Despite their importance in a diversified investment strategy, bonds remain one of the most misunderstood asset classes. Many investors are unclear about how bonds function, what influences their prices, and the critical role they play in portfolio construction.
A well-structured portfolio aims to reduce risk and perform across varying economic conditions. Achieving this balance typically requires a mix of stocks, bonds, alternatives, and cash equivalents. While many investors tend to be well-versed in equities and often consider them the primary driver of portfolio growth, bonds receive significantly less attention. Most discussions with financial advisors center around stocks simply because that’s where client interest lies.
Typically, investors only focus on bonds when they are dissatisfied with their performance. When equities are surging, it is common for investors to question the need for bond exposure. This article explores that question and provides insights on the role of bonds in a portfolio.
Understanding Bonds
Bonds are essentially loans made by investors to borrowers, corporations, municipalities, or governments. In exchange, borrowers agree to make regular interest payments and return the principal upon maturity. While similar to certificates of deposit (CDs) issued by banks, a key distinction is that bonds are priced daily and can fluctuate in value before maturity.
For example, when you buy a CD, you’re lending money to a bank and earning interest. The CD’s value only increases as interest accrues; it doesn’t fluctuate. Bonds, on the other hand, can decline in value if interest rates rise. Despite this volatility, if the issuer does not default (investment-grade bonds have a low default rate compared to non-investment-grade bonds), investors receive their full principal at maturity.
It’s worth noting that if CDs were marked to market daily, they too would show temporary declines when rates increase. This is a key aspect of bond pricing that many investors overlook.
Why are Investors Asking if They Should Continue to Own Bonds?
Investors typically compare bonds to either equities or cash equivalents. When stocks are performing strongly, bond returns can feel underwhelming—like a missed opportunity. Historically, the S&P 500 has delivered positive returns in 73% of calendar years[1], which means stocks are typically outperforming bonds.
More frustrating, perhaps, is when bonds underperform even conservative vehicles like CDs or money market funds. Rising interest rates can lead to paper losses in bond portfolios, especially when compared to short-term instruments like 90-day Treasury bills.
Viewed through the lens of absolute returns, it’s easy to understand investor frustration. Bonds often underperform equities, and occasionally, they underperform cash equivalents. However, this short-term underperformance can overshadow their strategic value, creating a gap between perception and reality.
The Benefits of Bonds in a Portfolio
Bonds offer several advantages that make them a vital component of an investment portfolio:
- Income Generation: Bonds provide consistent income through interest (or coupon) payments, which can be especially valuable for retirees and others seeking reliable cash flow.
- Capital Preservation: Compared to equities, bonds are generally less volatile, offering a measure of capital stability even in turbulent markets.
- Diversification: Bonds help diversify a portfolio, often moving in the opposite direction of stocks. This inverse correlation can reduce overall portfolio volatility and help buffer losses during equity market downturns.
- Long-Term Returns vs Cash Equivalents: Although bonds have lagged cash over the past few years, they have historically outperformed cash equivalents. From 1928 to 2023, bonds delivered an average annual return 1.3% higher than cash (from 1928-2023).[i][2]
- Potential Tax Benefits: For high-income investors, municipal bonds can offer compelling tax benefits. These instruments are typically exempt from federal—and sometimes state and local—taxes, making their tax-equivalent yields highly attractive when compared to CDs, savings accounts, or money market funds.
- Understanding Bond Pricing: Bond pricing is determined by several factors, including interest rates, the bond’s credit quality, its maturity date, call features, and the overall economic environment.
One of the key aspects of bond pricing is its inverse relationship with interest rates. When interest rates rise, the prices of existing bonds typically fall, and when interest rates decline, bond prices usually increase. This is because newly issued bonds will offer higher yields when interest rates are higher, making existing bonds with lower yields less attractive. Conversely, when interest rates fall, existing bonds with higher yields become more desirable, driving up their prices.
The maturity date of a bond will also influence bond pricing. Longer term bonds will be more price sensitive to interest rate movements. Short-term bonds are less price sensitive to rate changes and typically outperform longer-term bonds in a rising interest rate environment.
The creditworthiness of the issuer significantly affects a bond’s pricing. High-quality bonds (like those issued by governments or well-established corporations) are seen as safer. During economic slowdowns, demand often shifts from stocks to high-quality bonds, reinforcing the inverse relationship between the two. Conversely, lower-quality or high-yield bonds tend to move in tandem with equities and may decline when financial conditions worsen.[3]
Much of the recent discontent with bonds stems from 2022, when inflation surged to 9% [4]and the 10-year Treasury yield rose by 2.25%.[5] The Bloomberg U.S. Aggregate Bond Index fell by more than 13%—its worst year on record—wiping out years of gains. [6]This steep decline has dragged down three-, five-, and ten-year average returns for many bond funds.
Conclusion
Bonds remain a core element of a well-rounded investment portfolio. They offer stable income, capital preservation, and diversification, along with potential tax benefits, especially for high-income earners.
While recent bond performance has been disappointing, it is critical to remember that past returns do not dictate future outcomes. Today’s environment presents more favorable conditions. In January 2022, the effective Federal Funds Rate was near 0%: as of April 2025, the rate was 4.33%.[7] Yields on the 10-year Treasury are now at their highest levels since the financial crisis, providing investors with more attractive income and the potential for capital appreciation if rates decline.
Whether you’re seeking income, stability, or long-term growth, bonds remain an essential tool for managing risk and achieving investment goals. For investors focused on diversification and consistent returns, bonds should continue to play a prominent role in a thoughtfully constructed portfolio.
[1] https://www.capitalgroup.com/individual/planning/investing-fundamentals/time-not-timing-is-what-matters.html
[2] From 1928-2023 comparing 10 year Treasuries vs 3 month T-bills per NYU https://www.quantifiedstrategies.com/wp-content/uploads/2024/01/stocks-and-bonds-returns-and-risk.png
[3] https://www.alliancebernstein.com/us/en-us/investments/insights/investment-insights/high-yield-equity-like-returns-with-half-the-risk-and-can-tactical-moves-help-too.html?utm_source=chatgpt.com
[4] https://ycharts.com/indicators/us_consumer_price_index_yoy
[5] https://ycharts.com/indicators/10_year_treasury_rate_h15
[6] https://ycharts.com/companies/AGG/performance
[7] https://ycharts.com/indicators/effective_federal_funds_rate