What are bonds?

Learn all about the bond market, including the benefits and risks involved, potential yields, and how you can buy and sell bonds on our platform.

Bonds explained

Bonds are a type of fixed-income or fixed-instrument investment issued by governments and businesses around the world. They’re often popular with investors due to their low risk level.

Many investors buy bonds, such as:

• Individuals
• Banks
• Pension funds
• Insurance companies

When you invest in a bond, the company or government is known as the ‘issuer’ of your bond. It’s also a varied market – there are several different types of bonds, each with its own pros and cons.

How do bonds work?

Bonds work by an investor effectively lending money to the issuer until a specified date. This is known as the maturity or redemption date. When first issued, bonds are sold to investors via a broker or investment house. Gilts can be sold directly to the public through the UK Government Debt Management Office (DMO).

In return for buying the bond, you’ll receive an interest payment from the issuer, known as a coupon. This is usually paid once or twice a year, depending on the type of bond. At the end of a set period when it reaches maturity, you’ll get back the face value of the bond, also known as the ‘par’ value – unless there’s a default.

You can instead choose to sell your bond to another investor before the maturity date via an investment platform like AJ Bell. You’ll get the current market price for it, which will be different to the face value of the bond.

Keep in mind that corporate or government bonds aren’t the same as fixed-term accounts or cash savings bonds offered by banks and building societies.

What are the different types of bonds?

What affects the price of bonds?

Central banks set an official interest rate for their country. This is a benchmark for interest rates offered by banks and building societies. Generally, when interest rates rise, bond prices fall, and yields increase (and vice-versa).

To buy a bond, investors often require a particular level of return. The general rate of interest often influences their decisions – if interest rates rise, the required rate of return also rises.

In this situation, they may want to pay less for a bond already in issue, preferring newer bonds with higher yields. This can lead to investors selling existing bonds and pushing down bond prices.

If interest rates fall, investors may be willing to pay more for a fixed-rate bond than before, and bond prices may increase.

Learn about bond yields

Are bonds a good investment?

Investing in bonds is considered safer than investing in individual shares. Bonds are lower risk than shares but are not completely risk-free. As such, bonds can be an excellent investment option depending on your goals, portfolio and risk appetite.

Generally, there are two main reasons people invest in bonds:

1. Investors can buy income bonds to plan a predictable stream of cash over time
2. Other investors may look to sell bonds on the secondary market to make a profit

Most bonds available to retail investors fall under the category of ‘fixed-interest bonds’, meaning they pay a fixed rate of coupons each year. Knowing what you will receive throughout the lifespan of the bond can be helpful if you are working out how to pay for items such as school fees.

As long as the issuer remains solvent, you should continue to receive your regular coupon over time, along with the principle when the bond matures. In contrast, although a shareholder owns a part of a company, future dividends from shares depend on the company's profits and investment strategy. They could be reduced or cut altogether. That’s why bonds are often considered safer.

Investing via bond funds

If you're interested in the idea of bonds but don’t want to have to pick individual ones, you could invest in a specialist bond fund or exchange-traded funds (bond ETFs) instead.

There are different types of bond funds and bond ETFs. These include:

• Those that invest specifically in gilts or a broader range of global bonds.
• Strategic bond funds that have the flexibility to invest in any part of the market, be it bonds issued by governments or corporate businesses.
• Actively managed funds involving a fund manager deciding which bonds to buy or sell in the portfolio.
• Passive funds, such as an ETF or tracker fund that don’t use a fund manager but mirror the performance of a specific index made up of bonds.

What tax do you pay on bonds?

Gilts and most UK corporate bonds are free from capital gains tax. The income you receive from bonds is paid gross but is subject to tax (depending on your other income).

These investments won’t be subject to income tax if you hold the bond in a tax-efficient account like a Stocks and shares ISA or Self-invested personal pension. You can usually hold bonds listed on a recognised stock exchange in these accounts.

What are the risks of investing in bonds?

Below, we’ll run you through the main types of bond risks.

Default risk

Default risk is the potential for the issuer to be unable to repay the original loan and interest payments. If a company goes bust, bond investors are ranked higher than equity investors (shareholders) for repayment of funds. Even so, there’s no guarantee that there will be cash available to do so.

That’s why, when you consider whether to invest in a bond, it’s important to look at the issuer's creditworthiness. Some institutions or companies may be more of a credit or default risk than others. Credit rating agencies analyse, measure, and report their view of the credit risk of a bond issuer and the bonds it issues.

But although credit ratings can be useful, they aren’t recommendations and are subject to change. Movements in bond prices usually happen quicker than changes in credit ratings.

Interest rate risk

If interest rates go down, the fixed coupon of the bond starts to look more attractive to investors (particularly over the long term). This could generate demand for longer-dated bonds and cause their price to rise quicker than shorter-dated bonds offering the same coupon rate.

Inflation risk

Inflation erodes the purchasing power of money over time. This applies to the fixed-interest coupons paid by bonds as well. When inflation is increasing (or inflationary expectations are increasing), bonds can start to seem less attractive. This can result in demand falling and changes in market prices.

As with interest rates, the price of bonds with longer time to maturity can be more sensitive to inflation than shorter-dated bonds.

Currency risk

If you purchase bonds denominated in another currency, the return you receive in pounds will be influenced by fluctuations in exchange rates.