Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. Author's note: This is the next piece in our asset class primer series this year. You can read the previous issues on hedge funds and gold.

Before we dive in, we're hosting a summer get-together in Berlin on the 1st of July, with food, drinks, and a World Cup match on the screen. If you'd like to join us, reach out to us and we'll send you the details.

Of all the asset classes we get asked about, bonds come up more often than you might expect. 

Typically, there are two questions that get asked:

First, how bonds actually work. Equities tend to be more intuitive: you buy a share in a company, the company grows, the share price goes up. Bonds, in comparison, are less covered in financial media, less discussed in the circles of our clients, and the mechanics - coupons, duration, yield-to-maturity - can feel opaque. 

Secondly, and perhaps more importantly, whether they should bother with bonds at all. For young, risk-taking entrepreneurs, bonds and their (typically) lower expected return seem not so attractive. Why not either buy equities with a higher expected return, or just hold cash with lower yield but little to no risk? Stocks have outperformed bonds over essentially every sufficiently long historical period - basic math seems to argue for just owning equities and being patient through drawdowns. 

We think that conclusion is too quick. But before getting to the portfolio role of bonds, it helps to understand what you're actually buying when you invest in them. Today, let’s give you the primer on bonds.

A bond is, at its core, a loan. You lend money to an issuer, such as a government, a company, a municipality, and in return are promised to receive regular interest (the coupon) and to have your initial investment (the principal) returned at the end of the term (maturity).

This is worth pausing on, because it marks an important difference from equities. When you buy a share, you’re buying a stake in a company’s future with no guaranteed return, but theoretically unlimited upside. With a bond, the economics are defined from day one. You know exactly how much you’ll receive in coupon payments each year, and you know exactly what you’ll get back at maturity. Bondholders also sit ahead of shareholders in the capital structure, meaning that if a company runs into serious trouble, you get paid back before equity holders do. It’s a clear trade-off - you give up the upside, but in return you get predictability, seniority, and a contractually defined return from day one. 

In a perfect world, bond investing is simple. You buy a bond at €1,000, collect your coupon every year, and receive your €1,000 back at maturity. The price stays flat, income flows in, no surprises. Reality looks vastly different - bond prices fluctuate, sometimes significantly, falling below that €1,000 face value or rising above it. Why does that happen?

The most important driver of bond prices - and also a factor that tends to trip up investors - is interest rates, or in other words, how the price of a bond changes when rates do.

Let's work through a simple example. Imagine you buy a bond today at €1,000 with a 4% annual coupon and ten years to maturity. You'll receive €40 per year, plus your €1,000 back in 2036. Now imagine that a year later, new bonds with similar risk are being issued at 5%. Suddenly, your 4% bond looks less attractive to any potential buyer - why would they pay €1,000 for €40 per year when they could get €50 per year on a new bond? Most likely, they wouldn’t. Instead, your bond's market price would likely fall, roughly to a level where the yield-to-maturity (the combined expected return of the coupon payments plus the eventual recovery of the bond price) matches the new prevailing rate of 5%. In our example, that new price would be approximately €929. A buyer paying €929 today, receiving €40 per year for nine remaining years and €1,000 at maturity, earns roughly 5% per year. 

This inverse relationship (bond prices fall when interest rates rise, and vice versa) is crucial to understanding fixed income. The degree to which a given bond's price moves in response to rate changes is captured by a measure called duration. The longer the time to maturity and the lower the coupon, the higher the duration, and the more sensitive the price is to rate movements. A ten-year government bond with a 4% coupon might have a duration of around 8, meaning roughly an 8% price decline for a 1% rise in interest rates, and vice-versa.

This is not a hypothetical risk. In 2022, long-duration government bonds, widely considered to be the “safe” part of most portfolios, fell 15–30% in value when Central Banks around the world lifted interest rates after a decade of zero or negative rates - a rude awakening to investors who had bought these bonds as a highly conservative investment. While the coupon itself doesn’t change (hence the name “fixed income”), a bond’s market price can fluctuate substantially (as outlined in our example above) to adjust its effective yield in-line with the prevailing interest rate environment. 

Understanding this distinction, between the coupon (fixed) and the yield (market-determined), is foundational to understanding bonds. A notable exception to this rule are floating-rate bonds (predominantly issued by banks), where the interest paid is linked to short-term interest rates. If those rates go up, the coupon payments of such a bond also resets to the new level automatically. Therefore, this type of bond is somewhat “immune” to interest rate changes. However, floating-rate bonds introduce a different kind of uncertainty, because the coupon isn’t fixed, you cannot know in advance exactly what income you’ll receive over the life of the bond. For investors who rely on predictable cash flows, that trade-off matters. 

