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Investing basics: how and why to invest in bonds

Tom Lauricella  |  18 Oct 2019Text size  Decrease  Increase  |  
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Many investors feel they should have bonds somewhere in their portfolios. But most don't know how to address their fundamental questions about how to do so. How much of their portfolios should be invested in bonds? Individual bonds or bond funds? What mix of different kinds of bonds is best over time?

In early 2019, Morningstar Inc conducted a series of forums with people interested in bond investing and found that, from the get-go, bond investing can be confusing for many individual investors. Confusion often starts with the fact that bad economic news is generally good news for bond prices and vice versa. In other words, if greed makes stocks go up and fear makes them go down, it is the opposite for bond prices.

Rising bond prices also mean lower yields (and vice versa!). So, in a time of crisis, investors are willing to pay more, and accept a lower yield, in exchange for the relative safety of bonds. And yet, for an investor looking to invest in a bond fund for income, it can be good news when bond prices are falling and yields are rising. Also confusing? High-yield corporate-bond funds may act more like stock funds than government-bond funds.

But a smart allocation to bonds can make the difference between a portfolio with scary ups and downs that spook long-term investors out of the stock market, leaving a retiree short on the money needed to pay bills, and a more stable and diversified portfolio that can deliver the outcome an investor needs to pay expenses.

For this report, we’ve turned to a wide range of Morningstar's experts, from our veteran personal finance columnists to our investment management team. For beginner investors, we've explained the basics of bond investing step by step, in plain English. But more experienced investors will also find valuable insights on building bond portfolios based on Morningstar's independent research and commentary.

  • What role do bonds play in a portfolio?
  • How much of a portfolio belongs in bonds?
  • How do you know if the bond market is cheap or expensive? Does it matter? Where are we now?
  • What factors should be considered when deciding among different kinds of bond investments?
  • What strategies make the most sense in different market and economic environments, such as rising inflation and bond yields?

A very short primer on bond terminology

There are two main terms that will come up again and again with bonds: duration and credit quality.

For a bond market pro, duration can be a complex variable. For most everyone else, it is easiest to think of duration as a bond’s maturity. Bond investments are generally broken into three segments: short--less than two years, intermediate--two through 10 years, and long-term--bonds maturing in more than 10 years. In general, long-term bonds are more prone to wider swings in price than short-term bonds.

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Credit quality boils down to the ability of the bond issuer to make good on interest payments. Government bonds are generally the highest quality because governments, including municipalities, can use taxes to generate revenue to pay off debt, while a corporation's ability to pay debt depends on its business prospects.

The following authors contributed to this series:
Tom Lauricella, Editorial Director, Professional Audiences
Christine Benz, Director of Personal Finance
Sarah Bush, Director, Fixed-Income Strategies
Jeff Westergaard, Director, Fixed-Income Data

is the editor of Morningstar Direct.

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