The Basics of Bonds And Why You Want Them

Want to learn more about bonds, and why they're attractive investments? This is our bonds primer.

Putting You in the Business of Loaning, And Making, Money

A bond is a loan to a company or government. So "buying" a bond means you're loaning your money. Why would you do that? For the same reason a bank gives you a mortgage: to make money on the interest.

Unlike stocks, bonds guarantee you'll make a certain amount of money over time. Investors do pay a price for that certainty, though. While bonds deliver reliable returns, over the long term those returns have historically been lower than those produced by stocks. That's why many investors choose a balance of safe and rewarding, a strategy known as diversification.

That said, all bonds carry credit risk. This is a polite way of saying the borrower could default before paying you back.

Why Are Bonds So Secure?

Most people who invest in bonds will buy U.S. Treasuries because they're so safe. Treasury bonds sold by the U.S. government are effectively risk-free; Uncle Sam has never defaulted on a bond. Ever. (The federal government can't skip town, and if it runs out of cash to pay back loans, it can literally print more.) You have four basic choices:

• Treasury bills have a maturity of less than a year. That means within one year they will be paid back in full with interest. If you have a money market savings account, your cash will likely be invested in T-bills
• Treasury notes mature in two, three, five, seven or 10 years
• Treasury bonds mature in 30 years
• Treasury Inflation-Protected Securities (TIPS) mature in five, 10 or 30 years, and they increase in value along with inflation

Beyond U.S. Bonds

Almost as safe as U.S. Treasury bonds are municipal bonds, which are issued by states and local governments. The interest you earn on munis is tax-exempt.

On the riskier side are corporate bonds, since companies can, and do, skip town. The riskiest are called junk bonds, which are issued by companies with a high probability of default.

With all those nice, safe U.S. government bonds to choose from, why would you ever loan money to Montana or Atlanta or any random company?

You'd do this to take advantage of what's called the risk premium. The greater the risk of any bond, the more interest you will make. Those safe Treasury bonds, for example, pay rock-bottom interest. But investors who take on relatively more risk with municipal or corporate bonds do so to take advantage of higher interest.

But remember, if stocks take a dip, bonds can easily beat them-in the short run. But over the long run, you have bonds in your portfolio for their dependability, not their returns.