What Is a bond? What the average investor should know

New investors are often overwhelmed with advice on how they should and shouldn't invest their money. But there are a few tried-and-true rules, including that you should diversify your portfolio.

Essentially, that means spreading your money across different assets and investment vehicles to reduce the risk of losing everything in a financial crisis.

While you might automatically think about stocks when you begin to plan your investing strategy, bonds are another type of investment asset that helps you achieve diversification. Plus, bonds typically carry less risk and can act as an inverse to stock performance.

In short, bonds are debt. It's not unusual for individuals to take on debt from banks when they borrow money (in the form of a loan) to pay for a mortgage, car, higher education, etc.

But with bonds, think of the role as reversed. Individuals, or investors, lend money to corporations and governments that need the funds. We can call the corporations and governments the borrowers in this scenario.

In exchange for lending money, investors are paid interest on bonds, just as loan providers or credit card issuers charge consumers interest when they lend us money. Because bonds pay investors interest at regular intervals, they are often referred to as "fixed income investments" and can help offset any losses you may experience when you also put your money in stocks.

The annual interest rate bonds pay investors between the date of issuance and maturity, is known as a coupon payment, and it's usually paid twice a year.

With bonds, your investment is tied up until the maturity date. This is unlike stocks, where you can buy and sell at any time. So, a 10-year bond has to be left untouched for a decade.

It's important to know a bond's maturity date before buying one.

Similar to how consumers have  show lenders their creditworthiness and how likely they are to repay their debt, certain types of bonds also have credit ratings that show investors the likelihood they'll be repaid on their investments.

The highest bond rating is AAA, on the S&P rating model. Any bond with a rating of C or below is considered to be at higher risk of default, which means investors could lose their investment.

You should also pay attention to interest rates and inflation when you purchase a bond. Two big risks to bonds are rising inflation and rising interest rates, the latter of which can lead to bond prices falling. Both can cause bonds to lose value.

There are different types of bonds

The three main types of bonds to know are corporate, municipal and Treasury bonds:

1. Corporate bonds: As you might guess, these are bonds issued by corporations. Companies may issue bonds to raise capital for research and development. Investing in corporate bonds means you'll have to pay taxes on the interest you collect, but these types of bonds typically offer higher yields than municipal bonds.
   
2. Municipal bonds: Municipal bonds are issued by local (a city or town) and state governments that are looking to raise money for public projects, like infrastructure, parks or hospitals. Investing in municipal bonds means you don't have to pay taxes on the interest you earn.
   
3. Treasury bonds: Commonly referred to as T-bonds, these are bonds issued by the federal government and thus considered low risk. In return, interest rates are lower than those for corporate bonds. Investing in Treasury bonds means you'll have to pay federal taxes on your earnings, but not state or local. They can also be a smart buy during an inflation surge.

Investors buy bonds from brokers or, in the case of U.S. Treasury bonds, directly from the government. Some of the big brokerage firms like E*TRADE, Charles Schwab and Fidelity specialize in bond investing and have tens of thousands of bonds available to investors.

In addition to purchasing bonds directly, you can also invest in a bond fund. Bond funds give you access to various types of bonds so you can invest in a mix.

When you sign up for a robo-advisor, you'll take a survey to assess your risk. Then the service's algorithm will recommend the best portfolio for your financial needs, which will often include a mix of stocks and bonds. We reviewed dozens of robo-advisors and two of our top picks, Betterment and Wealthfront, both offer a mix of stocks and bonds in their portfolios.

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