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I recently received this email:

“I have been following your work since 2011 when I was an intern in emergency medicine. Thanks to you, I have saved up an incredible amount of money and will be financially free in the next five years (I’m currently 39, will be 40 this year) to the point where I may exit emergency medicine and retire or cut down to ultra part-time work because I still enjoy EM. Up until now, I have been ultra-aggressive in my investments as I am exclusively invested in the S&P 500 with a 10% small cap value tilt. My plan is to continue my ultra-aggressive investment plan until I stop working. My question for you is this: once I stop working, what is a recommended investment plan strategy for the rest of my life? Do I put all my money in a target date fund or do I split it 50-50 in the S&P 500 and bonds? I would appreciate any guidance or recommendations you may have. I have already saved up for my kids' college in their 529 accounts. I could pay off my house today if I wanted, but I am enjoying my low interest rate of 2.7% while I invest the rest of my money. I carry no other debt and everything else that I own, including my cars, are all paid off.”

I congratulated him on his success and told him that yes, it was probably time to dial back the risk somewhat and perhaps add some bonds into the mix. After all, it seems silly to keep playing the game after you've won it, and it is definitely silly to risk money you need in order to get money you don't need in order to buy things you don't want so you can impress people you don't care about. I told him any mix between 50/50 and 80/20 seems reasonable to me, given what he had told me. However, his follow-up question needed more info than I was going to put into a single email.

“For the bond portion of my allocation, what do I use?”

That's like asking, “For the stocks portion of my allocation, what do I use?” While it's a great question, it doesn't have any sort of easy answer, just like other frequent questions like “Should I pay off debt or invest?” and “Should I make Roth or traditional 401(k) contributions?” Before you become financially literate, you might mistakenly think the answers to these questions are easy and straightforward. But without a functional crystal ball, they're usually impossible to answer. You do the best you can, make a reasonable decision, and move forward with life.

In this post, I thought it would be worthwhile to discuss this question. Note that we are not discussing any of the following questions:

Don't get me wrong. They're all good questions. But we need to limit the scope of this article to answer the question at hand in a concise way.

Risk and Bonds

The most important aspect of investing is not returns; it's risk management. Investing is all about risk management. So, if we're going to talk about an asset class and its sub-asset classes, what we really need to talk about is risk. When it comes to investing in bonds, you have to be aware of five risks. Let's spend some time on each of them.

#1 Interest Rate/Term Risk

The first risk is the risk that interest rates change. Mostly, the risk is that they go up, because when rates go up, the value of a bond you already own goes down, and vice versa. This is because investors buying a new investment can either buy a bond that has a higher yield than yours, or they can buy the one you're selling. The value of the bond must be adjusted so the yields are now equal. So, it HAS to be worth less than you paid for it.

The main way to control interest rate risk is to keep durations short. Duration is just a fancy term that determines how much the value of your bond will drop if interest rates increase. Cash has the ultimate short duration. It has a duration of zero years. If interest rates go up, you don't lose any principal at all. “Cash” generally means high-yield savings accounts and money market funds, but other investments also avoid the loss of principal when interest rates rise—like certificates of deposit (CDs), savings bonds, and the TSP G Fund. Once you move away from those investments, the longer the term on the bond, the higher the maturity, and the more interest rate/term risk you are running. Most of the time, that higher risk comes with a higher yield (risk and return are related after all), but there are times when the yield curve is “inverted” when that is not necessarily the case. The more yield you chase, the more risk you run, and the more you will lose if interest rates rise.

As a general rule, I prefer to take my risk on the equity side of my portfolio, so I tend to keep interest rates short to medium. But a case can be made for long-term bonds as a portfolio diversifier. When the economy (and stocks) really tank, interest rates tend to fall, and those long bonds benefit the most from that bump in value that comes from lower interest rates. You just have to be prepared for times like 2022, when very long-term bonds lost 41% of their value. If you can't tolerate that from the “safe” portion of your portfolio and that will cause you to panic and sell low, don't use long-term bonds.

#2 Credit/Default Risk

The next important risk with bonds is credit or default risk. At their essence, bonds are a loan to an entity, such as a government or a business, and credit risk is the risk that they don't pay back that loan and instead default on it. Default risk is generally considered to be very low when loaning money to the US government (Treasuries), a little higher when loaning money to states and municipalities (municipal bonds), significantly higher when loaning money to companies (corporates), and even higher when loaning money to businesses that might go out of business (junk bonds). It can be particularly high when loaning money to individuals to buy houses (mortgage bonds), and it's astronomically high when loaning money to individuals for whatever they want without any collateral (peer-to-peer loans).

