All Bonds Are Not Created Equal
Underline that. There's three things you need to understand: duration, quality, and purpose. Duration is basically how long it is until a bond matures. It also tells you how sensitive the bond is to interest rate changes. The longer you're locked in, the more pain you'll feel if rates move against you. Let me explain why that is. So let's say you have a 30-year rate that you locked in at 3% and the par value is $1,000.
That's typically how bonds are priced. So you have a $1,000 par value and you have a duration of 30 years and the coupon rate, the interest rate it's going to pay is 3%, meaning that for every bond you have, right? For each $1,000 par value, you get $30 in yield. So you get two coupon payments, typically $15 twice a year. So you've locked this in for 30 years. Now what you need to understand is assuming the company does not go out of business, as long as you hold that bond to duration, if you hold it for 30 years, each year they're going to pay you your 3% and at the end they're going to give you back your original par value, which is $1,000.
But during that time period, interest rates go from 3% to 6%. Well now other people are getting paid 6%. You're only getting paid 3% and you're like, this is a major bummer. My buddy over here is getting $60 a year from his bond. I'm only making $30 a year. I don't want this crappy bond anymore. The problem is no one is going to pay par value, going to pay you $1,000 on a bond that's only clipping 3% a year. So if you're like, I want out of this bond.
I need the cash. I need money for retirement or whatever it might be. I need to sell this bond. No one's going to pay you a thousand. You're going to have to sell for a discount and that discount is going to have to adjust to the the prevailing rate. And I haven't done the actual math, but let's just assume the bond is a thousand dollar par value. You might have to sell it for $900. So, if you have to sell before duration, you're not going to get the full thousand dollars you invested in the bond.
Now, if you held it to the end of the 30 years, they're going to pay you every year assuming they don't go bankrupt and they're going to give you back your thousand dollars. The problem is you need to sell it early. That's why duration matters because in retirement in particular, if you're using it to fund income or you're using it for liquidity and you have too long a duration bonds and you need the cash to live, you might have to sell it early.
Short-term bonds are flexible and less affected when the rate moves. Long-term bonds historically have given you more income, but they swing much harder in value. Now, there is a case to be made for long duration bonds as a protection against stock market crashes because historically when stock markets have crashed, longer duration bonds have spiked in value. They are also much more sensitive to rate moves. If you don't believe me, go to Google, type in TLT and look at the price return for the past five years of the 20-year Treasury.
It's down nearly 40% not taking into account coupon payments. And so, the first question to ask about your bond isn't how much does it pay me? The question is how long am I locked in, right? That's the question you need to care about first of all because if you have a five-year bond and you need the money in one year and interest rates move, you might have to sell it for less than what you invested in. On the other hand, if you held it for five years to duration, assuming the company doesn't go bankrupt, you're going to get your money back.
The second thing you need to be thinking about is credit quality. Government-issued bonds by the Treasury are historically the safest. Then you have investment grade corporate bonds, they're next, right? So you you earn the least for government bonds and you earn a little more for corporate bonds. And then you've got what are called high yield bonds, they're a little more risky. So they pay out a slightly higher yield.
They're sometimes called junk bonds, right? The more risk you take, the more interest you pay, but they also have higher default rates. For most retirees, you want to be very careful about the yield you're going to get from junk bonds because often the extra volatility, in my opinion, isn't worth it. You'd probably be better off in stocks than junk bonds. You can make a case for junk bonds, but cuz you have a higher upside.
There might be slightly more volatility, but junk bonds are pretty volatile and you just don't have near the upsides, especially when markets get rough and those bonds start behaving more like stocks than bonds. So the first thing you need to think about, just quickly to recap, is is duration. How long is this bond? The second thing you need to think about is quality. Is it a government bond, a corporate bond, is it a junk bond?
And then the third piece is purpose. I'm going to put all this together in just a minute. This is what a lot of people get wrong. In a retirement portfolio, bonds have a couple of jobs. They're not to make you rich, they're there to reduce volatility, potentially to generate income, and to provide a cushion when stocks fall. But ultimately, what I'm most interested in when I'm putting together a portfolio is the protective nature of fixed income, right?
I don't want you to be forced to sell equities at the worst possible time. So let me give you an idea of what this would look like if we were putting together a portfolio for a client.