Companies and governments pay for some of their expenses by borrowing money from individual investors.

Just as you may borrow money for major expenses if you don't have enough cash on hand, so may businesses and governments. Sometimes they borrow from a bank, as you needed a mortgage to buy a new home. But they can also borrow by issuing a bond that promises to pay investors a fixed percentage of interest for the use of their money.

The Value of Debt

From an investor's standpoint, what bonds provide is a stream of interest payments. In retirement, for example, your bond interest may be an essential source of income. In fact, that's one reason many financial advisers suggest increasing the amount you have invested in bonds as you grow older.

Even if you don't need the income to live on, interest on bonds can provide a regular infusion of cash for your investment account. For example, suppose you had $40,000 in bonds earning 5% interest that paid you $2,000 a year, probably in two $1,000 payments. That money could be allocated toward a mutual fund account or pay for 200 shares of a stock trading at $10 a share.

While you're building your portfolio, though, you may want to put the interest in an investment account rather than in your checking account, where you might be tempted to use it to pay day-to-day bills.

Inflation Bites

The chief limitation of bonds, from the perspective of long-term financial security, is that both principal, or the amount you invest, and interest are vulnerable to inflation.

If a $1,000 bond pays 5% interest each year for ten years, the $50 will buy less the tenth year than it did the first. If that's the money you're using to buy athletic shoes, for instance, you might find yourself short at the checkout counter.

One way to minimize the inflation threat is to buy short-term bonds with a portion of the principal you've allocated to fixed income. Because they mature within a year or less, the buying power of the interest they pay isn't eroded.

What Bonds Cost

Investing in bonds can help you diversify your portfolio and may provide a source of income. A bond's initial selling price — usually $1,000 — is also known as its par value. That's the amount you get back when the bond matures, and it's the base on which the interest payments are figured. However, some bonds may require an investment of $10,000 or more. The price tag can make bonds hard to afford, especially if you're just starting to build an investment portfolio.

It can also be hard to diversify your bond investments, since each purchase requires a substantial sum. But there are strategies you can use to build your bond holdings, by channeling earnings on other investments into bonds, or by using one–time windfalls like an inheritance to get you started. Once you have a foothold, you can use the principal you get back when a bond matures to buy another bond.

Bonds and Bond Funds

Many financial advisers suggest buying bond funds rather than individual bonds. One reason is that you usually need less money to invest in a fund than you do to make a bond purchase. And since funds own many bonds, you get more diversification in your portfolio.

You, as an investor, don't actually own the bonds, but shares in the bond fund. The fund pays you distributions, or your share of the fund's earnings, based on the interest it receives on its bond holdings.

The fund makes no promise that you'll get your investment back at a particular point in time, the way a bond does. Nor is there a fixed rate of interest, because the fund buys and sells bonds regularly, rather than holding them to maturity. As a result, the fund doesn't earn interest at a single, set rate, but collects from many bonds paying at different rates.

While all bonds raise money in essentially the same way, different types of bonds have different characteristics:

Corporate Bonds

These bonds are sold by publicly held companies as a way of raising money for a range of activities, from expanding operations to building new facilities. Many companies prefer borrowing to issuing additional shares of stock, which dilutes the value of the stock already in the market. The interest you earn is taxable. But corporate bonds generally pay higher interest than other types, in part because they may have a higher risk of default.

US Treasury Notes

The federal government sells two-, three-, five-, and ten-year notes to raise money to finance running the government. Since the government doesn't sell stocks (because there's nothing to own), the only way it can raise money is by collecting taxes and issuing bonds. You owe federal income taxes on the interest you earn, but not state or local taxes.

Municipal Bonds

Sold by state and local governments, these bonds raise money to pay for a wide array of projects and expenses, and sometimes the actual operation of the government. You owe no federal tax on municipal bonds, and generally no state or local tax on bonds issued by the municipality where you live.

For example, if you live in New York and buy New York State bonds, you owe no tax on the interest you earn. But if you live in California and buy New York bonds, you will owe tax on your earnings to California.

Agency Bonds

These bonds are issued by various government agencies, both in Washington and around the country. Among the best known are those that provide mortgage money (especially GNMAs, widely known as Ginnie Maes). The interest is taxable, so the rates are generally slightly higher than on other government bonds.

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