Answers to your questions about bonds

Bonds can play an important role in almost any portfolio. But many investors find them perplexing. How do they work? What's the best way to invest? And how much money should you commit?

In a live video webcast on June 10, Greg Davis of Vanguard Fixed Income Group explained how bonds can help you reach your financial goals, discussed trends affecting the bond market, and answered questions from investors around the country. Here's a summary of the event, along with answers to several questions we didn't have time to address during the webcast.

1. What are bonds, and how do they make money for investors?

In essence, a bond represents a loan that an investor makes to a corporation, government, or public agency. When you purchase bonds or shares in a bond mutual fund, you (the lender) earn income through the interest paid by the bonds' issuers (the borrowers), and at maturity your principal is returned to you. There are several other factors that determine how well your bond performs on the open market, as discussed below.

Given their historical track record, bonds have a reputation as conservative investments. However, there are risks associated with bonds, including the risk that changes in interest rates will cause prices to rise or fall. Bonds are also subject to credit risk—for example, the risk that a bond issuer might not be able to repay its lenders over time.

• Learn more about how bonds work
• Learn more about bonds' historical performance record
• Vanguard Blog: Do you have the bond gene?

2. What are the advantages of bond funds over individual bonds?

It's generally easier and more convenient to invest in a bond fund than to purchase individual bonds. It also tends to be less expensive, since you're not competing with bond fund managers, who "buy in bulk."

Perhaps the key selling point of bond funds, however, is diversification. Fund managers are able to construct portfolios that are highly diversified across economic sectors, issuers, maturities, duration, and other important characteristics. Diversification can help minimize the risk that a sudden downturn for a single bond issuer—for example, a corporation facing bankruptcy or a municipality flirting with default—could send your portfolio into a tailspin.

3. How much of my portfolio should be in bonds?

The answer to this question is different for everyone. Ultimately, it comes down to your personal goals, time frame, and tolerance for risk. Vanguard's Investor Questionnaire can help you decide how to allocate your portfolio between stocks, bonds, and cash (or cash equivalents).

Although bonds can play a role in virtually any portfolio, given their conservative nature they have historically been particularly useful as a means of preserving one's assets over shorter time frames. Generally speaking, the closer you are to your investment goal—retirement, for example—the more conservative your approach to investing should be.

Price stability has always been a major part of bonds' appeal. Consider the illustration below, which examines the growth of a hypothetical $10,000 investment from 1970 to 2009. The red line represents a portfolio composed entirely of stocks, while the blue line shows one invested entirely in bonds. The black line represents an even stock/bond split. As you can see, the all-bond portfolio produced much smaller returns than either of the others, but it experienced much less volatility along the way.

For each period, we selected the index that we deemed to be a fair representation of the characteristics of the referenced market. For U.S. stock market returns, we use the Standard & Poor’s 500 Index through 1974, the Wilshire 5000 Index from 1975 through April 22, 2005 and the MSCI US Broad Market Index thereafter. For U.S. bond market returns, we use the Citigroup High Grade Index through 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 to 1975 and the Barclays U.S. Aggregate Bond Index thereafter.

4. The stock market volatility of the last few years has scared me. Would I benefit from being invested solely in bond funds?

All investments, including bonds, are subject to risk. If you're so concerned about the possibility of another stock market downturn that you're thinking about abandoning equities entirely, you may need to consider whether you should be investing at all, and instead concentrate your assets in a money market fund, bank savings account, or CDs.

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5. I'm 59 and most of my portfolio is in stocks. What's the best way to increase my allocation to bonds?

If you're investing for the long term—and at age 59, you certainly still are!—it's probably best to adjust your portfolio in gradual steps over several months or even years. Shifting suddenly from one asset class to another could produce unwanted tax consequences.

Your first step is to choose an asset allocation target, which you can do with the aid of our Investor Questionnaire. If you're overweighted in stocks, you may simply want to direct any new investments (for example, ongoing contributions to your 401(k) or IRA) into bonds until you've met your target.

6. Are bonds a good investment for a 75-year-old retiree?

As noted in question 3, bonds may be an effective investment vehicle regardless of your age or goal. What really matters is how much of your portfolio is allocated to bonds. And that depends on your personal objectives, time frame, and risk tolerance.

