How Do You Build a Bond Portfolio?

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

LIZ ANN: Well, hi, Kathy. I hope that you got a bit of a break last week with the Thanksgiving holiday. It's hard to believe we are now into December. And as you, I'm sure, remember the theme of our last episode was uncertainty in the market. So let's tee off this episode by asking whether you're seeing any changes in the data in terms of what the market is expecting or maybe expectations around what the Fed might do, especially with the jobs numbers out this week and then some inflation data coming next week as well.

KATHY: Well, so far, the market seems to be looking for a rate cut at the December meeting. It looks like the odds as we're speaking right now are in the 70, 75% area, which I find a little surprising given some of the commentary that we've heard, including comments from Fed Chair Powell about, well, keeping an open mind about all this. I'm a little surprised that the conviction is that firm. But as we've seen, convictions go up and down very quickly. So there's a lot of volatility around what people expect. And I think that that will probably continue. As you know, we get some employment numbers coming out fairly soon. And that's going to be important, I think, in terms of the Fed's thinking, and it will certainly be interesting to see some of the other data when we get to that inflation data coming up.

What about you, Liz Ann? What are you expecting from here?

LIZ ANN: It's hard to know what we should expect at this point. There's so many cross-currents, but part of our job is to not just assess opportunities but assess risks, and, I suppose, worst-case scenario, particularly because it would happen in advance of any knowledge we have with regard to the things we've been talking about—tariffs and immigration and the effect on growth and inflation—but I suppose thinking about the next week of data coming in, a little bit of a worst-case scenario would be a weaker jobs report but a hotter inflation report. And I think that would easily move the Fed into the pause camp, at least on the inflation front. But then the question is, how do they approach it from the other part of their mandate, the employment front? So I think that would add a little bit of a pickle versus a backdrop of stronger-than-expected job report and benign inflation. That would be the ideal scenario and could be supportive of the Fed moving to lower interest rates without attendant concern about inflation reigniting. So we'll have to see. 

As we look ahead to the policy changes that could have the biggest impact, what we can go by based on the 2018 playbook is an administration that likes to announce policy via social media. So it's government policy at times by tweet. And we of course have a Fed that's also data-dependent, making the market data-dependent and business leaders data-dependent. So you've got government policy being tweet-dependent and monetary policy being data-dependent. And it really does sort of shorten time horizons and add to the uncertainty making our jobs, both of us a little bit trickier. One overarching theme, as I think ahead to next year, is that when we think about the tails of outcomes, both on the left side and the right side, meaning, you know, positive risks and negative risks, I don't know about you, but I think that the tails might be a little bit fatter in this environment than maybe in a normal environment to the extent that there is such a thing.

KATHY: Yeah, one thing that we've mentioned in our outlook is just a wide range of potential outcomes, right? You have all these potential changes. You don't know if they will actually materialize and, if they do, in what form they'll materialize. And that gets really difficult then to kind of model out, "Well, you know, where will we go from here? Well, you know, if you assume these three things, we go there. If you assume those three things, we go somewhere else."

So I do think that it'll take some time to kind of figure out, you know, where we're going to end up with some of these potential changes. But you know, the stock market keeps marching higher. So there is optimism in your world, as always.

LIZ ANN: Certainly at the index level there continues to be a lot of rotations happening under the surface, and I think that's likely to continue in part because of all of these cross-currents. So that is something that we will go into detail in our outlook, which comes out shortly.

So this week, Kathy, our episode is about building a bond portfolio. And this is maybe something unique about our show, which is that we look at both stocks and bonds, but bonds tend to get generally less airplay in the media. Although in the past year, I might argue a little bit against that. I think that's where the volatility action has been, more in the bond market than the equity market. But tell us about our guest and the discussion you had.

KATHY: Sure. So the guest this week is my colleague Cooper Howard. Cooper is a Chartered Financial Analyst and a director at the Schwab Center for Financial Research. He's an expert on the municipal bond market, which is a really important market for a lot of individual investors. He's been quoted in many financial publications—The New York Times, Bloomberg, Bond Buyer, and CNBC—and I'm really looking forward to this conversation as a bond nerd.

So Cooper, thanks for being here.

COOPER HOWARD: Thank you for having me, Kathy.

