Bonds are loans that investors make to corporations and governments. The lenders earn interest, and borrowers get the cash they need to carry out their business plan. A bond is a loan that pays interest over a fixed term, or period of time. When the bond matures at the end of the term, the principal, or investment amount, is repaid to the lender, or owner of the bond.

Typically, the rate at which interest is paid and the amount of each payment is fixed at the time the bond is offered for sale. That is why bonds are known as fixed-income securities and one reason that a bond seems less risky than an investment whose return might change dramatically in the short term.

A bond's interest rate is competitive, which means that the rate it pays is comparable to what is being paid for other bonds of similar quality being issued at the same time. It's also related to the cost of borrowing in the economy at large, so when mortgage rates are down, for example, bond rates also trend lower.

Why Bonds are Issued
When companies need to raise money to invest in growth and development, they can issue stock or sell bonds. They often prefer bonds, in part because issuing more stock tends to dilute, or lessen, the value of shares investors already own. Unlike companies, governments aren't profit-making enterprises and can't issue stock. Bonds are the primary way they raise money to fund capital improvements such as highways or airports. Money from bond issues also keeps everyday operations running when other revenues (like taxes and other fees) aren't available to cover current costs.

A Bond is Born
When a company or government wants to raise cash, it tests the waters by floating a bond. That is, it offers the public an opportunity to invest for a fixed period of time at a specific rate of interest. If investors think the rate justifies the risk and buy the bond, the issue floats.

Term of a Bond
The term of a bond can range from short-term (usually a year or less), to intermediate-term (two to ten years), to long-term (30 years or more).

The life, or term, of any bond is fixed at the time of issue.

Generally speaking, the longer the term, the higher the interest rate. This is to make up for the additional risk of tying up your money for a longer period. The relationship between the interest rates paid on short-term and long-term bonds is called the yield curve.

Profiting from Bonds
Conservative investors use bonds to provide a steady income. They buy a bond when it is issued and hold it, expecting to receive regular, fixed-interest payments until the bond matures. Then they receive the principal back to reinvest.

More aggressive investors trade bonds, or buy and sell as they might with stocks, hoping to make money by selling a bond for more than they paid for it. Bonds that are issued when interest rates are high become increasingly valuable when interest rates fall. That is because investors are willing to pay more than the face value of a bond with an 8% interest rate if the current rate is 5%.

In this way, an increase in the price of a bond, or its capital appreciation, often produces more current profits for bond sellers, than they would by holding the bond to maturity.

But there are also risks in bond trading. If interest rates rise, a bondholder could lose money by selling an older bond, which is paying a lower rate of interest. That is because potential buyers will typically pay less for the bond than you paid to buy it.

The other risk bondholders face is rising inflation. Since the dollar amount earned on a bond investment doesn't change, the value of that money can be eroded by inflation. For example, if you held a 30-year bond paying $5,000 annual interest, the money would buy less at the end of the term than at the beginning.

Selling Bonds
For corporations, issuing a bond is similar to making an initial public offering. An investment firm helps set the terms and underwrites the sale by buying up the issue. In cooperation with other companies, the investment firm then offers the bonds for sale to the public.

When bonds are issued, they are sold at par, or face value, usually in units of $1,000. The issuer absorbs whatever sales charges there are. After issue, bonds trade in the secondary market, which means that they are bought and sold through brokerages, similar to the way stocks are traded. The issuing company receives no money from these secondary trades.