When people talk about investing, shares usually receive most of the attention. Bonds can seem less exciting, but they play an important role in many investment portfolios, pension funds, and financial markets.
A bond is essentially an IOU. A government or company borrows money from investors and promises to make payments under agreed terms. Depending on the bond, those payments may include regular interest and the return of the original amount when the borrowing period ends.
Understanding what bonds are and how investors make money from them is not quite as simple as looking at the advertised interest rate. A bond’s market price can rise or fall, its issuer might experience financial trouble, and inflation can reduce the real value of future payments.
This guide explains coupons, yields, maturity dates, gilts, corporate bonds, and bond funds in straightforward language. Here, “bond” means a tradable debt investment-not a fixed-rate bank savings account or a life-insurance investment bond.
1. What Is a Bond?
A bond is a debt security issued by a government, company, or other organisation that wants to raise money. Instead of borrowing everything from a bank, the organisation divides the debt into securities that investors can buy.
By purchasing a bond, you become a lender rather than a part-owner. A shareholder owns part of a company, while a bondholder is generally entitled to payments specified in the bond agreement.
In the UK, government bonds are called gilts. They are sterling-denominated liabilities issued by HM Treasury and listed on the London Stock Exchange. Conventional gilts promise fixed coupon payments until maturity, followed by repayment of the principal.
Companies also issue corporate bonds to fund expansion, equipment, acquisitions, refinancing, and other business activities. The return depends partly on whether the issuer can continue meeting its obligations.
2. Learn the Main Bond Terms
The face value, also called par or nominal value, is the amount the issuer promises to repay at maturity. A bond with a £1,000 face value should return £1,000 when it matures, assuming the issuer does not default.
The coupon rate determines the interest payments. If a £1,000 bond has a fixed coupon rate of 4%, it pays £40 of interest each year. The payments may be divided into two instalments, depending on the bond’s terms.
Conventional UK gilts normally make two equal coupon payments each year. Their prices are quoted per £100 of face value, but the market price may be higher or lower than the nominal amount.
The maturity date is when the borrowing period ends and the principal becomes due. A bond might mature in one year, ten years, or several decades.
The yield represents the return relative to the bond’s current market price. It can differ from the coupon rate because investors may buy the bond above or below face value.
3. How Do Investors Make Money from Bonds?
Bond investors can potentially earn returns in three main ways. The amount actually received depends on the purchase price, holding period, issuer, market conditions, and whether the bond is held until maturity.
Coupon Payments
Many bonds provide regular interest payments. A £5 annual coupon on a bond bought for £100 produces a simple current yield of 5%.
If the market price rises to £125 but the coupon remains £5, the current yield falls to 4%. The cash payment has not changed, but a new buyer must pay more to receive it.
Fixed-rate bond coupons remain unchanged even when wider market interest rates move. Some bonds instead have floating rates that are periodically adjusted using a benchmark.
Repayment at Maturity
An investor who holds an individual bond until maturity should receive its face value, provided the issuer can pay.
Suppose you buy a bond with a £1,000 face value for £950. If it matures normally, you receive £1,000, creating a £50 capital gain in addition to any coupon income.
The opposite can happen when you buy above face value. If you pay £1,050 but receive £1,000 at maturity, part of your coupon income is offset by the £50 capital loss.
Selling at a Higher Price
Bonds can often be traded before maturity. An investor may make a profit by selling a bond for more than the purchase price.
However, the selling price is not guaranteed. If market rates, inflation expectations, or the issuer’s financial condition change, the bond may be worth less than you originally paid. UK gilt prices can move continuously while markets are open.
4. Why Do Bond Prices and Yields Move in Opposite Directions?
Bond prices generally move in the opposite direction to market interest rates.
Imagine you own a £100 bond paying a £5 annual coupon. If newly issued bonds begin paying £7 for every £100 invested, buyers will be less interested in your older bond. Its price may need to fall before another investor considers its £5 payment attractive.
If newly issued bonds pay only £3, your £5 coupon looks more appealing. Investors may then be willing to pay more than £100 for it.
The Bank of England illustrates this relationship with a £100 bond paying a £5 coupon. When its price rises to £120, its current yield falls from 5% to about 4.2%.
Longer-dated bonds are usually more sensitive to interest-rate changes because investors must wait longer to receive the principal. Price movements matter especially when you need to sell before maturity.
5. What Types of Bonds Can UK Investors Buy?
Gilts are issued by the UK government. Conventional gilts pay fixed coupons, while index-linked gilts adjust coupon and principal payments using the Retail Prices Index, subject to their specific terms.
Corporate bonds are issued by businesses. Their yields are often higher than government-bond yields because companies generally carry greater default risk.
Investment-grade corporate bonds receive stronger credit ratings and are considered more likely to pay on time than non-investment-grade bonds. High-yield bonds offer greater potential income partly to compensate investors for a higher estimated risk of default.
Zero-coupon bonds do not make regular interest payments. They are normally purchased below face value, with the investor’s return coming from the difference between the purchase price and the amount received at maturity.
Investors should be particularly careful with speculative mini-bonds. The FCA warns that these products may offer high advertised returns because their risks are much higher, and investors could lose everything if the issuing business fails.
6. What Are the Main Risks of Bonds?
Bonds are sometimes described as safer than shares, but “safer” does not mean risk-free.
Credit risk is the possibility that the issuer cannot make an interest or principal payment. Government and corporate issuers do not all have the same financial strength.
Interest-rate risk is the danger that rising market rates reduce the value of existing bonds. This may not affect the amount repaid when an individual bond is held to maturity, but it can create a loss if the investor must sell early.
Inflation risk matters because fixed payments may buy less in the future. Receiving £40 annually can feel attractive today, but its spending power could decline during a long period of rising prices.
Liquidity risk means there may not be a willing buyer when you want to sell. You could have to accept a lower price, particularly with smaller or less frequently traded issues.
Some bonds also have call risk, meaning the issuer can repay them before the scheduled maturity date. This often happens when interest rates fall and the issuer can refinance more cheaply, leaving the investor to reinvest at potentially lower yields.
7. Individual Bonds versus Bond Funds
Buying individual bonds gives you specific maturity dates, coupon terms, and face values. You can estimate the expected cash flow when the bonds are held until maturity and the issuers continue paying.
However, building a diversified portfolio of individual bonds may require substantial money and research. You must assess multiple issuers, maturity dates, credit ratings, prices, and trading costs.
A bond fund pools money from many investors and holds a portfolio of bonds. This can provide convenient diversification and professional management, while some index bond funds track a particular fixed-income market.
A fund’s value can still fall. Bond funds face credit and interest-rate risks, and funds holding longer-maturity bonds are generally more sensitive to rate changes.
Unlike an individual bond with a stated repayment date, owning a fund does not guarantee that your units will return to their original purchase price on a particular day.
Before investing, review the fund’s duration, credit quality, yield, charges, geographic exposure, and underlying holdings. A high yield should prompt more investigation rather than being treated as free additional income.
Bonds allow governments and companies to borrow directly from investors. In return, investors may receive coupon income, repayment of principal at maturity, and potential gains if a bond is sold at a higher market price.
Those returns are not guaranteed. Bond values respond to interest rates, inflation expectations, maturity, and the issuer’s financial strength. Higher yields frequently come with higher credit, liquidity, or market risk.
Start by comparing a short-dated gilt, an investment-grade corporate bond, and a diversified bond fund. Review their yields, maturity profiles, fees, and risks before investing.
Bonds can provide income and diversification, but they work best when you understand exactly where the return comes from-and what could prevent you from receiving it.