At age 75, your risk comfort level is presumably lower than it was at 45, which means you could be well served by a significant allocation to conservative investments like bonds. But because your time frame may still be 20 years or longer, there may still be a place in your portfolio for stocks—and their potential for long-term growth, judging by historical performance.

Vanguard's Investor Questionnaire can help you decide how to allocate your portfolio.

7. I just retired and I'm looking to move my 401(k) into an IRA. Are bonds a good choice?

Without knowing more about your individual situation, it's difficult to offer specific guidance. With any investment decision, we believe the most important thing to consider is how it affects your asset allocation, keeping in mind your goal, time frame, and tolerance for risk.

Vanguard's Investor Questionnaire can help you decide how to allocate your portfolio. As noted in question 5, a sudden shift from one asset class to another could produce unwanted tax consequences.

8. Do bonds always rise when stocks fall, and vice versa?

Historically, there has sometimes been an inverse relationship between stock and bond performance. But that's had more to do with investor psychology than anything else. When the stock market stumbles, we often witness a "flight to quality," with investors rushing to the relative safety of bonds—particularly Treasury securities and other government issues. That's certainly what happened in 2008 and early 2009. But it tends to be a temporary phenomenon. Once investors become more comfortable with taking risk, they typically migrate back to stocks.

9. How do interest rates affect bonds and bond funds?

Interest rates and bond prices work in opposite directions. When interest rates rise, bond prices generally fall, and vice versa.

For example, assume you own a 10-year bond with a face value of $1,000 and a yield of 3%. (In other words, the bond issuer has borrowed $1,000 from you and committed to paying you 3% interest at regular intervals until the bond reaches maturity, at which point your "loan" is repaid in full.) If prevailing interest rates rise above 3%, your bond will be less attractive in the marketplace, because other investors could presumably purchase different $1,000 bonds at the new (higher) interest rate. If interest rates fall below 3%, on the other hand, your bond would be more attractive, and its price would probably increase.

Over the longer term, however, rising interest rates can be good news for bond investors. If you reinvest the interest income you receive from your bonds instead of spending it, higher interest rates could mean higher earnings over time. As your bond matures, for example, you’d presumably prefer to reinvest at a 6% yield than at 4%. (At 6%, money takes roughly 12 years to double. At 4%, it takes about 18 years.)

A related concept is duration, which is the degree to which a bond or bond fund is sensitive to interest rate changes. For example, if you own a short-term bond with a duration of 2½ years and interest rates increase by 1%, you can expect the price of your bond to drop by about 2.5%.

10. What's likely to happen to bonds if interest rates rise from their current low levels?

Most economists expect a slow, incremental rise in interest rates over the next several years—not a sudden, dramatic surge.

Once the Federal Reserve begins raising its interest rate target, bond prices are likely to decline. The degree of that decline will depend largely on how quickly interest rates rise and on the duration of the bonds in question. As noted in question 9, rising interest rates can be good news for bond investors over the long run, provided you reinvest your earnings instead of spending them.

Bear in mind that changes in interest rates are sometimes—though not always—anticipated in advance, meaning the possibility of a future rate increase may already be reflected in a bond's price.

• Bonds and rates: The reality behind the headlines
• "Bear flattening" could surprise bond investors in 2010

11. Is it better to be in a short-term bond fund if interest rates rise?

Historically, when interest rates rose substantially, bonds at the "short end" of the market—that is, bonds with short maturities, such as one to three years—were most affected.

Here's where the yield curve (see question 28) comes into play. Because rate changes by the Federal Reserve affect very short-term interest rates (you may have heard the term "overnight lending rate," which refers to the interest rate at which large banks lend money to one another), yields on bonds with short maturities are most affected, though their prices may not be, given their lower durations. Bonds with longer maturities—in the 10- or 30-year range, for example—are affected less by Fed-engineered changes in short-term interest rates and more by the influence of inflation and other economic factors on longer-term rates.

12. Are some bonds less sensitive to interest rate increases?

High-yield bonds tend to be less affected by movements in interest rates than by trends in the overall economy. Historically, their performance has been similar to equities in that they've generally benefited when the economy was strong, and vice versa.

13. Would rising interest rates improve money market yields?

That's likely. Money market fund performance is closely tied to the Federal Reserve's interest rate decisions. But again, we don't expect major rate increases in the immediate future.

