Bonds can help cushion your portfolio during stock market downturns, since they generally provide a steady stream of income. There are three common reasons investors buy bonds:

Interest payments - The issuer pays the bondholder a stated amount of interest at regular intervals throughout the life of the bond.

Principal repayment - The par value (also referred to as the face value) of the bond, usually $1,000, is repaid on the date of maturity to the current bondholder.

Capital gain - The bondholder has the potential to make a profit from selling a bond before maturity at a price greater than its purchase price.

There is an inverse relationship with bond prices and interest rates. When interest rates rise, bond prices fall and vice versa. The reason'investors generally buy bonds for the interest and if interest rates are increasing and Bond X has a lower interest rate, Bond X will be less attractive, thus the price of Bond X will fall. The opposite is also true. If interest rates are falling, and Bond Y has a higher interest rate, Bond Y's price will increase since it has a more attractive interest rate.

Since it is difficult to predict interest rate movements, consider utilizing a strategy called .laddering., purchasing a variety of interest-bearing securities that have different maturity dates so that there is always money coming due to reinvest no matter where interest rates are at the time.

There are four issuers of bonds, including federal government, corporations, municipalities, and federal agencies. The interest from these bonds may or may not be exempt from taxation depending on the issuer. Federal government bonds are generally exempt from state and local taxes. Corporate bonds are not exempt from taxes. Municipal bonds are exempt from federal taxes (in some cases, exempt from state taxes as well). Some federal agency bonds are tax exempt, while others are not.

Credit rating agencies assign a bond grade or rating to many bonds based on the bond issuer's ability to meet their promised principal and interest payments. These letter grades, which are similar to grades in school, start from the highest grade of triple-A down to a single C, which is considered a junk bond. A 'D' generally means the issuer is in default.

When considering investing in bonds, watch out for call features. Call features are a provision in many bonds that allows the issuer to repurchase the bonds at a fixed price before maturity. This feature is detrimental to investors since bonds are generally called during lower interest rate time periods. As a result, the bond investor whose bond has been called must find an alternative investment, frequently settling for a lower return investment.