What the Heck are Bonds Anyway?

We are firm believers that every investor's portfolio should contain a fixed-income component - that is, an investment that pays a constant, fixed rate of return.

In many cases, that means "bonds."

But for a lot of folks, bonds are different animals that are hard to understand. Don't you worry! We'll demystify bonds for you with our "Bonds 101" lesson so you'll know exactly why they are an essential part of your overall investing strategy.

Bonds 101

When you buy a bond, you are in essence lending money to an entity. It's the entity's debt. That entity promises to pay principal and interest back to you on a timely basis.

In our opinion, the point of bonds is to generate predictable income. So we believe in buying only the high-grade bonds.

Here is how the bond-rating company Standard & Poor's (S&P) grades bonds:

• AAA is the top grade, applied to the bonds pretty much certain to maintain their principal value.
• AA is the next-highest rating.
• A
• BBB
• BB At this point, the bond has a higher-than-average chance of defaulting. Bonds of this grade and below are known as "junk bonds."
• B
• CCC These bonds are extremely vulnerable to loss of principal value.
• D Applied to a bond that has failed to maintain its principal value. The lowest grade.
• G refers to U.S. government securities, the safest bonds of all.

Dolan Smart Money Move: We believe that most investors should not buy any bonds with less than an AA rating from S&P or Moody's. Don't chase yields, which means buying a bond with the highest interest rate (be concerned about the bond's rating, too). Don't forget, the higher the interest rate, the higher the risk. "Total return" is the key.