KATHY: This is a topic we get a lot of questions on regularly, so I'm really excited to have you on to talk about it. The idea of how to build a bond portfolio is something I think a lot of people wonder about, but they're not really sure where to get started. But before we get into the nitty-gritty, let's just start with a question I think that we should tackle, and that's why should you even be interested in investing in bonds?

COOPER: You know, I think that that's a great question to start with. And I'd really boil it down to three reasons why you should invest in bonds. The first one is the income. Bonds can be confusing, but really they aren't. If you've invested in a CD in the past, for example, a bond is very similar to a CD. So a bond can provide a steady, predictable income stream. And that's something that's pretty good for planning purposes. So if you know that you have a known expense in the future—say it's a child's education, say it's retirement, and you're needing that income from it—that's where bonds can be a pretty good investment, assuming they fit into your risk tolerance. The second reason is capital preservation. So a bond, Kathy, is really just a contract between you and the issuer. Now, it's not something that you actually have to sign or enter into a formal agreement, but that issuer agrees to pay you back a certain amount over a certain time period, barring default.

So you know what you're going to get, when you're going to get it, and you know that known amount in the future. So that's capital preservation. That's the second point. The third point that I think bonds are a fairly good investment for is diversification. Now, many bonds are uncorrelated to stocks. What that means is that when stocks move up, maybe bonds move slightly down, or when stocks move down, maybe bonds move slightly up. And I want to highlight an example of that. And let's go back to COVID, for example.

And I'll cherry pick some data here. So from mid-February 2020 to mid-March 2020. Now over that scary period of time, stocks were down about 34%. But over that exact same period of time, high-quality fixed income, that was only down about 0.8%. So you can see there's a significant decline in a portfolio if it would be all stocks, whereas that decline would be much less if it was a mix of both stocks and bonds.

KATHY: Yeah, those are really good points, especially the point about knowing what you're going to get and when you're going to get it. That's what really distinguishes bonds from most other investments, as a matter of fact, because you have a legal right to those payments, those interest payments and getting the principle back at par. OK, so let's just jump into it. Where do you even start when it comes to building a bond portfolio? What should the first step be?

COOPER: Yeah, so the first step, I think, is that you should have a plan or roadmap. And this is really in line with kind of what else we do in terms of life. So let's say that we're going on a road trip. You want to first determine "What is my destination?" and then "How am I going to get there?" And that's really going to dictate what you're going to do in terms of your bond portfolio. So you have to understand, well, "What is the purpose of this money that I want to invest it for? Is this something that I'm saving for a grandkid's college? I'm using it for my retirement, or I'm going to be living off of this money?" So overall, that's going to be your first step.

KATHY: And then what types of bonds should an investor focus on? So say I'm a retiree, and I want to use my portfolio to supplement my income in retirement. Can you tell me how I might go about approaching that?

COOPER: Yeah, so if you look at the global bond market, it's about 20% larger than the global stock market. So I know that the stock market gets a lot of the attention, but the bond market is actually much bigger. So for a lot of our clients, that can really raise kind of a question of, "Where do I even start?" And "I'm in retirement. I need to kind of understand how do I build a bond portfolio?" And from a basic standpoint, this is really going to depend from investor to investor based off of a number of different factors. But a general guideline for a retiree is we usually like to start with one year of cash, after accounting for predictable income sources. So if you know that "I've got some money coming in from dividends, interest payments, other retirement income sources," say a pension or something of that nature, Social Security, then figure out your budget, set aside enough money, and put that into cash so that you know that that's going to be readily available.

And you really don't have to think about your spending over the next year. From there, we suggest putting two to three years' worth of spending in high-quality short-term bonds. And then finally, you can build out the rest of your bond portfolio by focusing on higher-rated investment-grade bonds, either corporate bonds, Treasury bonds, or things like municipal bonds.

KATHY: So the idea there is to keep the high quality, in other words, not be doing a lot of speculating and junk bonds and things like that?

COOPER: That's correct. And I think one of the things that I like about that strategy of having a year in cash, the next two to three years of spending in short-term fixed income, and then building out the rest in high-quality fixed income investments, and maybe dabbling a little bit into more aggressive income sectors is that it accounts for two things of risk that we like to focus on. The first is your risk tolerance, and then your risk capacity.

