A bond is a type of debt instrument that a bondholder lends to a bond issuer. A bond, like a loan, is issued when the need for funds arise. The issuer of a bond can be a government, corporation, municipality or a corporate entity.

Buying a government bond would mean that you are in effect lending money to the government. Similarly if you buy a corporate bond, you are lending money to that corporate body.

Just as a loan is repaid, a bond too must be repaid. The issuer does this by making regular interest payments and repaying the entire amount at maturity.

For example, let us suppose that Microsoft wants to raise $1 million for expansion and decides that they are going to raise this amount through the issue of bonds. The company may decide to sell 1,000 bonds to investors for $1,000 each. In this case, the "face value" of each bond is $1,000. Microsoft is now referred to as the bond "issuer" and it determines the annual interest rate, known as the "coupon," as well as a timeframe within which it will repay the principal amount of $1 million, spread over 1000 bonds. To set the coupon, the issuer takes into account the prevailing interest rate environment, mainly to ensure that the coupon is competitive and attractive to investors.

The amount of risk and returns associated with a bond depends on its maturity. A $1 million dollar bond repaid in five years is typically regarded as less risky than the same bond repaid over 30 years. This is because in the long run many factors can have a negative impact on the issuer's ability to pay bondholders over a 30-year period. The risk associated with longer maturity is the interest rate. Over a long period of time the investor stands to lose from an increase in the rate of interest.

When the bond issuer fails to repay the money taken from the bondholder, they are said to have 'defaulted'. An investor can easily safeguard himself against such eventualities by referring to the bond issuers credit ratings. This not only the investors evaluate risk but also helps determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.