Put simply, bonds are loans. When a corporation or a government entity needs to borrow a large amount of money, it does so by selling bonds to investors. Each bond has a contract which specifies the terms of the loan, how much interest will be paid, and when the loaned amount (called principal) will be paid back.
When investing, bonds are generally considered to be safer than stocks. The primary reason for this is that, in the event of bankruptcy, bondholders typically must be paid back in full before stockholders get anything. Also, a bond contract typically lays out various protective requirements for how much other debt a company may take on. This helps to ensure that the bond is backed by sufficient collateral.
Due to the protective features of bonds, it may often be possible for bondholders to recover part or all of their principal, even in the worst case scenario of bankruptcy of the issuing entity. This is in contrast to stockholders, who can expect to recover little, if any, of their money in the case of bankruptcy.
In exchange for increased safety, bonds generally give pay investors less in returns. If an investor buys a bond and holds it until the loan is paid back (called maturity) then he or she can expect to earn the effective rate of interest on the bond, nothing more, nothing less. By contrast, a stockholder may earn large gains if the company is successful, or lose significant funds if the company performs poorly.
Typically bond investors are those that are willing to settle for a smaller, but more steady and safer return on their investment. For example, bonds are ideal for investors who are entering retirement, since they can pay out a steady amount of interest which retirees can count on to pay living expenses.
When thinking about investing in bonds, it is often wise to invest through a bond fund, because they can offer greater diversification and more professional management of bond investments. Investing in individual bonds can be tricky for individuals, because minimum investments are large, and it takes significant skill and time to understand the provisions of complex bond contracts, which are not standardized.
Investing in bonds is a good choice for a well balanced portfolio. Bonds can offer greater stability of value and steady returns. If you are a retail investor, stick primarily with bond funds since the bond market is much more complex even than the stock market.