Bonds are a loan to a company. The traditional type works as follows:
You loan the company $1,000 (you buy the bond). The company pays you interest (the coupon rate, or interest rate) every period. At the end, they pay you back the principle of the bond. In this sense, it is very similar to a CD. You loan the bank $1,000 for 6 months, they pay you a certain amount of interest each month, then they pay you back the $1,000 of principle.
Many variations exist.
Because the bond is tradeable and has a limited duration (for example, 10 years), the prices of bonds can change. You might buy one that has 2004's interest rate, and will only last for an additional 6 years. Someone else collected the first few years' worth of interest and then sold it to you. The YTM (yield-to-maturity) is an attempt to capture the value of the bond that's "left".
The price of a bond varies inversely with the prevailing interest rates. Here's why:
Let's say you buy a 10-year bond in 2005 for $1000 that pays 5% interest per year. Every year it pays $50. Now, let's say it's 2006 and the interest rate has gone down. Today, new bonds are offered for 10 years with a 2.5% interest rate for $1000 (the $1000 is called the face value or par value). If you bought bonds today, and you wanted to get $50/yr in interest, then you'd have to buy TWO of the 2006 bonds, because each one pays only $25/yr. Therefore, your bond from 2005 is now worth TWICE as much as the bonds from 2006. If you sell your 2005 bond on the open market, it will have a price of roughly $2,000 (actually, there are other factors that go into the price, but that's the main idea).
So, you can make money in 2 ways from bonds: 1) the interest payments, or 2) the price of the bond goes up and you sell it. The price of a bond can go below $1,000, but you will still get $1,000 if you hold the bond when it's due (the end of the bond, also called the "call date").
The interest payments for most bonds are paid quarterly, yearly, or twice-yearly. The interest is often taxable, but not always. There are also "zero-coupon" bonds, where instead of receiving interest every year, you buy the bond at a discount and get a larger lump-sum back at the end. It's as if all the interest is lumped together and thrown into the principle. These kinds of bonds have two main differences: 1) they do not generate income in the short-term 2) you do not pay taxes on the interest as regular income every quarter or year.
In general, bonds give you a higher return than cash, but with a higher risk. They will generally give you a lower return than stocks with a lower risk than stocks, because if a company goes bankrupt, bonds are paid off first, before stockholders get anything.
Here is a list of types of bonds, with descriptions of each. I have made a chart that summarizes the main types; and specifically the types in which you might be interested. One key thing to remember is that bonds can be taxable, or tax-free. Mostly only government bonds are tax-free. These tax-free bonds look like they have much lower interest rates (or yields), but they may be better or worse for a given investor, because you don't have to pay taxes on them. How valuable the tax-free bonds are depends on what tax bracket you're likely to be in while collecting the interest and how the rates compare to the taxable bonds.
Here is a chart that explains the bond ratings. The rating is a measure of the risk. The higher the rating (like AAA), the lower the risk. Bonds with ratings of BB+/Ba1 are generally considered speculative, higher-risk (AKA "junk") bonds. This doesn't mean they are bad. It means that they carry more risk and pay higher interest rates than the higher-rated or "investment-grade" bonds. Like with stocks, if you want to buy these higher return bonds, you should probably not pick individual ones, but should pick some kind of junk-bond fund or mixed bond fund. Such a fund might also be called "speculative" or "high-yield."
Two other interesting notes:
Callable bonds can be "ended" early. Some are callable by the company (seller), and some by the owner (buyer). If you have a long-term bond with a very high interest rate, it might seem like a great investment, but if it can be recalled by the company, you will get your money back, but you may not be able to continue receiving that interest for the life of the bond.
Although there are many choices, they are generally priced very fairly. It hardly matters which you pick because they're all roughly worth the same amount, given that people have bid up or down the prices for you already. The factors that are most important for most people are: 1) taxable or non-taxable, 2) interest-bearing or zero-coupon, 3) risk level (rating) - higher risk, higher reward.
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