What it is:
A bond, also known as a fixed-income security, is a debt instrument created for the purpose of raising capital. They are essentially loan agreements between the bond issuer and an investor, in which the bond issuer is obligated to pay a specified amount of money at specified future dates.
There are four major bond types in the U.S. markets, which are represented by four major issuers:
How it works (Example):
When an investor purchases a bond, they are "loaning" that money (called the principal) to the bond issuer, which is usually raising money for some project. When the bond matures, the issuer repays the principal to the investor. In most cases, the investor will receive regular interest payments from the issuer until the bond matures.
Different types of bonds offer investors different options. For example, there are bonds that can be redeemed prior to their specified maturity date, and bonds that can be exchanged for shares of a company. Other bonds have different levels of risk, which can be determined by its credit rating.
Bond rating agencies like Moody's and Standard & Poor's (S&P) provide a service to investors by grading fixed income securities based on current research. The rating system indicates the likelihood that the issuer will default either on interest or capital payments.
Why it Matters:
Bonds and other fixed-income securities play a critical role in an investor's portfolio. Owning bonds helps to diversify a portfolio, as the bond market doesn't rise or fall alongside the stock market. More important, bonds are generally less volatile then stocks, and are usually viewed as a "safer" investment.
If you'd like to read more in-depth bond-related definitions, check out these definitions:
Collateralized Bond Obligation -- A bond that uses high-yielding junk bonds as collateral.
Commercial Paper -- A short-term commercial bond that matures in less than three months.
Convertible Bond -- A bond that can be exchanged for other investment securities.
Covenant -- The specific promises the bond issuer sets in the contract.
Credit Rating -- A grade assigned to a bond to indicate how risky it is.
Debentures -- An unsecured bond not backed by collateral.
Maturity Date -- The specified date when the bond issuer must pay back the investor's principal.
Municipal Bond -- A bond issued by a state or local government.
Treasury Bond -- Long-term bonds issued by the U.S. Treasury.
More bond-related definitions can be found at the InvestingAnswers Bond Category Page.