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Bonds · 09 / 09
Bonds in a portfolioLevel 2Intermediate9 minUpdated

The special role of bonds in a portfolio

Bonds bring stability and diversification to a portfolio, because they often move out of step with stocks. Bonds are not risk-free, but they are typically the calmest layer of a portfolio.

What you'll learn
  • Three roles bonds can play in a portfolio
  • Three key risks that come with bonds
  • The most common mistakes and a checklist for building your own bond allocation

Three roles

Bonds typically have three jobs in a portfolio. It is worth choosing deliberately, because the role determines both the duration and the credit quality.

Stabilizer
Smooths the portfolio's journey, especially when stocks fall, because bonds often move out of step with them.
Cash flow
Regular and predictable coupon income without selling holdings.
Alternative to cash
Short-term bonds earn a return on money that is waiting to be used or invested.

Three risks

Bonds are not risk-free. Three risks are worth keeping in mind:

  • Interest rate risk: interest rates rise, and the price of bonds already in circulation falls.
  • Credit risk: the borrower doesn't repay as agreed.
  • Liquidity risk: you can't sell the bond at a good price when you want to.
Bonds are not risk-free, but they are typically the calmest layer of a portfolio.

Common mistakes

A few mistakes keep recurring among bond investors year after year.

What happens
A long-term bond fund can fall by tens of percent when interest rates rise.
Why it surprises
The product is considered safe, so the fall feels like a fault, even though it is the mechanism at work.

How to build your bond allocation

Building a bond allocation comes down to six questions. When you answer them, the allocation becomes controlled rather than random.

  • Purpose: stability, cash flow or an alternative to cash?
  • Duration: how much interest rate sensitivity can you tolerate; short or long?
  • Credit quality: investment grade for a stable core, high yield only as a considered addition.
  • Implementation: a diversified bond ETF for most people; an individual bond if you want a fixed maturity date.
  • Real return: does the expected return exceed inflation?
  • Role: how does this fit with the other parts of the portfolio?

This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns.

Check your understanding
Test yourself: bonds in a portfolio
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Why do bonds smooth the portfolio's journey?
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What is the most common mistake bond investors make?
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What should you define first when building a bond allocation?
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