Two methods are used to manage this risk. The first is not to loan money to entities unlikely to pay you back. At all. For example, some people ONLY loan money to the US government. Their entire bond portfolio is Treasuries. While I suppose the US government can default on its bonds, it doesn't do it very often and shouldn't have to, given its ability to raise taxes and defend itself using its military. The other method is diversification. Not only between subasset classes like Treasuries, munis, corporates, and mortgages, but within them as well by purchasing dozens, hundreds, or even thousands of different bonds. If one subasset class does poorly, no big deal, and you won't even notice if one of your ten thousand individual bonds defaults.

As I mentioned earlier, I prefer to take my risk on the equity side. I don't buy corporate bonds at all. Our portfolio is basically all Treasuries and munis. I figure if you really want to take risk on the “fixed income” side of your portfolio, you might as well go big. Why mess around with corporate bonds or even junk bonds when you can make 7%-11% a year with a diversified portfolio of professionally managed loans to real estate developers, all in first lien position? Even a portfolio of peer-to-peer loans may get you 8%-12%, although there is a lot more risk there than in real estate-backed loans. Our real estate allocation also includes a 5% slice of real estate debt.

#3 Inflation Risk

Perhaps the most important risk when it comes to bonds is inflation risk. Inflation absolutely decimates the value of most bonds. Imagine loaning money to someone at an interest rate of 3% for 30 years, then having inflation increase to 6% a year for the next 30 years. Not only will you be paid less interest over that time period than you could earn with a very safe cash investment, but when you are paid back the principal at the end of the 30 years, it will only be worth 16% of what you loaned out decades earlier.

Two methods are used to minimize this risk. The first is to keep durations short. Typically in inflationary times, interest rates also become quite high. If inflation shows up, you get your principal back relatively quickly—before it falls too much in value—and you can reinvest it at the new, higher rates. The second method is to somehow index those bond values to inflation. In the US, the main products used to do this are Treasury Inflation Protected Securities (TIPS) and Type I Savings Bonds (I Bonds). These bonds are typically priced in such a way as to protect the investor from unexpected inflation; if inflation is what people expect it to be when the bonds are purchased, nominal bonds will pay about the same as inflation-indexed bonds. If inflation is less, the nominal bonds end up doing better, and if it is more, the inflation-indexed bonds do better.

We decided to just split the difference in our portfolio, so half of our bond portfolio is inflation-indexed and the other half is not, although, as mentioned earlier, we tend to keep durations pretty short anyway.

#4 Unique Risks of Bond Funds

Bond funds are a convenient way to invest in bonds. Like all mutual funds, you get the following benefits:

  • Professional management
  • Daily liquidity
  • Pooled costs
  • Massive diversification

However, there are some potential downsides compared to building your own portfolio of bonds. If you just buy a bond, its value goes up and down every day until it matures. If it has to be sold at any time before the date of maturity, it might be higher or lower than its value on the day of maturity. Consider a bond fund in a year when bond values drop dramatically and all the investors decide to pull their money out of the fund. That action forces the manager to fire-sale bonds while their value is down, locking in those losses and passing them on to the remaining investors.

Due to this risk, some bond investors just buy individual bonds (and typically just Treasuries) so this can't happen to them. When you hear people talk about “bond ladders,” this is what they're talking about. The rung of the ladder matures in the year when they plan to spend that money, so there's no risk of having to sell while values are low. Since Treasuries can be purchased for no commission and without an ongoing fee, you can save a few basis points even when compared to a low-cost Treasury bond fund.

We have gone back and forth on this particular risk, owning both funds and individual Treasuries, but we mostly prefer the simplicity, diversification, and liquidity of a fund more than eliminating this relatively small risk.

#5 Illiquidity Risk

Some bonds are easier to sell than others in strange economic times. Treasuries are pretty easy to liquidate, but some obscure corporate bond may not be. And a private real estate debt fund may become completely illiquid for months or years. Illiquidity risk seems to be related to but is not equal to default risk. If there is any possibility you may need your money back before the bonds mature, stick with Treasuries or use a fund.

