At their most basic, bonds are loans. When you buy a bond, you become a lender to an institution. Your loan lasts a certain period of time—until the date when the bond reaches maturity—and you get a certain dividend payment each month (commonly known as a coupon) as interest on the loan. As long as the institution does not go bankrupt, it will also pay back the principal on the bond, but no more than the principal.

There are two basic types of bonds: government bonds and corporate bonds. U.S. government bonds (otherwise known as T-bills or Treasuries) are issued and guaranteed by Uncle Sam. They typically offer a modest return with low risk. Corporate bonds are issued by companies and carry a higher degree of risk (should the company default) as well as return.

Two forces govern the performance of bonds and bond funds: interest rate sensitivity and credit risk.

Interest Rate Risk
Bond prices move in the opposite direction of interest rates. When rates fall, bond prices rise. When rates rise, bond prices fall. To determine how dramatic a fund's ups and downs might be, check out its duration—a measure that considers a bond's maturity, the cash flows from coupons and principal, and current interest rates to produce a risk measure that investors can use for comparisons.

The higher a bond's duration (measured in years), the more it responds to changes in interest rates. If a bond has a duration of five years, you can expect it to gain 5% if interest rates fall by one percentage point, and to lose 5% if interest rates rise by one percentage point. So a bond with a duration of four years should be twice as volatile as a bond with a duration of two years.

Credit Risk
Credit quality measures the likelihood of an issuer repaying its debts. Judgments about a firm's ability to pay its debts are encapsulated in a credit rating. Credit rating firms, such as Moody's and Standard & Poor's, closely examine a firm's financial statements and assign a letter grade to the company's debt: AAA indicates the highest credit quality and D indicates the lowest.

All other things being equal, the lower a bond's credit quality, the higher its yield. Because higher-grade issuers are more likely to meet their obligations, investors trade greater certainty for higher income.

Credit quality affects more than just a bond's yield, though; it can also affect its performance. High-yield bond funds usually take a hit when investors are worried about the economy, as recessions usually mean lower corporate profits and thus less money to pay bondholders.

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