Sometimes there’s a world of nuance hiding inside things we barely notice.
Kind of like the Dr. Seuss book, Horton Hears a Who!, where Horton the Elephant discovers Whoville, an entire microscopic city that exists on a floating speck of dust.
Well, this article is about one of those nuanced topics many people never think much about — but those of us in retirement planning think about all the time.
Bonds.
And as many retirees discovered in 2022, understanding bonds matters more than most people realize.
So here we go… into Whoville.
Today, Dana shares insight into How Bonds Work in Retirement Portfolios. Share on X
With this article, my goal is to help you better understand:
bond terms like yield-to-maturity and duration,
the difference between bonds and bond funds,
and how each may fit into different retirement strategies.
Wait. Have I lost a few of you already?
I promise I’ll try to make this nerdy topic as interesting as possible.
Why We Get Confused About Bonds
Bonds are supposed to be the safe, stable part of your portfolio… right?
So why does the financial media suddenly start talking about bonds every time interest rates change?
And why did many investors express alarm in 2022 when both bond funds and stock funds went down at the same time?
Here’s the source of much of the confusion:
There’s a big difference between:
owning an individual bond
and owning a bond fund
Most people lump them together as if they’re the same thing.
They’re not.
Once you understand the difference, much of the confusion around bonds starts to make sense.
What a Bond Actually Is
At the heart of every investment is one of two things: owning or lending.
With stocks, you own a piece of a business.
With bonds, you’re lending money.
You can lend money to:
the U.S. government in the form of treasury bills, notes, and bonds,
a city or state through municipal bonds,
to corporations through corporate bonds.
At its core, a bond is simply a contract between you and the borrower. It works like an interest-only mortgage with a balloon payment at the end.
You lend them money. They agree to terms such as:
Coupon rate — how much interest they’ll pay and how often.
Maturity date — when you get your principal back.
Like stocks, bonds can be purchased when first issued—or later, on the secondary market from another investor.
And just like stocks, you can buy them individually or own them through mutual funds or exchange-traded funds (ETFs).
Sounds pretty straightforward so far.
Likelihood of Getting Your Money Back
If we could all lend money with 100% assurance of being repaid, we would always lend to whoever offered the highest rate.
But those assurances don’t exist, so rates vary to compensate investors for risk.
Credit rating agencies evaluate the financial strength of borrowers and assign ratings to their bonds. Bonds with higher ratings are considered investment-grade.
In general:
investment-grade bonds = historically reliable
lower-quality bonds = higher yields but more risk
When we talk about bond risk, there are really two different types:
Default risk — the issuer fails to repay you.
Interest rate risk — bond prices fluctuate as interest rates change.
Let’s look at each.
The Risk of Default
Bond ratings make default risk relatively easy to assess.
Here’s what default rates have looked like over a cumulative 10-year period:
All investment-grade bonds: about 2.2%.
And even in a default case, bondholders have typically recovered 40 – 50% of the principal, so not a total loss.
Municipal bonds: about one-tenth of 1%.
Highest-rated investment grade: historical default rates near 0%.
That sounds reassuring.
Yet in 2022, both bond and stock funds fell sharply at the same time, and suddenly the media was talking about the “broken” 60/40 portfolio (60% stocks/40% bonds).
Why?
Default risk wasn’t the problem.
Interest rate risk was.
Bond Prices & Interest Rates
(ChatGPT/Claude)
When interest rates rise, existing bond prices typically fall.
When interest rates fall, existing bond prices typically rise.
An example helps explain why.
Suppose you lend me $1,000 for 10 years at 4% interest. Five years later, new 5-year bonds are paying 6%.
Now your bond is less attractive. Why would someone pay you full price for a bond paying 4% when they could buy a new issue bond paying 6%?
They wouldn’t.
So your bond would trade at a discount — about $915. That discount compensates the buyer for receiving lower interest payments relative to current market rates. When they eventually receive the full $1,000 at maturity, their total return becomes similar to buying a newly issued 6% bond.
The opposite happens when interest rates fall. If new bonds are paying only 2%, your 4% bond becomes more valuable and will trade at a premium.
A simple rule of thumb is this:
If interest rates rise 1%, a bond with 5 years remaining to maturity may fall roughly 5% in value.
If interest rates fall 1%, it may rise roughly 5% in value.
The graphic above illustrates the same relationship for a bond with 10 years remaining to maturity. You can find more specific math and a detailed explanation in this American Association of Individual Investors article on How Interest Rate Changes Affect the Price of Bonds.
Because bond prices fluctuate, investors focus on yield-to-maturity (YTM), not just the coupon rate. YTM reflects both the interest payments and any gain or loss between the purchase price and the amount received at maturity.
This is why a bond paying only a 2% coupon may still offer a 4–5% yield if purchased at a sufficient discount.
Bonds and Performance Measurement
Bond price fluctuations are one reason I think short-term investment performance can be a misleading metric in retirement.
Suppose you own a ladder of individual bonds and plan to hold them until maturity. If interest rates rise, the market value of those bonds may temporarily decline.
On paper, your account statement may show a loss.
But if you plan to hold the bonds to maturity, and the issuers remain financially sound, nothing about your future cash flow has actually changed.
You still know:
What you’ll receive
When you’ll receive it
In retirement, it often makes sense to focus less on short-term account values and more on whether investments are aligned with future spending needs.