And risk tolerance is basically, "If I open up my account one day and I look online and I see a bunch of red, how does that make me feel? Is that going to make me panic, have to sell out early? Am I going to have consternation for the rest of the day?" The other piece of it is your risk capacity. And that's really a question of "How much can my portfolio go down without me having to change my lifestyle?" So I like that when we build out a portfolio that way for somebody who is living off of their portfolio, it takes into account both their risk capacity and their risk tolerance.

KATHY: Yeah, I think that second piece, that risk capacity is really important because a lot of times we focus on what's the best return we can get, right? And we end up taking a fair amount of risk. But if we're going to have to dip into parts of the portfolio because they decline so much, and we need that income or we need that cash at a time that isn't a good time to do it, then we are losing out in the overall capital value. And it's really hard to come back to the starting point if you do that. So keeping some of it kind of isolated from that sort of a risk seems to me to be a really important component of an overall portfolio.

OK so now I have a good idea of why I want to invest in bonds and how to approach it from kind of an allocation point of view. But now let's get into another aspect that often gets confusing: What products do I use? So there are individual bonds or bond funds or ETFs. Is there one choice that makes the most sense? What are the trade-offs between those various ways of investing in the bond market?

COOPER: Yeah, and I think this can also add to the complexity of the fixed income market is that there is no single way to invest. And I think if you look at it, we don't have a preference on "Are mutual funds or ETFs better than individual bonds?" It really comes down to the characteristics of each. So if you look at a mutual fund or an ETF, at the bottom line, it's just a portfolio of a bunch of individual bonds. So it's very similar to a portfolio of individual bonds if you were to build it yourself. 

However, if you're going to build a portfolio of individual bonds yourself, generally speaking, it's going to require a larger dollar amount to get adequate diversification. So we usually recommend, Kathy, that you invest in at least 10 different issuers with different credit risks. So depending on how much money you have to invest, that can be difficult with individual bonds. Now, the flip side is that for mutual funds and ETFs, for every dollar that you're investing, that's generally spread out across multiple different bonds. So you can achieve diversification a little bit easier. 

However, one of the downsides of mutual funds or ETFs is that they have a net asset value that fluctuates, or a price that you would look at on your account statement or online that's going to go up and down. Now, depending on the types of bonds you invest in, that price might move a little bit more or a little bit less. But for some individuals, they don't like to see that price fluctuate when they look at their bond portfolio, or the portion of their portfolio that they believe is kind of the safe, conservative part of their allocation. 

Individual bonds, you mentioned this earlier, but they're a contract really between you and the issuer of that bond. They agree to pay you back a stated coupon rate, plus give you back the principal at some time in the future. 

Now, the other thing to consider is what types of bonds are you investing in? So if you're investing in more riskier types of bonds, maybe going the way of a mutual fund or an ETF makes a little bit more sense because you have that broader diversification and potentially an active manager that can do some of that credit research and watch over it.

KATHY: Yeah, I think that that's something that I often talk with clients about, because we'll talk about building portfolios of individual bonds, and we do have people who can assist with that. But you do have to kind of monitor and stay on top of it over time. And a lot of people don't really want to be bond fund managers in their free time. They'd rather play tennis or golf or have lunch with their friends. And so sometimes having a manager, even though that comes with a fee, can make a lot of sense because doing credit research is rather involved. It's a skill. It's a full-time job for a lot of people. And as we both know, it can be a challenging one at times. So I think that's kind of a good distinction for people to think about when they're thinking about individual bonds versus using a mutual fund or ETF or some other sort of product where it's managed for you.

OK, so then we get down to different accounts. What kind of accounts should investors think about when they're holding bonds? Do they just go into, can you put them in an IRA? Can you put them in your general brokerage account? What do have to think about when you decide what account to allocate them to?

COOPER: Yeah, so this adds a whole other level of complexity on things. And I think this is very important to go back to the original question of "Why are you even investing in bonds to begin with? When do you need that money?" If you're in retirement and you need that money right away, then you have to plan out, say, your required minimum distributions or consider your taxes with distributions from your IRAs. So I think that that's another thing to factor in. The other thing that I'd factor in is tax considerations.

Now, municipal bonds, for example, they pay interest income that's generally exempt from federal and possibly state income taxes. It really does not make sense to hold those in a IRA or a tax-sheltered account. Right now, it makes sense to hold them in a taxable account. And if you're comparing corporate bonds, which are fully federally taxable, to municipal bonds, and thinking, "Well, at what rate does it make sense to invest in corporate bonds versus municipal bonds?"

