Anchor text is the content in between the opening and closing HTML a Elements. The anchor text is used by search engines in their ranking factors of individual web pages – in short, the text used in incoming links may effect how the given web page is ranked in the SERPs.
Ranking algorithms will typically analyze the anchor text of incoming links to individual web pages – this is then thrown in with a bunch of other not-so-important ranking factors. People have abused this in the past to make certain web pages rank for words not even appearing anywhere on the page itself.
How Anchor text works
In the past it would be fairly easy to make a page rank for a given search keyword or keyphrase, but as people abused it it has become a little harder – it is however still one of the main factors that can effect a page directly – getting a few incoming links for your pages with relevant Keyphrases or Keywords, may show to be a very efficient way to make your pages rank for the given search string.
Pages linking out to other pages generally flow anchor text, as well as authority and pagerank – authority is not the same as pagerank – but that will be explained elsewhere.
It is also guessed at, that internal links flow anchor text as well as pagerank – but if this is the case, it surely does not carry as much weight as the incoming links.