Building the Bond Side of a Portfolio

Once you have chosen how much to hold in bonds, a second set of choices remains: how long the bonds should be, how much credit risk to take, and whether to own a fund or bonds that mature on dates you choose. These choices decide whether the bond side of a portfolio does its job, which is to be there, at a known value, when you need it. This chapter covers duration, credit quality, three common ways to build the bond side, bond ladders, and how to match bonds to the dates you will spend the money.

Start with the job the bonds are doing

Bonds can do three different jobs, and each points to different choices.

• Preserving money you will spend soon. For a home deposit or tuition due in a few years, the priority is that the money is there. That points to short maturities and the highest credit quality, accepting a lower yield.
• Steadying a long-term portfolio. Next to a large stock holding, bonds are there to hold up when stocks fall. High-quality bonds of intermediate length have usually done this best, because in a recession investors buy them and interest rates tend to fall.
• Producing income. Retirees and others living on their portfolio may want more interest. Longer maturities and lower credit quality pay more, but they bring larger price swings, and lower-quality bonds tend to fall along with stocks.

Writing down which job your bonds are doing makes the rest of the choices much easier.

Duration: how much a bond moves when rates move

Chapter 3 explained that bond prices fall when interest rates rise. Duration, measured in years, tells you by how much. A useful rule: a bond or fund's price changes by roughly its duration, in percent, for each one-point change in interest rates, in the opposite direction. A fund with a duration of 6 years loses about 6% if rates rise one point and gains about 6% if they fall one point.

Duration depends mostly on maturity, and also on the coupon: a longer maturity or a lower coupon means a higher duration. Broad investment-grade bond index funds have usually had durations in the intermediate range of about five to seven years; short-term funds about two or three; long-term funds fifteen or more. Every fund publishes its average duration on its fact sheet.

The rule that matters most is to match duration to when you need the money. Here is what a one-point rise in rates does to money set aside for a goal two years away, held in two different kinds of fund.

The long fund falls to about $25,500, the short fund to about $29,400. Both figures ignore the interest earned during the year, which narrows the gap a little. For money needed in two years, the long fund would have to recover before the bill is due, and it may not. For money not needed for fifteen years, the same fall matters much less: the fund reinvests at the new, higher rates, and over a period close to its duration the higher income tends to make up for the lower price.

Longer bonds usually, though not always, pay more. That extra yield is the payment for taking the price risk.

If rates stay put, the extra half point grows the sum to about $62,309 instead of $60,833 over five years. Whether that is worth a larger price swing depends on when you need the money, which is the point of the rule above.

Credit quality: how much default risk to take

Rating agencies grade bonds by the chance the issuer fails to pay. The grades fall into four broad bands.

• Highest quality (AAA to A). US Treasuries, which carry the backing of the federal government, and the strongest companies and municipalities. Default risk is very low and so are the yields.
• Lower investment grade (BBB). Sound issuers with more exposure to a downturn. Yields are higher, and prices fall more in a recession.
• High yield (BB and B). Riskier issuers paying substantially more. Defaults rise sharply in recessions, and these bonds tend to move with stocks, so they do little to steady a portfolio.
• Distressed (CCC and below). Issuers near or in default. Outside specialist strategies, they do not belong in an ordinary portfolio.

The trade-off is direct: more yield for more chance of loss, and that loss tends to arrive at the same time as stock losses. If your bonds are there to steady a stock portfolio, high quality does that job best.

Three ways to build the bond side

These are illustrations of common structures, not recommendations for any specific fund.

One broad fund. A total bond market index fund holds thousands of investment-grade bonds: Treasuries, government-agency mortgage bonds and corporate bonds, with an intermediate duration. It is the simplest choice and is what many target-date funds hold.

Government only. A Treasury fund, or a mix of Treasuries and TIPS, removes credit risk entirely, leaving only interest-rate risk. It tends to rise the most when stocks fall in a recession, and its interest is exempt from state income tax. Adding TIPS protects part of the bond side against unexpected inflation.

Core plus income. A broad core with a smaller slice of corporate or high-yield bonds raises income in exchange for more volatility and more correlation with stocks.

Where you hold bonds matters too. Interest from taxable bonds is taxed every year at ordinary income rates, so many investors hold them in tax-deferred accounts such as a 401(k) or traditional IRA, and hold municipal bonds in taxable accounts if they are in a high bracket. The asset location calculator estimates the difference for your accounts.

Bond ladders and matching bonds to dates

A bond ladder splits money into equal parts that mature in successive years, for example one part maturing each year for five years. When the shortest bond matures, you either spend the money or reinvest it in a new bond at the long end of the ladder. A ladder gives you three things a bond fund does not: a known amount of cash arriving on known dates, regular reinvestment at whatever rates are then available, so you never have to guess the right moment to lock in a rate, and no need to sell a bond before maturity at a loss. Ladders can be built from Treasuries, TIPS or bank certificates of deposit, and some funds now hold bonds that all mature in one chosen year, which can be combined into a ladder.

The same idea, matching what you own to when you will spend it, guides the whole bond side:

• Within a year: cash, a money market fund or Treasury bills. A 26-week bill yielded 4.37% on September 29, 2026, and TreasuryDirect sells bills in multiples of $100.
• Two to five years: short-term Treasuries, certificates of deposit, or a short ladder.
• Five to ten years: an intermediate fund, or a ladder of Treasuries or TIPS ending when the money is needed.
• Retirement income over many years: a mix of an intermediate fund and a longer ladder, often with TIPS so the income keeps up with prices.

When a bond or ladder is matched to a date, the price swings in between stop mattering: you hold to maturity and receive the face value.