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Bonds: Clipping Coupons
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The government is asking you for a loan. So are many of the companies in America. But they don't call them loans–they call them bonds.
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When you buy a bond, you're lending the issuer of the bond some money. In return, the issuer promises to pay you a certain amount of cash each year (the bond's yield). The yield is paid out as a portion of the bond's original price (face value). For example, say you buy a 30-year bond with a face value of $10,000 that pays a 6% yield. Each year you'd get $600 (commonly known as a coupon). And at the end of the 30 years, you'd get your $10,000 back.
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Over the long haul, bonds are usually safer than stocks, since they promise regular payments and the return of your investment. But they generally don't earn as much as stocks, so you might not be able to retire comfortably if you invest in bonds alone.
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Bonds are categorized based on their credit quality and their maturity, or how long the issuer has to pay back the loan. Credit quality ranges from US government bonds (the safest, since Uncle Sam always pays off his debts), to high-yield, or junk, bonds (issued by companies with questionable credit). There is always the risk that institution that you are lending money to will go bankrupt. That is why it is important to always research the institution's credit risk.
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When evaluating a bond's maturity, keep in mind that the longer your money is tied up, the riskier the bond. After all, if you lock your money away in a 30-year bond paying 5%, you won't be able to reinvest it right away should interest rates go up. In fact, your bond's value can go up and down depending on interest rates. If rates go up, your bond is worth less–after all, who'd want to buy a bond paying 5% if rates were at 6%?.
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Finally, there are zero-coupon bonds, which don't pay any interest. Instead, you buy them for less than face value and then cash them in at full price on their due date. With zero-coupon bonds, you know you'll be getting a certain amount of money at a certain future date.
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