More information here:

Some Reasonable Bond Portfolios

I hope this list provides a similar function to the 150 Portfolios Better Than Yours post. The point is that the perfect portfolio can't be known in advance, so choose something reasonable and stick with it. Here are 12 reasonable bond portfolios. Note that these portfolios and the percentages only refer to the bond portion of a portfolio. There are precious few people on this planet for whom a 100% bond portfolio is appropriate.

#1 100% Total Bond Market Fund (TBM)

Vanguard, Fidelity, Schwab, BlackRock, and the Federal TSP all offer a very low-cost “total bond market” fund. These include essentially all of the investment-grade nominal bonds available in the US, including Treasuries, corporates, and even mortgage bonds. Notably excluded are TIPS, savings bonds, municipal bonds, and all foreign bonds.

#2 50% TBM/50% TIPS

Lots of people besides me split their bonds 50% nominal and 50% inflation-indexed. This is an easy way to do it with very broad diversification. TIPS funds are available in various durations from the usual providers.

#3 50% Intermediate Bond Index/50% TIPS

Don't like mortgage bonds? You can exclude them by using a fund like Vanguard's Intermediate Bond Index Fund (VBILX). Add in some cash, and this would be my parents' fixed-income portfolio.

#4 50% Intermediate Treasury/50% TIPS

Don't like corporates either? Here's a good option.

#5 33% TBM/33% TIPS 33%/International Bonds

This combination is a whole lot closer to a “total bond” approach than 100% TBM.

#6 50% Intermediate Munis/50% TIPS

There are no municipal (federal income tax-free) TIPS funds, but this isn't a bad approach if you invest in bonds in your taxable account. We've got slightly more complexity than this, but this is essentially our bond portfolio.

#7 100% TSP G Fund

Those with access to the federal Thrift Savings Plan could put all of their bond money into the G Fund, which provides one of the few “free lunches” available in bond investing—Treasury yields with money market risk.

#8 100% Money Market Fund

Just keeping it all in cash isn't as bananas as it might sound. The yield is usually a little lower than short-term bonds, but the principal is also a little bit safer. If you really want to take all your risk on the equity side, this is one way to do it. It's also available in lower-yielding municipal or Treasury-only varieties for those looking for those tax advantages.

#9 20% International Bonds/20% TIPS/20% Junk Bonds/20% Total Bond Market/10% Real Estate Debt/10% Peer-to-Peer Loans

Prefer more risk (and complexity)? This portfolio includes eight bond asset classes across six funds.

#10 30-Year TIPS Ladder

Some people build a 30-year ladder of individual TIPS, although they have to compromise a bit since there are a few missing rungs for years when the Treasury didn't issue them. The idea is to lock in a real (after-inflation) amount that can be spent in each of the 30 years of retirement. It's not quite the same thing as a pension or a SPIA, but it's hard to get those in an inflation-indexed variety nowadays anyway, at least outside of Social Security.

#11 100% CDs

If you prefer CDs instead of bonds, it is perfectly reasonable to use them. You get more stability of principal, FDIC insurance, and sometimes even higher yields if you shop carefully.

#12 100% MYGAs

Long-term readers know I'm generally not a fan of annuities because they are often products designed to be sold, not bought. However, a Multi-Year Guaranteed Annuity (MYGA) is a type of annuity that competes well with a CD retirement strategy. It offers the advantage of shielding the interest yield from taxation until you're ready to spend the money in retirement. When the term is up, you can exchange tax-free from one to another. They don't rebalance well with the rest of the portfolio, and you definitely should be sure that you don't want to spend the money before age 59 1/2 before buying one.

More information here:

After Asset Allocation

Once you choose the asset allocation you want, the rest is usually pretty easy. Most of these asset allocations are available in very low-cost, broadly diversified options if you invest at Vanguard. Good options can generally be found at Schwab and Fidelity, and via BlackRock, Vanguard, and Schwab ETFs at any brokerage. Your 401(k), where you may prefer to hold your bonds, probably won't offer all of them, but it will hopefully offer you something acceptable to use.

The Bottom Line

Many people think bonds are more complex to invest in than stocks. But in reality, they are far simpler to understand, and it is easier to predict their behavior in various future economic scenarios. Adding them to your portfolio is a good way to decrease the amount of risk you're taking. If you're having trouble understanding them, consider reading books such as the following:

What do you think? What does your bond allocation look like and why?