Bonds in a retirement portfolio

Fixed income is the part of a retirement portfolio people understand least, and the past few years have made the questions more pressing.

What bonds are for

Three functions, which are frequently conflated.

Income. Interest payments, which are predictable in nominal terms.

Volatility reduction. Bonds generally fluctuate less than equities, which reduces overall portfolio variation.

Diversification. The expectation that bonds will perform differently from equities, particularly during equity declines.

That third function is the one that has been questioned, because in a period of rapidly rising interest rates both asset classes fell together, which is precisely when diversification was wanted.

The correlation between bonds and equities is not fixed. It has been negative during periods where the dominant concern was growth, and positive during periods where the dominant concern was inflation.

Which means the diversification benefit is real and conditional, and a portfolio relying on it should recognise that.

Interest rate risk

The mechanism people find counterintuitive.

When interest rates rise, the market value of existing bonds falls, because newly issued bonds pay more.

The size of that effect depends on duration — a measure of sensitivity to rate changes, related to the time until the bond's payments are received.

Longer duration means larger price movements in both directions.

Importantly, for a bond held to maturity, the price movement is temporary: the bond still pays its coupons and returns its principal.

For a bond fund, which continuously replaces maturing holdings, the effect is different: prices fall immediately and the income rises over time as the fund buys higher-yielding bonds.

Over a period roughly equal to the fund's duration, the higher income generally compensates for the price decline.

Credit risk

The other major dimension.

Government bonds carry minimal credit risk. Corporate bonds pay more to compensate for the possibility of default.

The problem for a retirement portfolio is that credit risk correlates with equity risk. Corporate bonds tend to fall when equities fall, because both reflect concerns about the economy.

Which means reaching for yield in the fixed income allocation undermines the diversification the allocation was intended to provide.

The general recommendation for the defensive portion of a portfolio is to take risk on the equity side and keep the fixed income side genuinely defensive.

Inflation-protected bonds

A specific and useful instrument for retirees.

These adjust principal in line with a measure of consumer prices, which means they provide a real return rather than a nominal one.

For someone whose main long-term risk is inflation, that is a direct hedge unavailable elsewhere.

The mechanics have quirks worth understanding, including how the inflation adjustment is taxed, which makes them generally more suitable for tax-advantaged accounts.

Bonds versus bond funds

A recurring debate.

Individual bonds held to maturity provide a known outcome, which is valuable for funding a specific future expense.

A ladder of individual bonds maturing in successive years is a well-established approach for generating predictable retirement income.

Funds provide diversification and convenience, and remove the need to reinvest maturing bonds.

For most people, low-cost funds are adequate. For someone matching specific liabilities, individual bonds have a genuine advantage.

How much to hold

The perennial question, with no universal answer.

The traditional guidance based on age is a crude starting point rather than a rule.

The more useful framing is about what the fixed income allocation needs to do: cover several years of spending without selling equities, and reduce portfolio volatility to a level that will actually be tolerated.

Someone with substantial guaranteed income covering essentials needs less. Someone whose portfolio funds everything needs more.

And the counterintuitive finding from the withdrawal literature applies: portfolios that are too conservative fail more often over thirty years, not less.

Matching bonds to liabilities

An approach worth knowing about for specific purposes.

Where a known expense falls in a known year — a planned purchase, a tax payment, a period before Social Security begins — a bond maturing in that year removes the uncertainty entirely.

Building a ladder of maturities across the first several years of retirement is a well-established way of funding the period of highest sequence risk without depending on market conditions.

It is more administration than a single bond fund and it converts an uncertain outcome into a known one, which is occasionally worth the effort.

General information only, not financial advice. Bond prices and yields move — consult a qualified adviser about your own situation.