14. With money market yields so low, are bonds a better alternative for short-term savings?

Before you put money into bonds for emergency spending needs and other short-term saving goals, you need to think about the risks involved.

For example, if interest rates rise in the near future, short-term bonds are likely to be negatively affected. That could threaten your investment principal. (Granted, with a money market fund you also need to weigh the danger of inflation eroding the purchasing power of your savings, but that's a fairly minor concern at the moment.)

Also worth considering: A bond fund may not give you the convenient access to your money that you'd get from a money market fund.

15. What's the benefit of tax-exempt bonds, such as municipal bonds, over taxable bonds? Which is the better investment?

As the name implies, a tax-exempt bond is exempt from federal taxes on interest income. Some bonds are exempt from state and local taxes as well, provided you're a resident of the locality in question.

Whether they make sense for you depends in large part on your tax bracket. If you’re in a high bracket, municipal bond funds are likely to give you more after-tax income than similar taxable funds.

Use Vanguard's taxable-equivalent yield calculator to find out the potential yield you'd have to get from a taxable investment to match that of a Vanguard tax-exempt bond or money market fund

16. A number of U.S. states and municipalities are experiencing severe budget shortfalls. How is this likely to affect bond investors?

Budget troubles in California and elsewhere have led some analysts and investors to worry about the possibility of default, which would of course represent a blow to the bond market. But Vanguard believes this fear is more a matter of perception than reality, or what's sometimes called "headline risk." The likelihood of a spate of defaults appears quite low.

Still, if you're concerned about the risk of default—or any other type of investment risk—we think the smartest way to ease those concerns is to be well-diversified.

• Will state budget woes drag on municipal bonds?
• What's causing the slump in muni bond ratings?

17. Should I put my bond funds in my IRA, or in my nonretirement account?

It depends on whether the bonds themselves are taxable. Generally speaking, you'll want to consider putting any investments that are likely to produce significant taxable income in a tax-deferred account, such as a 401(k) or IRA. Investments that are less likely to produce high taxable income, such as municipal bond funds or stock index funds, may be better suited for taxable nonretirement accounts.

18. How has the bond market performed lately?

Not surprisingly, the instability we've witnessed in the stock market in recent years has prompted many investors to turn to the relative safety and stability of bonds and bond funds.

In 2008, for example, the Standard & Poor's 500 Index (all stocks) declined nearly 40%, while the Lehman U.S. Aggregate Bond Index—a broad-based benchmark of bond performance—was up 5%. In 2009, investors continued pouring money into bonds despite the stock market rebound.* Treasury bonds and corporate bonds performed particularly well during this volatile period.

Looking ahead, the key questions for bond investors are when the Federal Reserve will act to raise interest rate targets from their current historically low levels, and by how much. As noted in question 9, bond prices generally fall when interest rates rise.

* Data source: Vanguard.

19. Are we in a bond bubble?

Given bonds' strong performance over the last few years, it's easy to see why some investors think we're in a bubble. But in Vanguard's view, it's nothing like the technology bubble of the 1990s or the housing bubble we experienced more recently.

Changes in interest rates will help answer this question. If the Federal Reserve triggers a sudden spike in rates—for example, an increase of 4%, which is extremely unlikely—you could expect to see a decline of about 10% for a short-term bond fund. But as noted in question 11, the impact on bonds in the 5-year, 10-year, and longer-range bond market will depend much more on macroeconomic factors such as inflation than on anything the Federal Reserve does.

20. Some financial experts are predicting another major bear market for stocks. Should I move into bonds immediately?

It's virtually impossible for anyone to predict what the stock market is going to do today, tomorrow, next week, or next year. We think it's unwise to base any investment decision on a near-term forecast by a pundit or self-described expert.

Historically, the best course, regardless of market conditions, has been to stick with a long-term investment plan and allocate your portfolio in a way that's appropriate for your goals, time frame, and risk tolerance. That was our advice to investors during the 2008–09 bear market, and it turned out to be sound guidance.

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21. How is the bond market affected by the debt crisis in Greece?

The Greek debt crisis has affected the bond market mainly in terms of raising demand for U.S. Treasury securities. In recent months, corporate bond issuers have been forced to offer higher yields to remain competitive with Treasuries, which is what we mean when we talk about bond "spreads."