Bonds and Bucketing Strategies
Because investment-grade bonds have relatively predictable cash flows — known maturity dates, principal amounts, and coupon payments — they work well in bucketing or asset-liability matching strategies.
If I know I’ll need to withdraw $50,000 next year and I own a bond maturing at roughly that amount, I don’t have to worry much about market fluctuations or interest rate changes.
The bond’s maturity date is already aligned with the cash flow I need.
That predictability can be especially valuable in retirement, when the goal is no longer simply maximizing returns, but creating dependable income.
Bonds vs Bond Funds
For the assurance of getting your money back, you can either stick with top-rated bonds and accept lower yields, or venture into lower-rated bonds that pay more but carry higher default risk.
While default rates on investment-grade bonds are relatively low, they are not zero.
So rather than owning just a handful of bonds — where a single default could meaningfully impact your portfolio — bond funds allow you to diversify across many issuers and maturities.
Three common types of bond funds are:
Total return or total market funds, which own many types of bonds across varying maturities
Short-term bond funds, which focus on bonds maturing within a few years
High-yield bond funds, which own lower-rated, non-investment-grade bonds
With a bond fund, you gain diversification and professional management.
But unlike an individual bond, you no longer have a specific maturity date — making it harder to know exactly what you’ll get and when.
So what metric should you focus on instead?
Bond Funds & Duration
When you sell shares of a bond fund, the price depends largely on prevailing interest rates relative to the collective coupon rates of the underlying bonds.
That’s where duration comes in.
Duration provides a way to estimate how sensitive a bond fund is to changes in interest rates. The higher the duration, the more sensitive the fund’s share price becomes to interest rate changes.
Just as a 5-year individual bond value might fluctuate roughly 5% for a 1% interest rate change, a bond fund with a 5-year duration may behave similarly.
If you really want to dive into Whoville, there are even different ways to measure duration. A short AI chat on Macaulay Duration will probably provide more information than you ever wanted to know.
For a less nerdy primer on bonds, watch my YouTube video on “Understanding the Income Side of Investing,” where I try to keep it simple and under 20 minutes.
Bond Funds & the Bucket Strategy
A bond fund with a 5-year duration might seem like a good fit for a mid-term bucket — money you expect to spend about five years from now.
But there’s an important difference between a bond fund and an individual bond.
An individual bond’s maturity date gets shorter every year. A bond fund’s duration typically stays relatively constant because the underlying bonds are continually being replaced.
So as the time for a withdrawal gets closer, the fund may still carry meaningful interest rate risk.
For example, if rates rise 2%, a fund with a 5-year duration could decline roughly 10% in value.
That doesn’t necessarily matter if the fund is part of a long-term total return strategy.
But if the money is needed soon for retirement income and counted on as the “stable” part of your portfolio, those fluctuations can create additional uncertainty that must be managed.
Some hybrid structures attempt to address this issue. Funds such as Invesco’s BulletShares ETFs (no affiliation) hold diversified baskets of bonds that mature in a specific year, creating something that behaves more like an individual bond ladder while still offering diversification.
Fritz here with a quick comment: I use the BulletShares Dana mentions above in my personal Bond Ladder, which currently has annually expiring rungs covering 50% of my annual spending through 2036. I consider it part of the second bucket in my Bucket Strategy. To see how I constructed it, read “How To Build A Bond Ladder.“
Bond Funds in the Total Return Approach
Now, if you’re using a total return approach, you are likely to approach bonds differently.
With a total return strategy, bonds are not necessarily there to provide a known maturity value at a specific date. Instead, they serve as the stabilizing portion of the portfolio that can potentially hold up better when stocks decline.
During market downturns, retirees may rebalance by selling bonds and buying stocks at lower prices.
Duration still matters because it tells you how sensitive the bond fund may be to interest rate changes. But short-term price fluctuations are generally less important because the strategy is built around managing the portfolio as a whole rather than matching individual bonds to future spending needs.
Of course, as we saw in 2022, bonds and stocks can sometimes decline at the same time.
With individual bonds maturing each year, this may have little impact on the cash flow you need. With a bond fund, however, it could mean selling shares during a decline.
One Other Distinction – Expenses
With a bond fund, you pay an ongoing expense ratio each year.
With individual bonds, there’s typically no annual expense ratio. Instead, the cost is built into the bid/ask spread when the bond is purchased.
Sorting Through the Confusion
As is the case with all investments, different tools serve different purposes.
Individual bonds can provide predictability and known cash flows. Bond funds can provide diversification and flexibility. Neither is inherently “better.” The key is understanding how each behaves, what role it plays in your portfolio, and whether that role aligns with when and how you plan to spend your money in retirement.
With inflation still running hot and corporate earnings remaining strong, there’s growing discussion that rates could stay higher for longer — or even rise further.
Yes, bond prices on paper will fluctuate if this happens.
But when you understand what you own, why you own it, and when you plan to use it, those short-term price movements become far less important.
In retirement, understanding how different investments behave matters. It helps you stick with the plan during volatile markets.
And sometimes that insight starts with a trip into Whoville to better understand the parts of a portfolio that are easy to overlook.
What About You?
How do you use bonds in your portfolio? Have you had any surprises or insights that you wish you had known earlier? Share your experiences in the comments below.