That all-in tax rate's about 35%. So that's saying that if you have a federal tax rate, state tax rate, and any other applicable tax rates that's above 35%, and you're investing in a taxable account, it probably makes sense to use municipal bonds. If you're in a tax bracket that's below 35%, then it probably makes sense to invest in things like corporate bonds. The other thing to consider is that corporate bonds, they're not too tax efficient.

So the interest income they pay is fully subject to income taxes. Usually, income tax rates are higher than dividend tax rates. So it makes sense to hold corporate bonds or things like that in a tax-sheltered account, like an IRA or like a 401(k). However, the bottom line on this is that it depends on "When do you need the money?" So if you need the money very soon, and you're looking at taking distributions from an IRA, it probably makes sense to focus more on your taxable accounts, which are fully liquid, and you can draw on a little bit easier than something like an IRA.

KATHY: Great point. And one that gets confusing. It does tend to get confusing because you have to sit and kind of figure out, "Well, what's the yield I'm getting on this bond if it's in a tax-sheltered account? Can I get something comparable, a tax-exempt bond, in a taxable account?" And we can help do the math with that. But it is something that really is important because what's important is how much you keep of your investment, not just how much you make.

COOPER: Exactly.

So good points on those accounts. You know, one thing our team often talks about is ladders, bond ladders. And we do this because it's kind of a go-to strategy in our view that a lot of people can use and can make sense for them. So can you explain what a bond ladder is?

COOPER: Yeah, it is a very good go-to strategy that's kind of an all-bellwether strategy that takes a lot of the guesswork out of things. And the way I like to describe it is, if you were to go to a hardware store and you see a ladder, a ladder is going to have multiple different rungs on it. And that's similar to building a ladder of individual bonds or bond mutual funds. You can do it with mutual funds or ETFs as well. And what a ladder is, is you would invest incremental amounts to incremental time periods.

So let's assume that you just had $50,000 to invest. You'd buy $10,000 into a one-year bond, 10,000 into a two-year bond, 10,000 into a three-year bond, etc., all the way out to five years. Now, what happens with that is that in one year, your one-year bond is going to come due. So you can either take that money, and you can spend it, you can do what you choose with it, or you can go ahead and you can buy a new five-year bond. So that's the strategy that's constantly going to be kind of cycling through itself. One of the things that I really like about a bond ladder strategy, Kathy, is what I've found with many of our clients is that it automatically creates a check-in point of when they should re-evaluate their portfolio overall to make sure that their goals and things are back on track and what they're doing is kind of in line with what they want their money to be doing. 

Now, this is similar to something that we would do in normal life. So for example, I always make sure that at the beginning of December, I know that in my family, our advent calendar comes out. But I also know that it's time for me to go downstairs and to change my water filter. So how those two go hand-in-hand, I don't know. But somehow in my mind, I know that it's time to change the water filter as it is time to bring out the advent calendar. So it just creates a natural check-in point for me.

KATHY: That's great, yeah. What I love about ladders is they're just kind of elegant in their simplicity, right? So you break up the maturities of your bonds evenly over time, whatever time frame you want to use, five years, 10 years, you name it. And when you're rotating like that, not only do you have that, "OK, I'm having a check-in every six months or once a year when the water filter needs changing."

I take a look at my bonds, and I say, "Is this still working for me? Is this making sense? Do I have the right bonds, etc.? But also then my 10-year bonds—say, it's a 10-year bond ladder—becomes a nine-year, and my nine-year, an eight-year, etc. So then I invest in a new 10-year bond. And if yields go up, I'm actually going to generate more income as I rotate because I'll be investing in the higher-yielding bonds. So particularly for somebody who's using this as a strategy to deliver income over a long period of time like retirement, it gives you a little bit of an edge when rates actually do go up. Now, the price of the bonds will fall, but if you're just doing it for the income and you're holding all these bonds to maturity over time and rotating, you actually don't mind if yields go up. It's a less disturbing kind of experience than when you're holding bonds for a total return and they go down in price.

So I love bond ladders as a go-to strategy. So let's talk a little bit about when, what opportunities might come along, and how you'd know that there were opportunities, a good time to be looking at bonds, etc. So when the yield curve is inverted, and that means the short-term yields are above longer-term yields, is that a good time? A bad time? Do I only look at short-term bonds when I do that, or should I still consider longer-term bonds? How do you make that decision?