In a globally interconnected economy, a crisis in one country can extend to others. But it's important to remember that Greece represents only about 3% of the European Union's total GDP. Even if you include Spain, Portugal, and some of the other European countries that are struggling with debt repayment, it's still a small fraction of the developed world's economy.

• Podcast: An update on the Greek debt crisis
• Vanguard Blog: Thoughts on the Greek crisis

22. The debt crisis has generated a lot of volatility in the stock market. Is this a signal to move into bonds, or should I be concerned about higher interest rates?

As noted in question 3, bonds have historically proved quite useful in reducing the impact of stock market volatility on investors' portfolios. If your tolerance for market risk has taken a beating in recent months, you may want to think about boosting your allocation to bonds. But only do so if it's in line with your long-term investment objectives. (Vanguard's Investor Questionnaire can help you decide how to allocate your portfolio.)

The potential for higher interest rates can be a legitimate factor in your decisions about asset allocation, but it shouldn't be the sole factor—nor should it dissuade you from investing in bonds if your asset-allocation strategy calls for it. If you're convinced that a significant, sustained increase in rates is imminent, you could mitigate the risk by expanding your bond allocation in gradual increments over time, rather than all at once.

23. Is the United States likely to face a similar debt crisis?

America's rising debt-to-GDP ratio is a cause for concern, of course, but our finances are in significantly better shape than those of Greece and other European countries.

It's the judgment of the international financial community—and of Vanguard's in-house economists—that the U.S. economy remains vibrant and highly productive, and that's unlikely to change any time soon. America's long-term economic potential remains great. Our view is that with some prudent belt tightening, the U.S. will be able to head off a situation like the one currently facing Europe.

• Video: Digging out of the deficit dilemma
• Deficits, the Fed, and rising interest rates: Implications and considerations for bond investors

24. With the economic outlook uncertain, which type of bond makes more sense—short-, intermediate-, or long-term?

Vanguard believes diversification is important regardless of your investment goal or time frame.

For bond investors, it can be helpful to own a broad selection of securities—a mix of short-, intermediate, and long-term bonds, as well as a selection of government, corporate, and mortgage-backed securities. An easy way to do this is to invest in a mutual fund that seeks to reflect the composition of the entire bond market, such as Vanguard Total Bond Market Index Fund.

If you're thinking about the potential impact of interest rate changes on bond performance, remember that it varies across the bond spectrum. A 1% change in interest rates typically won't affect a 3-year bond to the same degree as it would a 30-year bond. In the end, diversification can help you mitigate the risk that rising or falling interest rates will hurt your performance.

26. What's the difference between inflation and deflation? Which are you more concerned about?

We're all familiar with inflation, which refers to rising consumer prices. Deflation—falling prices—may sound attractive to consumers at first, but it can actually be much more damaging to the economy.

Think of it this way: If you're shopping for a new car and prices are falling, you may decide to hold off making a purchase until that $35,000 luxury model drops to $30,000 or lower. Far from stimulating consumer demand, falling prices actually translate into lower demand, which hurts the job market and weakens economic growth.

While deflation has affected Japan and other countries, it seems to be an unlikely scenario in the U.S. at this point. Vanguard's economists anticipate that inflation will remain in the 1–1.5% range for the remainder of 2010 and into 2011.

26. In terms of credit quality, can we really trust bond ratings?

Some of the major rating agencies have been criticized in recent years for giving very high marks—AAA, in some cases—to complex bond securities, particularly in the mortgage market, that turned out to be at high risk of default.

At Vanguard, our experienced credit analysts do their own research, and a credit rating from Moody's, S&P, or any other agency is just one of a number of data points that we use when selecting bonds for our funds. We also look closely at a bond's yield in the marketplace. For example, if a bond with a AAA rating is producing a yield similar to what you'd expect from bonds rated BBB, that tells us there may be more risk embedded in that AAA bond than meets the eye. Our analysts' built-in bias toward caution served us well during the subprime mortgage bubble and its ensuing collapse.