So far we've been talking about interest rate risk, meaning how bonds respond to the broader rate environment. But there's a second, equally important dimension to understand, which is credit risk - the risk that an issuer simply doesn’t pay you back. A government bond and a high-yield corporate bond might have identical maturities and coupons, but they are fundamentally different investments. One carries essentially no default risk while the other is pricing in an increased possibility that the borrower may run into trouble. The market expresses this difference through credit spreads: the additional yield an investor demands over a comparable government bond as compensation for taking on default risk. The wider the spread, the more risk the market is pricing in.

With interest and credit risk in mind, it becomes a bit easier to navigate the bond universe. Rather than one homogenous asset class, bonds are really a family of quite different instruments, each carrying a distinct combination of risks and return characteristics.

At the low-risk end, you have government bonds from highly rated sovereigns, such as German Bundesanleihen, US Treasuries, and similar nations. Default risk here is small, so virtually all the risk comes from duration. A two-year Bund and a thirty-year Bund are both “safe” in the credit sense, but they behave differently when rates move.

Investment-grade corporate bonds add a layer of credit risk on top. Companies like Siemens or Apple borrow in the bond markets and pay a spread over the equivalent government bond to compensate investors for the possibility, however remote, that they might default. The higher that spread, the more credit risk the market is pricing in. Duration characteristics are broadly similar to government bonds, though corporates tend to skew slightly shorter.

High-yield bonds, sometimes also called junk bonds, are issued by companies with weaker balance sheets. The credit risk here is real, which is reflected accordingly in the spreads. In exchange, investors receive higher yields, and the return and risk profile starts to resemble equities more than traditional fixed income. Credit default risk increases in an economic downturn, therefore high-yield bonds and equities tend to fall together, which is an important portfolio construction consideration.

Emerging market bonds layer in an additional dimension. Many are issued in USD or more rarely in EUR, which introduces currency risk for the issuer (and potential instability for the investor), while local-currency EM bonds expose the investor directly to exchange rate movements. Next to the currency component, investors have to carefully evaluate the mix of countries in their EM bond allocation and whether corporate bonds are included or not, given that the composition of EM bond benchmarks varies widely between the different index providers.

Inflation-linked (government) bonds work differently from standard fixed-rate bonds. Their repayment value is adjusted in line with inflation over time. And given that the coupon payments are calculated based on that repayment value, these move in line with inflation, too. They offer less yield than nominal bonds in normal conditions, but provide protection if inflation turns out higher than expected, making them a useful portfolio hedge.

Finally, structured credit instruments like CLOs sit at the more complex end of the spectrum (more about the complexity premium in Structural Alpha). They bundle together pools of loans, then slice the resulting cash flows into tranches with different risk and return profiles. While the risk of a higher-rated tranche might be theoretically lower than the underlying loans, the complexity of the ‘structuring’ (called a securitization) might appear in different ways, such as lower liquidity in market turmoil or more binary default risk.

In our view, the sub-asset classes within fixed income are substantially more varied in the ways they can contribute to a portfolio than for example the sub-asset classes within equities. A small-cap German stock and Apple are both companies that carry equity risk and tend to move broadly together when markets sell off. Two bonds that both carry an investment-grade rating might have almost nothing else in common - one could be a thirty-year German government bond, the other a floating-rate bank note. The underlying issuers, risk drivers, and market dynamics can be entirely different, which is precisely what makes fixed income useful for portfolio construction.

Accordingly, each type of bond investment serves a different purpose in a portfolio. The precondition for using them well is understanding which risk you are actually taking on, and whether you are being adequately compensated for it. (If you're unsure which part of the bond universe makes sense for your portfolio, we’d be happy to help - don’t hesitate to reach out.)

Let’s address the question directly. If you truly are a long-term investor with a horizon of 30 years or more, no income requirements, and the psychological fortitude to sit through a 40–50% drawdown without getting nervous, then a 100% equity portfolio is a defensible choice. The above tends to be a reasonable description of many younger investors still in wealth accumulation mode, saving for retirement with decades ahead of them and no need to touch the capital in the meantime, as they typically have a cash reserve for emergencies, and an ongoing income that covers their day-to-day needs.

But that description fits fewer people than you might think, and it almost certainly doesn’t describe most of the entrepreneurs and founders we work with. If you’ve had a liquidity event, the calculus changes - you may need your portfolio to generate income (more on this in How To Spend It) to replace the salary or distributions you were drawing from your business. Your time horizon, while still long, is no longer infinite. And your ability to stomach a 50% drawdown, when that portfolio represents everything you’ve built, is probably lower than you’d like to believe in the abstract, especially if you require an ongoing income from it. For anyone in that position, bonds start to make a lot of sense, and not just as a defensive concession. There are three concrete reasons why.

