Bonds

Introduction

Shares get the headlines, but the bond market is bigger — and arguably more important. Governments fund themselves through it, companies raise money in it, pension funds are built on it, and the interest rates that flow from it shape the price of every other asset on Earth. If shares are the growth engine of a portfolio, bonds are its ballast.

A bond is, at heart, a simple thing: a loan you can trade. But that simplicity hides the single most counter-intuitive idea in finance — that a "safe" bond can lose you money when interest rates rise, and that its price moves in the opposite direction to its yield. Master that one relationship and a huge amount of market behaviour, from pension-fund crises to central-bank policy, suddenly makes sense. This article builds you up to it and beyond.

Quick Definition

A bond is a loan from an investor to a borrower — usually a government or a company. In return, the borrower pays regular interest (the coupon) and repays the original amount (the face value) on a set future date (the maturity). Unlike an ordinary loan, a bond can be bought and sold before it matures.

The Anatomy Of A Bond

Every bond is defined by a few key terms. Picture a 5-year UK government bond (a "gilt") with a £1,000 face value and a 4% coupon:

• Issuer — who is borrowing. Here, the UK government. It could be a company, a local authority or another government.
• Face value (par) — the amount repaid at maturity, and the base for the coupon. Here, £1,000.
• Coupon — the annual interest, as a percentage of face value. A 4% coupon pays £40 a year (often split into two £20 payments).
• Maturity — the date the face value is repaid and the bond ends. Here, 5 years away.

Government vs Corporate Bonds

Bonds are grouped by who issues them:

• Government bonds are loans to a national government — gilts in the UK, Treasuries in the US, Bunds in Germany. Bonds from stable governments are considered the safest investments available, because a government that borrows in its own currency can, in the last resort, always repay. Their yields are the benchmark "risk-free rate" against which everything else is measured.
• Corporate bonds are loans to companies. Because a company can go bankrupt, they carry more risk than government bonds and so pay higher yields. The extra yield over a comparable government bond is the credit spread — the market's price for the risk of not being repaid.

The Idea That Trips Everyone Up: Price And Yield Move Inversely

This is the heart of bond investing, and it feels wrong until it clicks. When interest rates rise, the prices of existing bonds fall. When rates fall, existing bond prices rise.

Why? Because a bond's coupon is fixed. Imagine you own that 4% gilt. Now the Bank of England raises rates and newly issued gilts pay 6%. Nobody will pay you full price for a 4% bond when they can buy a 6% one — so the price of your bond must fall until its effective return matches the new 6% going rate. The coupon never changed; the price adjusted to make the yield competitive.

Because of this, the way to compare bonds is not the coupon but the yield to maturity (YTM) — the total annualised return you'd earn buying at today's price and holding to maturity, counting every coupon plus any gain or loss versus the face value. YTM is the number that actually matters.

Two Risks That Never Leave

A bond has no upside surprise — you know the coupons and the repayment in advance. Its risks are therefore about what could go wrong:

Credit risk — the chance the issuer fails to pay. Rating agencies grade this from the safest investment grade down to high-yield (or "junk"). Lower grades pay more to compensate for the greater chance of default. A gilt has negligible credit risk; a bond from a struggling company has a great deal.

Interest-rate risk — the price swings caused by changing rates, measured by duration. Duration is roughly how many percent a bond's price moves for a 1-percentage-point change in rates. A bond with a duration of 8 falls about 8% if rates rise 1 point, and rises about 8% if they fall 1 point. Longer maturities and lower coupons mean higher duration — and bigger swings. This is why long-dated government bonds, despite near-zero credit risk, can be very volatile.

Why Hold Bonds At All?

If bonds can lose value, why own them? Because they do jobs shares can't:

• Income. Predictable coupons are valuable, especially for retirees and institutions with liabilities to meet.
• Ballast. Bonds are generally far less volatile than shares, steadying a portfolio's ride.
• Diversification. In many downturns, when shares fall and investors flee to safety, high-quality government bonds hold up or rise — a genuine cushion. (The link isn't guaranteed: in 2022, rising rates hit both at once.)
• Capital preservation. For money you'll need soon, the relative stability of short-dated high-quality bonds beats the wild swings of the stock market.

This is why the classic balanced portfolio mixes shares for growth with bonds for stability — a theme developed further in Yield Curve and the study of the economic cycle.

Bonds And The Economic Cycle

Bonds are not just an asset; they are a signal. Because their prices embed the market's expectations for interest rates and growth, the bond market is often described as "smarter" than the stock market. When investors fear a recession, they buy safe government bonds, pushing prices up and yields down. The pattern of yields across different maturities — the yield curve — is one of the most watched recession indicators in all of finance, and gets its own article next.

Common Misconceptions

"Bonds are completely safe." Government bonds have negligible credit risk, but every bond has interest-rate risk. Long-dated bonds can fall sharply when rates rise — 2022 was a brutal reminder.

"The coupon is my return." Only if you buy at face value and hold to maturity. If you buy on the secondary market at a different price, your true return is the yield to maturity, which can be well above or below the coupon.

"Higher yield is always better." A higher yield usually means higher risk — either credit risk (the issuer might default) or duration risk (the price is more volatile). Yield is compensation for risk, not free money.

"Bonds and shares always move oppositely." Often, but not always. When inflation and rates surge, both can fall together, as they did in 2022.

Real-World Application

Suppose you buy a 10-year gilt with a 4% coupon at its £1,000 face value, giving a 4% yield. A year later, inflation forces the Bank of England to raise rates, and similar new gilts now yield 6%.

Your bond still pays £40 a year — but to yield 6% for a new buyer, its market price must fall to roughly £850. On paper you've lost about 15%, purely from rates moving, despite holding a "safe" government bond. If you hold to maturity, you'll still get your £1,000 back and every coupon, so the loss is only realised if you sell early. But the episode shows why duration matters: a 10-year bond is far more exposed to this than a 2-year one.

Now run it the other way. If instead rates fell to 2%, your 4% bond would become highly desirable, and its price would rise well above £1,000. Same bond, opposite outcome — all driven by the see-saw between price and yield. Understanding that see-saw is what separates investors who are surprised by their "safe" bonds from those who chose their duration on purpose.

Key Takeaways

• A bond is a tradable loan: you receive fixed coupons and get the face value back at maturity.
• Government bonds (gilts, Treasuries) are the safest and set the benchmark rate; corporate bonds pay more to compensate for default risk (the credit spread).
• The core rule: bond prices move inversely to interest rates. Compare bonds by yield to maturity, not coupon.
• Two ever-present risks: credit risk (graded from investment grade to junk) and interest-rate risk (measured by duration).
• Investors hold bonds for income, ballast, diversification and capital preservation — but they are not risk-free.
• The bond market is a powerful economic signal; the shape of the yield curve is a leading recession indicator.