Bonds, duration and the bond ladder

Fixed income seems boring until a year like 2022 arrives, when many "safe" bond funds fell 10-15 %. Understanding why that happened is the difference between using bonds as a tool and suffering them as a surprise.

What a bond is and why its price moves

A bond is a loan: you lend money to an issuer (a government, a company) that pays you a periodic coupon and returns the face value at maturity. The coupon is simple interest on the face value.

The key: the price of an already-issued bond moves inversely to interest rates. If you hold a bond at 2 % and the market starts offering new bonds at 4 %, nobody will want yours at par: its price falls until its yield matches the new one. If rates fall, the opposite happens and your bond gains value.

Duration: how much a rate move affects you

Duration measures the price's sensitivity to rates. Rule of thumb:

Price change ≈ − duration × change in rates

A bond or fund with duration 7 loses about 7 % if rates rise 1 point (and gains 7 % if they fall 1). That's why in 2022 long-duration funds suffered so much: fast rate hikes on very sensitive portfolios. More duration means more expected return but bigger swings.

Individual bond vs. bond fund: a crucial difference

Individual bond held to maturity: whatever happens to its price along the way, if the issuer doesn't default you get the face value back on the agreed date. The interim price drop is "on paper".
Bond fund: it never matures. It rolls bonds constantly, so its net asset value always reflects market price. If rates rise, the fund drops and there's no date on which you "recover" by definition.

This distinction explains why someone holding Treasury bills to maturity in 2022 didn't lose, while their neighbour's bond fund did.

The bond ladder

A ladder means spreading your fixed income across bonds that mature in successive years: for example, equal parts at 1, 2, 3, 4 and 5 years. Each year a rung matures; you spend that money or reinvest it into a new bond at the long end of the ladder.

Advantages:

Predictable cash flow: you know what amount is available each year.
Less rate risk: you don't bet everything on a single moment; you reinvest at prevailing rates on each maturity.
Retirement buffer: a 1-3 year ladder is the natural way to build the cash bucket that mitigates sequence risk.

In Spain: Treasury bills, bonds and obligations

The Spanish Treasury (Tesoro Público) issues three maturities:

Letras (bills): short term (3, 6, 9 and 12 months). They pay no coupon; you buy at a discount and collect the face value. Ideal for the short rungs of the ladder.
Bonos: medium term (3 and 5 years), with an annual coupon.
Obligaciones: long term (10, 15, 30 years).

You can buy them at auction through the Tesoro website or your bank, and on the secondary market. For tax: the return on Letras is taxed in the savings base but carries no withholding (you declare it); bond coupons do carry 19 % withholding.

Common mistakes

Confusing a bond fund with a bond. The fund doesn't mature; don't expect to "recover" on a date.
Loading up on duration you don't need. If your horizon is short, long duration exposes you to drops you don't want.
Chasing high coupons while ignoring credit risk. A bond paying much more usually has a higher chance of default.
Holding all your fixed income at a single maturity. You lose the ladder's edge against rate moves.

What to do

For the buffer and the short term, a ladder of Treasury bills gives you safety, predictable cash flow and zero duration surprises. Match the duration of your fixed income to your horizon: money needed in 2 years, ~2-year bonds. And if you use bond funds, choose the duration deliberately, not by inertia.

Educational information, not investment advice. Fixed income also carries risks (rates, credit, inflation); consult a professional for your case.