The first is drawdown management. A 100% equity portfolio lost roughly 20% in 2022 and nearly 50% in 2000–2002. Bonds, particularly high-quality shorter-duration bonds, reduce those drawdowns. Furthermore, smaller drawdowns compound better than the raw return figures suggest: a portfolio that falls 40% needs to gain 67% just to get back to even, while one that falls 20% only needs 25%. Over long periods, a portfolio with modestly lower average returns but shallower drawdowns can end up ahead on realized wealth, not just on a risk-adjusted basis.

The second is the rebalancing effect. A mixed portfolio of equities and bonds creates a natural discipline. Sell the asset that has risen, buy the one that has fallen. When equities crashed in 2020, a rebalanced 60/40 portfolio bought equities near the bottom. That mechanical advantage doesn’t show up in simple asset class comparisons, but it adds up over time.

The third is that “bonds” doesn’t mean low returns. The bond universe includes high-yield credit, emerging market debt, and structured credit instruments like CLOs or even private credit, all of which have historically delivered high, sometimes equity-like returns over full market cycles, with better risk profiles. The decision to include fixed income doesn’t have to mean accepting 3–4% returns. It depends entirely on which part of the bond universe you’re allocating to.

The blanket dismissal of bonds as “for conservative people” misses all of this. To put it differently: if your equity allocation is sized correctly for your actual risk tolerance and income needs, you may not need bonds. But if it isn’t, bonds are one of the most efficient tools available to close that gap. (Another building block to add can be Gold or other commodities, which we touched on in another primer earlier this year. Check it out here.)

There are broadly three ways to get fixed income exposure: individual bonds, bond ETFs, and actively managed bond funds. The right choice depends on what you’re trying to achieve.

Individual bonds offer one thing that funds cannot - a defined maturity date. If you buy a German Bund maturing in 2030, you know exactly what you’ll receive and when, regardless of what interest rates do in the meantime. For investors who need to match specific future cash flows, that certainty has value. But there are some practical limitations, too: individual bonds typically trade in minimum sizes of €100,000 or more, and in the institutional market often €1,000,000. Bid-ask spreads can be wide, and transaction fees tend to be much higher than for ETFs and stocks, particularly for corporate and high-yield bonds, meaning entry and exit costs eat into returns. Building a properly diversified individual bond portfolio requires substantial capital and ongoing credit monitoring. For most private investors, individual bonds make sense only in very specific circumstances.

Bond ETFs are the most accessible entry point for most investors. They offer diversification across hundreds or thousands of issuers, daily liquidity, transparency, and low costs. A common argument against them is that a passive bond index allocates the most to the issuers with the most debt outstanding. But this critique misses the point: large companies borrow large amounts because they are large businesses, not because they are over-leveraged, and there is no systematic evidence that index-weighting overexposes investors to weaker credits. One thing worth understanding, unlike a DAX ETF which holds the underlying stocks directly, many bond ETFs use optimised sampling or synthetic replication rather than holding every bond in the index. This is a practical necessity, as bond indices contain thousands of instruments, not all of those being liquid all the time. 

Actively managed bond funds sit between the two. A good active manager can add value in less efficient parts of the market, such as high-yield credit, emerging market debt, or structured credit, where index construction is less straightforward and security selection matters. The trade-off is higher fees and the need to assess the manager carefully and continuously. For mainstream investment-grade exposure, the case for active management is weaker.

Our preferred vehicle are bond ETFs. For most of our clients, they offer diversification across hundreds or thousands of issuers (meaning individual default events don't derail the portfolio), transparency, liquidity, and meaningfully lower costs than the alternatives. If you're building a €5M portfolio and you want government bond exposure, a European government ETF does the job better than trying to pick individual maturities yourself.

But in the end, that’s always the second step. The right starting point is knowing what your challenges and risks are, and how bonds can help you mitigate them - and then to choose to vehicle that achieves your goals most effectively.

Haven't thought about how bonds fit into your portfolio or whether they should? Maybe you're unsure which segment makes sense for your situation, or you're looking at a larger liquidity event and want to think through how fixed income could play a role. We work with affluent entrepreneurs and family offices on these questions, from structuring a first bond allocation to navigating the full fixed income spectrum. We'd be happy to help, don't hesitate to reach out.

Disclaimer: Historical returns are no indicator of future performance. This article is provided for educational purposes only and does not constitute investment advice.

Cape May Wealth Advisors is a Berlin-based wealth management firm focused on helping affluent entrepreneurs find financial independence. If you are interested in learning more about how we can help you, reach out to us via email, and make sure to subscribe to our newsletter.