The purpose of an investment portfolio is to help individuals and families meet their financial goals. These goals differ from person to person and change over time. Some investors find that they need a portfolio that provides more current income and greater safety than a portfolio that is composed mainly of stocks and stock mutual funds can provide. One way to accommodate these needs for increased income and safety is to add bonds to a portfolio.

Bonds are an important component of most investment portfolios. Bonds reduce the overall risk of a portfolio by introducing diversity. Bonds produce steady current income—income that investors receive each month. This steady stream is important to some investors, depending on their current needs. Bonds are relatively safe investments if they are held to maturity because it is possible to calculate exactly how much interest they will earn. Bonds are lower risk investments than stocks; however, the returns on bonds are lower as well. Bonds are attractive options when the market offers low interest rates. As interest rates drop, bond values rise.

Bonds are a form of debt, and they are generally issued for periods of time longer than one year. Bonds are sold by national governments, local governments, municipalities, companies, and other institutions. When you buy a bond, you are lending money to the institution that is selling the bond. The seller of the bond agrees to repay the principal amount of the loan when the bond reaches maturity. For interest-bearing bonds, the seller also agrees to pay interest periodically, as specified in the loan contract. To understand bonds, you must understand the language of bonds.

While there are many different types of bonds, most bonds can be grouped into one of six major categories: corporate bonds, U.S. Treasury debt securities, municipal bonds, agency bonds, international bonds, and U.S. Treasury savings securities.

Bonds are valued in a number of different ways. Generally, the value of a bond is determined by the price an investor is willing to pay for the bond. Three key factors affect a bond’s price: the par value, the market interest rate and length of maturity, and the investor’s discount rate.

Now that you have completed this section, ask yourself the following questions:

1. Can you explain the risks and returns associated with bonds?
2. Do you understand bond terminology?
3. Can you describe the major types of bonds?
4. Can you explain how bonds are valued?
5. Can you explain the costs of investing in bonds?

If you can answer yes to each of these questions, you are ready to move on to the next section!