Have you ever forgotten to bring enough money and had to borrow from someone? You must have. All of us have had to borrow money sometime in our lives. And there are usually all kinds of reasons as to why we need to borrow money.

Similarly, companies, and even governments, might need to borrow money from time to time. However, the sums of money that they borrow are very large. So what they do is that they issue Bonds.

What are Bonds?  

Bonds are basically loans, where you are the lender. The companies or government which borrow the money from you, have to agree not only to pay back the amount they borrowed, but also to pay a little extra in the form of a fee (interest) for the privilege of borrowing your money. These interest payments (coupons) are usually paid at regular intervals (for example, every year). The full amount that is loaned out (the principal) is returned back to the lender (you) at a certain date. This date is called the maturity date. 

Bonds are I.O.Us. It is a piece of paper in writing that says that such-and-such company borrowed so much money from you. The main difference between stocks and bonds is that the company guarantees to pay you back your principal, plus interest. You know exactly how much you are going to get back, and when you are going to get it.

Bonds with less than 1 year to maturity are known as money market instruments (there are unit trusts which invests solely in these money market instruments). 

Bonds and money market instruments are also known as 'fixed-income' investments. This is because they pay out a regular 'income' (the interest coupons) to investors.

How risky are Bonds? 

Although the company whom you lent your money to guarantees to pay you back, it does not mean that Bonds are risk-free. 

Companies, and even governments can, and do go bankrupt. However, when that happens, bondholders will be at the front of the creditors' line, while stockholders would be at the rear of it.

But perhaps the most risky thing to bondholders is rising inflation rate. When the economy is booming and unemployment rates are falling, that is when bonds and bondholders suffer the most (the reverse applies. Recessions are great for bonds!). Inflation causes prices of things in general to rise. This means that $10 in the future would be able to buy less goods and services than $10 now. So your fixed fee from bonds would buy you less if there was inflation.

Which also means that the money which you get back when your bond matures, would be worth a lot less than what it is worth now when you loan it out. So the faster inflation rises, the faster your bond loses value.

Interest rates

Interest rates is another thing bond investors watch out for. Rising interest rates cause bond prices to fall, and vice versa. This is because bonds pay a fixed coupon. As interest rates fall, people are willing to pay more money for the bond because it's fixed coupon may represent a higher return than interest income. Conversely when interest rates rise, people are less willing to hold on to bonds because interest income would be higher than the fixed coupon, hence leading to a fall in bond prices (or what's called capital depreciation).

Bond Unit Trusts

If you see bonds as an essential part of your investment portfolio, but yet lack the time or investment capital to buy into local bonds (which can be very high in value), then opt to invest in a Bond Unit Trust. Bond unit trusts are basically a collection of different types of bonds. Instead of an individual bond, you are buying into a ready portfolio of bonds. 

A lot of people opt for bond unit trusts when they seek to diversify their investments with some fixed-income exposure. Even 'growth' investors invest in bonds when the timing calls for it (see Investing In Unit Trusts - Strategies for how this is done).