Introduction to Investing: What Are Bonds?

When you buy bonds, you're lending the bond issuer money in return for a fixed rate of return. Bonds are therefore known as fixed-income investments, and you are a creditor of the company. Stocks, on the other hand, go up and down in value depending on the stock market, and you are an owner of the company.

Bonds can be issued by corporations, states, cities, and the federal government. The interest on bonds is usually paid quarterly, but is sometimes paid at the date the bond matures, when the borrower pays you back the principal you lent them.

Bonds issued by the federal government are extremely safe. Corporate bonds and municipal bonds (munis), issued by states and cities, can be safe or high-risk. Just because a bond is issued by a city or state doesn't guarantee their safety.

Bonds are rated for safety by bond-rating companies like A.M. Best (www.ambest.com), Moody's (www.moodys.com), and Standard and Poor's (www.standardandpoors.com). These rating companies give each bond a grade between A (low risk) and C (high risk). The grade indicates the likelihood that the bond issuer will pay the interest and principal as promised.

A word of warning: bonds with a high yield (interest rate) are considered "junk bonds." Their title should be fair warning of the risk.

Since you lock-in your interest rate when you buy bonds, one of the risks of owning bonds is that you could be stuck with a lower interest rate while interest rates in the market are rising.

Bonds have a place in every portfolio. The danger is in being too conservative by having too much of your money invested in conservative bonds and not enough in more aggressive stocks or mutual funds.

For more in-depth information on bonds, see About.com's Stock Site.