COOPER: Yeah, so I think that you should still consider longer-term bonds. And one of the reasons why, and we know that for a lot of our clients, they say, "Well, why should I buy a bond that is going to pay me less, and I'm going to have to lock up my money for a longer period of time when I can get something northwards of, say, 4% on a cash or cash-like investment?" And the reason that you would buy a longer-term bond in that type of an environment is that you're locking in that yield.

One of the things that we discussed earlier is that by buying a bond, you're entering into a contract between you and the issuer, an implicit contract. There's nothing to sign, but you're guaranteed, assuming that they don't default, that coupon payment and that principal back at some point in time. Whereas if you're invested only in cash, cash tends to be highly correlated with what the Federal Reserve is doing. So as expected, they're going to likely lower interest rates later this year and potentially further into next year. And if they do, investments on cash, the yields on those, are likely to move lower. So by buying some longer-term bonds, you're capturing that yield for the life of the bond, barring a default. And you're making sure that even if yields do move around, you still know exactly what you're going to get when you're going to get it.

KATHY: Yeah, that's a good point. And just to throw in a little bit of jargon here, if you just stay very short-term in cash or cash-like investments, then you have re-investment risk, right? If you're in a three-month T-bill, and rates go down in three months, you'll be investing at lower and lower rates. Another fancy term for this is "path dependency." So you're depending on the path forward for the Federal Reserve in terms of short-term rates. And as we all know, paths go up and down and all around. And you're really very dependent on exactly following that path of short-term interest rates in terms of the income that you're generating. 

Well, it's been great. I really appreciate it. I do hope that we now have people little better prepared to think about building bond portfolios going forward. Thanks a lot, Cooper.

COOPER: Thanks so much for having me, Kathy.

LIZ ANN: So it's look-ahead time, that part of the podcast episode, Kathy. What is on your radar for the next week or so?

KATHY: Well, we have those inflation reports that you mentioned earlier. I think those are the really big ones. We'll have gotten the jobs numbers by next week. And so we'll have that under our belts. And then the last piece is the inflation numbers. And that should give us a pretty good idea as to what the Fed is leaning towards at the December 18th and 19th meeting.

Where market still expects a rate cut, but I'm a little bit less confident that it's going to materialize. So lots of other data, but I would pick that out, those inflation numbers, as the really big ones.

KATHY: What about you, Liz Ann? Besides those inflation numbers, what are you looking at?

LIZ ANN: also get the NFIB data, National Federation of Independent Business, and that always has really interesting nuggets. That's a federation for small businesses, and we have seen an immediate pop in optimism in the aftermath of the election, and that's not uncommon to see, particularly because the business leaders incorporated by the NFIB tend to be a little bit more Republican-leaning. So you did see something similar happen in 2016. We'll have to see the longevity of that. But I'll be focused on things like "What is the single most important problem?" Inflation has kind of been reigning supreme. But we'll have to see what happens with other concerns, whether it's growth concerns or quality of labor. So some of those subcomponent questions are interesting. 

We also get the productivity and unit labor costs data out. And I think that as a guide both on the inflation side of things, but also the productivity aspect of GDP could be important. And then we get the federal budget balance. I think that's increasingly in a lot of investors' sights given what we, you and I, hear all the time, concerns about the debt and deficit. And maybe import-export prices could start to have some interesting trends, not much maybe in advance of some of the tariff news that will inevitably start to get in more detail come January, but that's what's on my radar.

Well, that's it for us this week. As always, you can keep up with us in real time on social media. I'm @LizAnnSonders on X and LinkedIn. By the way, I'm not on Facebook. I'm not on Instagram. I'm not on WhatsApp. Although I've secured a handle on BlueSky, I'm not on there yet. And just today, I found out that there's now a rash of imposters that have me via AI on camera speaking and telling you all about my odd crypto- and stock-picking club. Those are all imposters. Even if you think you see me and hear me, it is not me. So that's yet again another PSA on my part to beware of the imposters.

KATHY: And I'm @KathyJones. That's Kathy with a K on X and LinkedIn. And if you've enjoyed the show, we'd really be grateful if you'd leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. You can also follow us for free in your favorite podcasting app. 

Next week, we'll have a part one of our 2025 market outlook. So stay tuned for that.

For important disclosures, see the show notes or schwab.com/OnInvesting.