Bond investments explained: the main types and risks to understand

Investors have two main options when it comes to investing in bonds. These are government bonds and corporate bonds.

When governments and companies need to borrow money, they issue bonds. If you buy one, you become the lender, and in return you receive regular interest payments plus your original investment back at the end.

However, within these two broad categories there are a range of different options for you to explore.

Government bonds

UK government bonds are issued by the Debt Management Office (DMO) on behalf of the Treasury to help fund spending on public services like the NHS and education.

The UK has run a budget deficit every year since 2001 and for the year ending March 2026, it stood at £132 billion, representing 4.3% of GDP.

This means the government bond market is very liquid, worth around £1.5 trillion, as the government issues bonds to sustain the deficit and pay-off older maturing bonds.

The UK has not defaulted on its debts (i.e. failed to repay) in more than 350 years, which is why they are perceived as a safe place to put your money.

Index-linked bonds

Inflation is the enemy of bonds because rising prices reduce the purchasing power of money, and most bond coupons are fixed. For example, the current inflation rate of 3% would reduce the purchasing power of £100 today to £20 over the course of two decades.

Inflation-linked bonds, sometimes referred to a ‘linkers’ are designed to solve this problem.

They are loans where both the interest payments (coupons) and the final payout at maturity automatically adjust upward or downward in line with the prevailing rate of inflation, currently measured by the UK retail price index.

The government is transitioning to the consumer price index from 2030, which includes owner occupied housing costs.

Linkers account for approximately a quarter of all outstanding government debt. They are mainly purchased by pension funds and insurance companies which use them to make inflation-protected payouts to retirees and match their long-term liabilities.

What to consider with overseas government bonds

While buying foreign government bonds can offer higher yields and diversification benefits (spreading investment risk) they also introduce added risks.

Bonds denominated in a foreign currency can have fluctuating returns due to changes in the exchange rate of sterling against the local currency, potentially eliminating gains.

A foreign government may lack the ability to honour its debt obligations, leading to delayed or missed interest payments. Emerging markets may present extra political and legal risks, and inflation risk is often higher.

Credit rating agencies like Standard & Poor's issue reports on the fiscal health and creditworthiness of different countries, to help investors make informed decisions when investing in international bond markets. For ordinary investors, exposure to overseas government debt is likely to be achieved through funds.

Investment grade corporate bonds

Corporate bonds offer investors higher rates of interest than government bonds and the money raised provides companies with a flexible funding option to grow their businesses. Plus, unlike issuing new shares, a business does not dilute its existing shareholders.

Typically, investment grade UK and European bonds have yields around 1% higher than government bonds, while US corporate bond spreads are tighter, at around 0.75%.

The UK corporate bond market is smaller than the gilts market, worth around £500 billion.

However, the global UK-listed market including companies issuing debt in US dollars and euros is worth closer to £2.9 trillion, according to estimates from the Financial Conduct Authority.

The reason corporate bonds offer higher yields is because of the risk some companies do not have the cash or financial strength to service their debts or pay back the loan.

This introduces credit risk which is less of a concern with UK government bonds because a government can always raise taxes to meet their obligations.

Bondholders come higher up the pecking order than shareholders which means they have legal protections should a company get into financial trouble.

Even in situations where shareholders lose all their investment, bondholders can recover some value from assets a company may own.

Investing in individual corporate bonds requires a skill in evaluating credit risk and financial strength and often involve large minimum amounts running into thousands of pounds.

For these reasons, actively managed bond funds and passive funds tracking benchmark indices may be more suitable for most investors.

High yield corporate bonds

Sometimes described as ‘junk bonds’, high yield bonds are riskier and issued by companies with patchy credit histories and weaker balance sheets, often operating in cyclical industries.

They offer higher yields than government bonds, with UK spreads (the difference over government yields) of between 3.8% and 4.3%, which is the price companies must pay to secure funding and compensate investors for higher risks. Equivalent high yield spreads in Europe and the US are around 3%.