Market Decode: How bonds work — and what they can do for you

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Generally considered the more boring, conservative part of an investor's portfolio, bonds typically don't get as much press as stocks do. And because they function differently from stocks and come in so many different flavors — Treasuries, municipals, corporate, high yield, etc. — they can be confusing. Here, Matthew Diczok, fixed income strategist for the Chief Investment Office at Merrill and Bank of America Private Bank, offers a clear, simple explanation of how bonds work and why they could be considered an important part of an investor's strategy.

How bonds work and what they can do for you
A well-diversified portfolio should include a mix of stocks, bonds and cash (the three major asset classes). How much of each you hold depends on your financial goals, risk tolerance, time horizon and liquidity, or cash, needs.
When it comes to bonds (also referred to as fixed income), there's a general rule of thumb: The more conservative you are as an investor, the more bonds you may want to own, relative to stocks (also known as equities). If you're willing to accept a greater amount of risk — and have a longer time horizon to pursue your investment goals — you may be more comfortable with stocks than with bonds.
Watch our video and then check out our slideshow below to find a recommended asset allocation based on the type of investor you are.
This chart presents a sample asset allocation for a conservative investor with investments of 16% cash, 26% stocks and 58% bonds. Source: Chief Investment Office, January 2020. Disclaimer: The strategic allocations shown here are designed as guidelines for a 25-year investment horizon for investors with the highest level of liquidity needs.
Note: These allocations may be subject to change based on periodic review and are for illustrative purposes only. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.
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Diversification does not ensure a profit or protect against loss in declining markets.

Investing involves risk including the possible loss of principal investment.

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Investments in high-yield bonds (sometimes referred to as "junk bonds") offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer's ability to make principal and interest payments.

Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is generally tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT).

Investments focused in a certain industry may pose additional risks due to lack of diversification, industry volatility, economic turmoil, susceptibility to economic, political or regulatory risks, and other sector concentration risks.