Bonds

Bonds are loans to companies that have been packaged by lawyers and banks into securities that can be bought and sold.  Companies issue bonds in the same they issue stock.  They sell the bonds to investors and put the proceeds into their treasury. Those initial investors can hold the bonds or sell them in the secondary market. 

Since they are loans, the company has to pay interest on the bonds to investors, usually on a quarterly basis, and at some point in the future they have to pay off the principal and retire the bonds. 

Your chances of getting back your investment is better with bonds than with stocks.  If the company runs into problems, it still has an obligation to pay off its debt but no such obligation to pay off stockholders.  Of course, in the event of complete disaster and bankruptcy, companies are often not able to pay off their bonds in full, and they may cease paying interest as well.  This is the so-called "credit risk" of a bond.

Bonds also carry what is called "interest-rate risk."  The rate of interest the company will pay is set when bonds are issued, based on prevailing interest rates at that time.  Factors that influence those rates are the likelihood that the company will pay the principal back ("credit risk"), the number of years the company has before having to pay off the principal (longer term bonds carry higher interest rates), current and anticipated inflation rates, and other specific conditions associated with the bonds. 

The risk is that after the bonds are issued, prevailing interest rates will rise, driving down the price of the bonds in the secondary market.  Here's how that works. If you buy a bond for $1000 with a 5% interest rate, it will pay you $50 each year.  But suppose because of inflation, government policy or general business conditions, investors start demanding 6% on their bonds.  That $50 you have been receiving at 5% of $1000 now needs to be $60 on $1000 but the payout was fixed at $50 at the time of issuance--so instead the value of the bond drops to $833, since $50 is 6% of $833.  Tugging against that drop in the value of the bond will be the prospect of getting the full $1000 back from the company when the bond matures.  That's fine if it's a short-term bond due to be paid off in a few years, but it's a long time to wait if the bond has a thirty-year maturity.  That is why long-term bonds command higher interest rates--they are much more volatile when it comes to the impact of changing interest rates. 

In contrast with stocks bonds have performed poorly overall since World War II because steady increases in interest rates have caused the market value of bonds to drop.  There are tactics that you can employ to minimize the problems with bonds.   One way is to buy a variety of bonds selling at a discount which have staggered maturities so that you can later redeem a certain number of bonds each year, receive the face value for them, and then reinvest the principal.  Another approach could be to buy into several bond mutual funds, which would give you diversification and help preserve your principal.

Despite the problems with bonds most financial pros argue that somewhere in the range of 30% of your assets should be in bonds.