Bond Basics for the Beginner

Bonds have often been the wary investor's substitute for a nice, safe mattress.

It's no wonder Americans are piling into bonds as the stock-market benchmark S&P 500 has fallen 19% so far this year and financial firms, including Washington Mutual(WM Quote) and Morgan Stanley(MS Quote), have lost more than half their value.

In recent weeks, though, even the bond market has started to look scary because of the government's planned bailout of companies infected with subprime securities, which could cause prices to fall. But not all bonds are alike. While some are virtually risk-free, others are quite volatile. Before you dip your toes into the bond market, it's a good idea to learn a few simple ins and outs of investing in fixed-income securities.

The Skinny on Bonds

Simply put, a bond is a loan. You can loan money to the government, a governmental agency or a corporation by buying their bonds. In return, those institutions pledge to pay you back by a certain date, and to pay you interest on that loan. That interest is paid in regular installments, and the amount of those payments is called the yield.

Say you invest $1,000 in a 10-year Treasury bond with a 3.85% yield, the going rate in late September, according to the U.S. Treasury. The federal government promises to pay you back that principal investment of $1,000 in 10 years, and also to pay you $38.50 a year -- 3.85% of your principal -- in interest, or yield.

And though bonds can't match the performance potential of stocks, investors can see modest growth among their fixed-income holdings. That's because high demand for bonds -- whether because of a flagging stock market or the promise of high yields -- can boost prices. While you spent $1,000 on that 10-year Treasury note with a 3.85% yield, investors may be willing to pay you more than $1,000 to get that yield. If you sold the bond, you would reap a return on your original investment. In short, the bond would offer you a capital gain much like that of a rising stock.