A bond is a form of debt. When you purchase a bond you become a bondholder.

As a bondholder you are lending your money to another entity. In return, the borrowing entity gives you regular interest payments on your initial investment. This is called investment income. Bonds are also known as fixed income securities for this reason.

Based on past performance, bonds offer a return lower than stocks. However, they are also less risky and usually less volatile than stocks. Bonds are considered the safest investment next to cash (CDs, savings accounts, money-market, etc...)

Bonds are often used by elderly or retired investors who desire a stable low-risk return on investment. These investors typically set up a portfolio so that they can live off of the interest payments.

For example, if you have $2 million in bonds paying 6% interest, that's $120,000 per year in interest income without even touching your principal!

Sounds good eh?

Well, the math only works like this if you have a large chunk of money. So for everyone else, bonds will only comprise a portion of your portfolio. You will use bonds to even out the volatility and risk level of your portfolio.

Just like with stocks, you don't want to own bonds of a single entity or type. Types of bonds include Corporate, U.S. Treasury(Federal Government), Municipal(States, Counties, Cities), and Mortgage-backed.

Choosing bonds can be just as complex as picking individual stocks. So leave that heavy lifting to the professionals. Utilize the magic of bond index mutual funds and exchange-traded funds (ETFs) such as AGG and BND to diversify the bond portion of your portfolio.