Key Takeaways
- A bond is essentially a loan to a government, company or other organisation.
- In return, the bond issuer generally pays you interest and agrees to repay the amount borrowed at an agreed date.
- Bond prices can rise and fall before maturity, with interest rates being one of the key factors that can affect them.
- Bond prices and yields generally move in opposite directions.
- Different bonds come with different levels and types of risk, so they’re not simply a “safer” version of shares or an alternative to cash.
- Bond funds can give investors exposure to lots of different bonds in one investment.
Bonds. They’re one of those investment terms that seem to pop up everywhere – in financial headlines, market updates, and conversations about interest rates.
But what actually is a bond? And why might you want to understand them if you’re investing for the long term?
Let’s break it down.
- What is a bond?
- The bond basics
- What is a bond yield?
- Why do bond prices change?
- Why are bonds getting more airtime?
- What types of bonds are there?
- What is a bond fund?
- What role can bonds play in a portfolio?
- Are bonds lower risk than shares?
- Final recap
What is a bond?
In simple terms, a bond is a loan.
When you buy a bond, you are lending money to a government, company or other organisation. In return, the issuer generally agrees to pay you interest and the amount borrowed at an agreed date (known as the ‘maturity date’).
Think of it as an official IOU.
For example, imagine a company wants to raise £10 million. Instead of borrowing all of that money from a bank, it could issue bonds to investors. Investors buy those bonds, effectively lending the company money, and the company agrees to make interest payments and eventually repay what it borrowed.
Governments do something similar. In the UK, government bonds are known as 'Gilts’, while US government bonds are commonly called ‘Treasuries’.
Of course, an IOU is only as good as the borrower’s ability to repay it, and there is always a risk that a bond issuer may not be able to make the payments it has promised.
The bond basics
You don’t need to become a bond market expert to understand the basics. But a few terms are useful to know.
- Face value: This is the amount the issuer agrees to repay when the bond matures.
- Maturity: This refers to the date when the bond is due to be repaid. This could be months, years or even decades after it is issued.
- Coupon: No, this isn't a savings token for the supermarket. In the context of bonds, "coupon" refers to the interest payment promised by the bond. For example, a bond with a £100 face value and a 4% annual coupon would pay £4 a year, subject to the terms of the bond. Zero coupon bonds with no interest payments are also possible.
- Price: What the bond is currently worth on the market. This can be higher or lower than its face value before maturity, and will typically move towards it face value as it approaches maturity.
And that last point is an important one. A bond with a face value of £100 might trade for £95 or £105. Why? Because the value of a bond can change as market conditions change.
What is a bond yield?
If you keep up with financial news, you’ve probably seen the phrase "bond yield" doing the rounds.
Put simply, a bond’s yield is a way of describing the return available from a bond, based on factors including its current market price and the payments it is expected to make.
It’s important to be aware that this is not the same thing as a coupon. The coupon is set when the bond is issued, whereas its yield can change as its market price does.
This is why bond prices and yields generally move in opposite directions. Here’s a simple example to help demonstrate (remember, this is purely illustrative).
Imagine a bond pays £5 a year.
If the bond costs £100, that £5 payment is equivalent to 5% of the purchase price.
But if the price falls to £80, that same £5 payment represents a higher percentage of the price.
This is why you’ll often hear that bond yields have risen, even though bond prices have fallen. Of course, there’s more to calculating a bond’s overall yield than this simple example, but it hopefully helps demonstrate the basic relationship between them.
Why do bond prices change?
There are lots of reasons bond prices can move, but interest rates are one of the big ones.
Imagine you own a bond paying a fixed 4% coupon. If interest rates rise and newly issued bonds start offering more attractive rates, your existing 4% bond may become less appealing by comparison.
As a result, its market price may fall.
The opposite can happen when interest rates fall. An existing bond paying a relatively attractive rate may become more appealing when compared to newly issued bonds, potentially pushing its market price higher.
This is why bond prices generally move in the opposite direction to interest rates.
Other factors can affect prices too. These include inflation expectations, economic conditions, supply and demand, and how confident investors are that the bond issuer will repay its debt.
Why are bonds getting more airtime?
No, it's not just you. In the news and financial world, bonds have been discussed more of late – but why?
Well, it may be due to interest rates and inflation, which have both shifted away from the unusually low levels seen for much of the previous decade. As we've mentioned, changes in interest rates can have a meaningful effect on bond prices and yields.
It also means bonds can behave differently from how someone unfamiliar with them might expect. They can provide interest payments, for example, while still falling in value.
What types of bonds are there?
