What Is A Bond?

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Bonds are a form of debt. Bonds are loans, or IOUs, but you serve as the bank. You loan your money to a company, a city, the government – and they promise to pay you back in full, with regular interest payments. A city may sell bonds to raise money to build a bridge, while the federal government issues bonds to finance its spiraling debts.
Nervous investors often flock to the safety of bonds – and the steady stream of income they generate — when the stock market becomes too volatile. Younger investors should carve out a portion of our retirement accounts – 15% or less, depending on one’s age, goals and risk tolerance – to balance out riskier stock-based investments.
That doesn’t mean that all bonds are risk-free – far from it. Some bonds happen to be downright dicey. As with all investments, you’re paid more for buying a riskier security. In the bond world, that risk comes in a few different forms.
The first is the likelihood the bond issuer will make good on its payments. Less credit-worthy issuers will pay a higher yield, or interest rate. That’s why the riskiest issuers offer what’s called high-yield or “junk” bonds. Those at the opposite end of the spectrum, or those with the best histories, are deemed investment-grade bonds.
The safest of the safe are issued by the U.S. government, known as Treasurys; they’re backed by the “full faith and credit” of the U.S. and are deemed virtually risk-free. As such, a Treasury bond will pay a lower yield then a bond issued by a storied company like Johnson & Johnson (investment grade). But J&J will pay less in interest than a bond issued by, say, Shady Joe’s Mail-Order Bride Inc.
How long you hold the bond (or how long you lend your money to the bond issuer) also comes into play. Bonds with longer durations – say a 10-year bond versus a one-year bond – pay higher yields. That’s because you’re being paid for keeping your money tied up for a longer period of time.
Interest rates, however, probably have the single largest impact on bond prices. As interest rates rise, bond prices fall. That’s because when rates climb, new bonds are issued at the higher rate, making existing bonds with lower rates less valuable.
Of course, if you hold onto your bond until maturity, it doesn’t matter how much the price fluctuates. Your interest rate was set when you bought it, and when the term is up, you’ll receive the face value (the money you initially invested) of the bond back — so long as the issuer doesn’t blow up. But if you need to sell your bond on the secondary market – before it matures – you could get less than your original investment back.
Up until now, we’ve talked about individual bonds. Mutual funds that invest in bonds, or bond funds, are a bit different: Bond funds do not have a maturity date (like individual bonds), so the amount you invested will fluctuate as will the interest payments it throws off.
Then why bother with a bond fund? You need a good hunk of money to build a diversified portfolio of individual bonds. Depending on the type of bond portfolio you’re looking to build, it could require tens of thousands in order to do it right. Bond funds, meanwhile, provide instant diversification. We explain more on the differences between bonds and bond funds below.
Before delving into the world of bonds, you’re going to want to familiarize yourself with the types of bonds available and some of the associated vocabulary.

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