Fixed Income
Bonds are math. They are legal contracts outlining a schedule of cash flows. Understanding fixed income requires separating credit risk from duration risk.
The Yield Curve & Duration
Fixed income serves two primary purposes in a portfolio: capital preservation (in the case of sovereign debt) and income generation. The defining metric of any bond is its yield relative to its duration.
Duration Risk
Duration measures a bond's price sensitivity to changes in interest rates. A duration of 5 means that if interest rates rise by 1%, the bond's price will fall by approximately 5%. This is the fundamental trade-off of fixed income: reaching for yield by extending maturity dramatically increases volatility.
The Yield Curve
The plot of yields across different maturities. An inverted yield curve (where short-term rates exceed long-term rates) historically signals that the market expects future growth and inflation to fall, often preceding a recession as central banks are forced to cut rates.
Common Mistakes
- Equating Bond Funds with Bonds: Individual bonds held to maturity return par. Bond funds roll their holdings and have constant duration, meaning they can suffer permanent capital loss if rates rise.
- Reaching for Yield: Moving down the credit spectrum (High Yield / Junk Bonds) increases correlation with equities, destroying the diversification benefit of bonds exactly when you need it.
Credit Risk & Spreads
Corporate bonds price at a spread over the risk-free rate (typically US Treasuries). This spread compensates the investor for the risk of default and illiquidity.
Bond Price Sensitivity Calculator
Estimate how a change in interest rates will impact a bond's price based on its duration.
Fixed Income Structures
| Type | Primary Risk | Tax Treatment (US) | Role in Portfolio |
|---|---|---|---|
| US Treasuries | Inflation / Duration | State tax exempt | Ultimate safe haven, deflation hedge |
| Municipal Bonds | Credit / Liquidity | Federal (and often State) exempt | Tax-efficient income for high brackets |
| Investment Grade Corporate | Credit / Duration | Fully taxable | Core income generator |
| High Yield (Junk) | Default Risk | Fully taxable | Equity-like return surrogate |
FAQ
Why hold bonds if inflation is higher than the yield?
Negative real yields are punitive, but nominal bonds act as a highly liquid counterweight to equity volatility. In a liquidity shock, Treasuries are often the only asset class that bids up.
What is a bond ladder?
Purchasing individual bonds that mature at staggered intervals. It mitigates reinvestment risk and provides predictable liquidity without the constant duration risk of a bond fund.