You’ve heard it before: Asset allocation is key to prudent, long-term investing. You’ve probably heard this before, too—depending on your age and tolerance for risk, your portfolio should contain a mixture of investments, including stocks, bonds and cash. This is sound advice. But do you understand the critical characteristics of bonds?

Bonds and bond funds can be extremely helpful to anyone concerned about capital preservation and income generation. Bonds and bond funds also can help partially offset the risks that come with equity investing—regardless of prevailing market conditions. They can be used to accomplish a variety of investment objectives. Bonds and bond funds hold opportunity—but they also carry risk.

What is Bond?
A bond is a loan that an investor makes to a corporation, government, federal agency or other organization. Consequently, bonds are sometimes referred to as debt securities. Since bond issuers know you aren’t going to lend your hard-earned money without compensation, the issuer of the bond (the borrower) enters into a legal agreement to pay you (the bondholder) interest.

The bond issuer also agrees to repay you the original sum loaned at the bond’s maturity date, though certain conditions, such as a bond being called, may cause repayment to be made earlier. The vast majority of bonds have a set maturity date—a specific date when the bond must be paid back at its face value, called par value. Bonds are called fixed-income securities because many pay you interest based on a regular, predetermined interest rate—also called a coupon rate—that is set when the bond is issued.

Understanding bond basics is critical to making informed investment decisions about this investment category. The more you know now, the less likely you will be to make a decision you later regret.

Top 10 things you need to know about investing in bonds.

  1. Bonds are fancy IOUs:Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects. When you buy a bond, you are loaning your money for a certain period of time to the issuer, be it General Electric or Uncle Sam. In return, bond holders get back the loan amount plus interest payments.
  2. Stocks do not always outperform bonds. It is only in the post-World War II era that stocks so widely outpaced bonds in the total-return derby. Stock and bond returns were about even from about 1870 to 1940. And, of course, bonds were well in front in 2000, 2001 and 2002 before stocks once again took charge in 2003 and 2004. By 2008, however, the bond market had far outpaced the stock market once again, and did so again in 2011.
  3. You can lose money in bonds. Bonds are not turbo-charged CDs. Though their life span and interest payments are fixed — thus the term “fixed-income” investments — their returns are not.
  4. Bond prices move in the opposite direction of interest rates. When interest rates fall, bond prices rise, and vice versa. If you hold a bond to maturity, price fluctuations don’t matter. You will get back the original face value of the bond, along with all the interest you expect.
  5. A bond and a bond mutual fund are totally different animals. With a bond, you always get your interest and principal at maturity, assuming the issuer doesn’t go belly up. With a bond fund, your return is uncertain because the fund’s value fluctuates.
  6. Don’t invest all your retirement money in bonds. Inflation erodes the value of bonds’ fixed interest payments. Stock returns, by contrast, stand a better chance of outpacing inflation. Despite the drubbing stocks sometimes take, young and middle-aged people should put a large chunk of their money in stocks. Even retirees should own some stocks, given that people are living longer than they used to.
  7. Consider tax-free bonds. Tax-exempt municipal bonds yield less than taxable bonds, but they can still be the better choice for taxable accounts. That’s because tax-frees sometimes net you more income than you’d get from taxable bonds after taxes, provided you’re in the 28 percent federal tax bracket or higher.
  8. Pay attention to total return, not just yield. Returns are a slippery matter in the bond world. A broker may sell you a bond that is paying a “coupon” – or interest rate – of 6 percent. If interest rates rise, however, and the price of the bond falls by, say, 2 percent, its total return for the first year – 6 percent in income less a 2 percent capital loss – would be only 4 percent.
  9. If you want capital gains, go long. When interest rates are high, gamblers who want to bet that they’ll head lower should buy long-term bonds or bond funds, especially “zeros.” Reason: when rates fall, longer-term bonds gain more in price than shorter-term bonds. So you win big – scoring a large potential capital gain in addition to whatever interest the bond may be paying. If rates rise, on the other hand, you lose big, too.
  10. If you want steady income, stick with short to medium terms. Investors looking for income should invest in a laddered portfolio of short- and intermediate-term bonds.