Invest in index funds according to your asset allocation of stocks and bonds and rebalance yearly. This is the basic advice that will lead you to financial freedom on your terms. To be honest, once you grasp this, you really don't need to inherently understand all that much about how the investments (stocks and bonds mainly) actually work. However, a lack of understanding can feel uncomfortable. So most of us, myself included, like to understand how they work. And there is a lot of great information out there about the stock market. But the bond market tend to be a much bigger black box. And a key concept to understand about bonds is how their price correlates with interest rates.

In this post, let's explore this key concept of bonds and interest rates and how it can impact our investing strategy.

A refresher on bonds

A quick refresher on basics.

A bond is basically an IOU from the government, a corporation, or other entity. You give them money and they promise you to give that amount of money back with a fixed interest rate at a later date (called the maturity of the bond, like 5 years, 7 years, or whatever).

In general, bonds are lower risk than stocks because you “buy” a largely fixed interest rate that you theoretically are guaranteed to receive if you hold the bond to maturity. Since it is lower risk and more stable, bonds generally have a lower return. But, stability and decreased risk play an important role in any investor’s portfolio.

Now, there are tons of different types of bonds. Treasury bonds, G bonds, inflation linked bonds like I-bonds or TIPS, corporate bonds, junk bonds, and so on. Within this range of bonds, some are riskier than others. 

Junk bonds are bonds from companies that have a high risk of default. Thus, this risk carries a higher potential return. Meanwhile, the government is very low risk to default so risk and returns are lower with things like treasury bonds.

For the purposes of this post, let’s just say we are discussing generic U.S. government bonds to keep things simple.

So, like anything involving an investment, we always seek to do what we can to get the greatest returns. With stocks, we know this is largely dependent on the performance of the underlying company or companies if we are talking about an index fund.

But what would make the rate of return on an IOU issued by a stable issuer like the US government higher or lower?

The relationship between bonds and interest rates

Let's discuss this without getting too into the weeds.

The price of a bond is the amount of money you need to pay to pay it. And the yield of the bond is the return you receive in the form of (for our purposes here) a fixed interest rate.

New bond yields are influenced by the interest rates set by the Federal Reserve. So, if the Fed increases rates, the yield of new bonds is higher. And if the Fed drops the interest rate, the yield of new bonds is lower.

Meanwhile, the yield of previously issued bonds does not change. At least not immediately. Just put a pin in that for now.

Once interest rates change, bond investors now have a choice

They can either buy the newly issued bonds or buy a previously issued bond. So, which is better?

Well, it depends on what the interest rates do:

• If interest rates rise, then yields on newer bonds rise as well and newer bonds are more desirable
  
• If interest rates fall, then yields on newer bonds fall as well and older bonds are more desirable

What is the result end result of this?

• If interest rates rise, the price of older bonds comes down as they look less attractive to buyers
  
• If interest rates fall, the price of older bonds goes up as they look more attractive to buyers

But how long do these price fluctuations last?

Not forever, of course.

Let's use an example to help illustrate.

If interest rates rise, that means that previously issued bonds with lower yields look worse. So their price drops. Well, as their price drops, their yield actually increases! Because the interest rates are fixed, but now the price is lower. This the yield (rate of return/price) increases until it equilibrates with the new higher interest rate and corresponding yield of newer bonds.

The opposite is true as well. If interest rates fall and the price of older bonds rises, their yield will subsequently fall until an equilibrium with the now lower yields of newer bonds is reached.

The market always accommodates.

What is a bond investor to do with this information?

This is all great to understand and it makes sense in an academic sense. But that does us little good unless we can implement a strategy to maximize results in the real world.

If you are investing in bonds, you can make money the following ways:

• Buy newly issued bonds when interest rates go up (because they will have higher yields)
• Buy older bonds with higher yields when interest rates go down
• If you are a seller you can also try to make money by trading both newer and older stocks trying to buy low and sell high during the period of price fluctuation before an equilibration is reached

Seems easy enough. But here is the issue: all of these strategies require a pretty clear crystal ball.

In order to correctly predict how the Fed will adjust interest rates requires a crystal ball. To accurately trade bonds requires a crystal ball to predict how and when the market will adjust.

And just like the stock market, this is impossible. And, for what it is worse, seems even less fun than trying to actively trade in the stock market with the same risk of loss. In any event, active trading in either market is best avoided.

How should you invest in bonds?

In short, keep it simple.

Invest in bonds via total market bond index funds. We can't predict interest rate changes. Or any micro-movements in the bond market. Nor is that what we want to spend our time doing. So avoid it altogether via index funds.

The only way that I have considered getting more fancy with my bond investing is potentially added a municipal bond fund to my taxable investing account given its improved tax efficiency. (Bonds are better situated as much as possible in your tax advantaged accounts as they are not as tax efficient as stock index funds.)

Other than that, I just look for my bonds to serve as ballast to my portfolio. At ~10% of my current asset allocation, they can add some stability when the stock market is volatile. And as I reach closer to retirement, more and more of my portfolio will transition to bonds as I look to preserve, rather than grow my nest egg.

This is what bonds are good at. So, my recommendation is to keep it simple and use them as such!

For a full guide to help you figure out what your asset allocation of bonds should be, check out: Bonds Asset Allocation: What Should Yours Be?

And to learn how to rebalance your portfolio, check out: Asset Allocation and Rebalancing: A How-To Guide for Buying Low, Selling High, and Relaxing In Between

What do you think? How do you use bond in your investment portfolio? Do you try to adjust your bond strategy based on interest rates? Why or why not? Let me know in the comments below!