While bonds generally all operate in somewhat similar ways, there are some variations it's helpful to be aware of.
Government bonds
Governments issue bonds to raise money. These are called ‘gilts’ in the UK, while other countries have their own names for government debt.
Government bonds are generally considered to have lower credit risk than many corporate bonds, but that doesn’t mean they are risk-free. Their prices can still fall, particularly when interest rates change.
Corporate bonds
Companies can also issue bonds to raise money. These are known as corporate bonds.
Because companies can have different levels of financial strength, corporate bonds can carry varying levels of credit risk – such as the chance that the issuer may not be able to make interest payments or repay the money borrowed.
Corporate bonds are often grouped by their credit ratings. Investment-grade bonds generally have higher credit ratings, while high-yield bonds have lower ratings and can carry greater credit risk.
A higher yield can therefore come with higher risk.
Emerging market bonds
You may also come across bonds issued by governments or companies in emerging markets (these are markets in countries with developing economies – typically growing fast and becoming more integrated into global trade and finance – but with higher volatility and risk than developed markets). These can carry additional risks, including currency risk for UK investors if the bonds are denominated in a foreign currency.
What is a bond fund?
You don’t necessarily have to buy individual bonds yourself. Instead, you can invest through a 'bond fund’.
A bond fund pools money from lots of investors and uses it to invest in a portfolio of bonds. That could mean government bonds, corporate bonds, or a mixture of different types.
One of the potential benefits is diversification. Rather than relying on one bond issuer to make a return, a fund can spread investments across many different bonds.
But diversification doesn’t entirely remove investment variability. A bond fund can still fall in value as the bonds it holds are affected by interest rates, credit risk, and wider market conditions.
An individual bond may have a specific maturity date, whereas a fund typically holds many bonds, and so, has many different maturity dates – and these can also be bought and sold over time.
What role can bonds play in a portfolio?
There’s no singular role or dynamic bonds play in an investment portfolio. It depends on many things, such as the type of bonds, the other investments held, and the overall approach to risk.
Broadly speaking, bonds can contribute income and diversification (which can help to spread your risk).
Many bonds make interest payments, which can provide income. But this shouldn’t be confused with a guaranteed investment return – as we've already covered, bond prices can fall, and issuers may not always be able to make the payments they have promised.
Bonds can also behave differently from shares because their returns are influenced by different factors. This is part of what can make them a useful part of a diversified portfolio, although bonds don’t always move in the opposite direction to shares.
At Wealthify, our investment portfolios can include different asset types, including bonds, shares, cash, and property. How these are arranged and managed depends on your attitude to risk – which is why we offer five investment styles:
- Cautious
- Tentative
- Confident
- Ambitious
- Adventurous
Then – whether you have a Stocks and Shares ISA, Junior ISA, Self-Invested Personal Pension, or General Investment Account – our expert team creates a Plan accordingly for you, investing in line with your appetite for risk.
Are bonds lower risk than shares?
You’ll often hear bonds described as “lower risk” than shares. That can be a useful generalisation, but it doesn’t necessarily tell the whole story.
A short-dated government bond and a long-dated, high-yield corporate bond can be very different investments. Some of the main risks to understand include:
- Interest-rate risk: bond prices can fall when interest rates rise. Longer-dated bonds are generally more sensitive to interest-rate changes.
- Credit risk: the issuer may be unable to make interest payments or repay the amount borrowed.
- Inflation risk: inflation can reduce the purchasing power of the income and money you receive from a bond.
- Currency risk: if a bond is denominated in a foreign currency, exchange-rate movements can affect its value for a UK investor.
- Fund risk: if you invest through a bond fund, the value of your investment can fall as well as rise.
So, while bonds can play a role in managing risk within a diversified portfolio, they shouldn’t be thought of as a guaranteed or "risk-free" investment.
Final recap
Bonds might sound complicated, but at the heart of it, they encapsulate a pretty simple idea.
A bond is just a type of loan (whether that be to a government, company or other organisation), and in return, the issuer strives to pay interest and agrees to repay the amount borrowed at maturity.
But really, the key thing to remember is that bonds don’t just sit still until that date. Their market prices can rise and fall, with interest rates, inflation expectations, economic conditions, and the financial strength of the issuer all playing a part.
And while bonds can provide income and diversification, they come with risks of their own. So, the next time you see a headline about bond yields rising or falling, you’ll know there’s more to it than just financial jargon.
Investing involves risk. The value of investments can go down as well as up, so you could get back less than you invest. It’s important to note this article is for general information only, and isn't personal financial advice.
