higher absolute returns over the past several decades, assuming that the assets are untouched, the narrative shifts when you factor in withdrawals.  In the case of the simulation illustrated to the right, the 40/60 portfolio displayed a higher likelihood of lasting 35 years in retirement than an 80/20 portfolio, assuming a 4% withdrawal rate.  Not only are your savings more likely to last when you add bonds to a portfolio that is being used to fund your lifestyle, but you also reduce the urge to make rash investment decisions.  In a market downturn, you may be more tempted to deviate from your long-term investment plan or pull capital out of the market if you have a more substantial allocation to equities.  Psychologically, incorporating fixed income may reduce the temptation to deviate from your long-term plan in periods of market distress.

Defining and Evaluating Risk in Fixed Income

When considering any investment endeavor, it’s essential to thoroughly understand the associated risks.  While many view bonds as less risky than equities, that’s a bit of an oversimplification.  Bond prices may be less volatile than equity prices.  However, they come with their own set of risks.  Perhaps the most important to understand is duration risk.  Duration risk represents a fixed income portfolio’s sensitivity to changes in interest rates.  For example, if you buy a 20-year fixed-coupon bond and rates go up or down, the value of the bond can fluctuate dramatically.  The inverse is reinvestment risk.  If you buy a short-term bond and rates decline, you then must reinvest into those lower rates.  Balancing these two risks is a critical component of managing a fixed income portfolio.

In addition, if your bond portfolio has exposure to low-quality bonds, default risk can diminish returns.  This is the risk that the issuer is unable to satisfy their obligations and misses a coupon or principal payment.  If you invest in a broadly diversified basket of fixed income securities, this risk can be minimized, as most bonds are likely to represent a tiny fraction of the overall portfolio.

While bonds generally experience less volatility than equities, they certainly carry their own set of risks.  The real magic happens when you combine equities and fixed income, particularly when you’re drawing on your assets to fund ongoing expenses.  The chart to the right, somewhat unexpectedly, indicates that the volatility risk for a 25% equity/75% fixed income portfolio is lower than that of a 100% fixed income allocation.  While that sounds counterintuitive, the diversification benefits of each asset class complement each other.  As such, adding a small amount of equities to a 100% fixed income portfolio may reduce volatility while increasing expected returns.

 

Key Takeaways

The bond market can be an intimidating place.  In 2025, there are roughly 4,000 publicly traded companies in the US.  That figure is dwarfed by the approximately 500,000 corporate bond issuances outstanding in the US alone.  That doesn’t even begin to account for Federal, municipal and asset-backed issuances.  While bonds can be as complex as you’d like to make them, the fundamental principles are straightforward.  When you purchase a fixed income instrument, you’re essentially buying a loan, in the hope of earning some return, whether that comes in the form of actual interest payments or receiving a larger amount at maturity than you purchased the bond for.

Bonds play a critical part in building diversified portfolios.  Their role as an income generator is eclipsed by their volatility dampening characteristics.  While not always the case, bonds tend to move inversely with equity markets.  This is a particularly valuable feature when you’re drawing on your portfolio to fund lifestyle spending.  A diversified portfolio that includes both equities and bonds encourages good investment habits and allows you to pull from your bond allocation when equities experience volatility.  A fixed income allocation also allows your portfolio to bounce back more rapidly during equity corrections, as drawdowns aren’t as sharp and bonds tend to move inversely to equities.

 

Portfolio construction can be a daunting task, but it doesn’t have to be.  While the universe of bonds is expansive and complex, the takeaway is simple.  Most portfolios experience far better risk-adjusted returns when they include an allocation to fixed income.  As you come closer to tapping into your assets to fund living expenses, that added resiliency during periods of volatility becomes even more beneficial.  Please reach out to your advisor to discuss the specifics of your asset allocation and how it relates to your personalized plan and goals.

Disclosure: This information was prepared by FSM Wealth Advisors, LLC d/b/a Journey Wealth Management, LLC, a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. Neither the information presented nor any opinion expressed herein should be construed as personalized investment, financial planning, tax, or legal advice. For advice specific to your situation, please consult an appropriately qualified professional adviser(s). Certain information herein may have been obtained from various third-party sources; Journey does not guarantee the accuracy or completeness of such information. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance is not indicative of future results.