27. What is the yield curve?

The yield curve is a way to show the interest rates—or yields—that are offered by bonds of different maturities. Typically, the yield curve is based on U.S. Treasury bonds. It's always fluctuating, depending on the direction of interest rates in the marketplace. The shape of the curve is one indicator that economists look at when they try to forecast what's ahead for the U.S. economy and the markets. Fund managers look at it, too, when deciding which securities to hold at a given time.

A "normal" yield curve looks something like this:

What makes this curve normal isn't the various yield figures—instead, it's the shape. A typical yield curve rises gradually from left to right. That's because people who invest in bonds with shorter maturities aren't taking on as much risk as those who invest in longer-term bonds, so they don't normally get paid as much.

When the curve slopes downward from left to right, it's said to be inverted. This may indicate that the bond market is under stress, because investors are being paid more for taking less risk. It could also be a signal that the market expects interest rates to fall, which often happens when the economy itself is under stress.

For most investors, the shape of the yield curve isn't particularly important. It can provide some context for investment and financial decisions, and it's a useful tool for economists and portfolio managers. But if you own a broadly diversified bond portfolio, you'll probably have exposure to all parts of the yield curve.

For more information on the yield curve, view this interactive illustration.

28. Do bond ETFs offer particular advantages?

Exchange-traded funds, or ETFs, differ from traditional mutual funds in that they can be bought and sold throughout the day through a brokerage account. An ETF typically carries a lower expense ratio than a comparable mutual fund, but there are other transaction costs to consider, and ETFs aren't right for all investors.

At present, Vanguard offers 12 bond ETFs as separate share classes of existing Vanguard bond funds.

• View Vanguard bond ETFs
• Podcast: An introduction to ETFs

29. How does a bond ladder work?

A bond ladder is a collection of individual bonds with different maturities—that is, the dates on which the bond issuers will finish repaying their investors' "loans." As each bond reaches maturity, the investor uses the proceeds to purchase new bonds with maturity dates that are farther out, creating an income stream.

If you're a Vanguard Brokerage Services client, you can create a bond ladder using our Bond Desk.

30. I'm interested in investing in foreign bonds. What's the best way to do this?

Many bond funds, including some Vanguard funds, own securities issued in the U.S. marketplace by overseas corporations or agencies. When the U.S. dollar was struggling against the euro and other foreign currencies, many investors were interested in overseas bonds. Because the dollar was weak, returns on foreign-denominated funds looked stronger in comparison. But given the constant fluctuations involved in dealing with foreign currencies, any foreign-issued bonds we purchase for funds offered to U.S. investors are denominated in dollars.

Notes:

• Past performance is no guarantee of future results.
• All investments, including mutual funds, are subject to risk.
• Diversification does not ensure a profit or protect against a loss in a declining market.
• Investments in bonds and bond funds are subject to interest rate, credit, and inflation risk.
• Foreign investing involves additional risks including currency fluctuations and political uncertainty.
• U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
• Dollar-cost averaging does not guarantee that your investments will make a profit, nor does it protect you against losses when stock or bond prices are falling. You should consider whether you would be willing to continue investing during a long downturn in the market, because dollar-cost averaging involves making continuous investments regardless of fluctuating price levels.
• Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
• An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
• When comparing bond mutual funds with individual bonds, consider the following differences before investing:
  
  
• You must buy and sell Vanguard ETF Shares through a broker like Vanguard Brokerage Services or through another broker. Vanguard ETFs are not redeemable directly with an applicant fund other than in creation unit aggregations. Like stocks, ETFs are subject to market volatility, so you could pay more than net asset value when buying and receive less than net asset value when selling any ETF.
• The examples discussed herein are hypothetical and do not represent any particular investment. Consider consulting a tax advisor concerning your individual situation.
• Bond Ratings: Independent bond-rating agencies evaluate the financial health of bond issuers and rate the quality of their bonds. Ratings may range from AAA (or Aaa) to D.
• Standard & Poor's®, S&P ®, S&P 500 ®, Standard & Poor's 500, and 500 are trademarks of The McGraw-Hill Companies, Inc., and have been licensed for use by The Vanguard Group, Inc. Vanguard mutual funds are not sponsored, endorsed, sold, or promoted by Standard & Poor's, and Standard & Poor's makes no representation regarding the advisability of investing in the funds.
• Vanguard Brokerage Services is a division of Vanguard Marketing Corporation, member FINRA.