What are bonds and how do they work?

What is a bond?

A bond is a debt instrument. When a government, company or other organisation needs to raise money, it can issue bonds to investors rather than borrowing from a bank. The investor lends money for a fixed period, receiving regular interest payments (the coupon) in return, and gets the original sum back when the bond matures. In this way, a bond functions like a contract: you receive a predictable income stream in exchange for lending your money. The most commonly discussed bonds in the UK context are government bonds (gilts), which are issued by the UK Debt Management Office on behalf of HM Treasury.

Bonds are traded on financial markets, which means their price rises and falls depending on interest rates, inflation expectations, and the creditworthiness of the issuer. This is what distinguishes them from a straightforward savings account: their market price can change between issuance and maturity, creating both opportunity and risk for investors who buy or sell before the maturity date.

How do bonds work?

Understanding a bond requires grasping a few key terms:

The most important relationship to understand is between bond prices and interest rates. When interest rates rise, newly issued bonds offer higher coupons, making existing bonds with lower coupons less attractive. Their price falls. When rates fall, existing bonds with higher coupons become more valuable, so their price rises. This inverse relationship is the primary driver of bond price volatility.

The bond market at a glance

Bond market: key figures

Source: Bank of England

Types of bond

Government bonds

Issued by national governments to fund spending. In the UK, these are called gilts. In the US, Treasury bonds (or T-bonds for long-dated, T-notes for medium-dated, T-bills for short-dated). In Germany, Bunds. Government bonds from developed economies are considered among the safest investments available, since they carry the full backing of a sovereign state. The government bonds guide covers UK gilts in detail, including how to buy them, current yields and the CGT exemption that makes them particularly attractive for higher-rate taxpayers.

Corporate bonds

Issued by companies to raise capital. They offer higher yields than government bonds to compensate investors for the additional risk that the company may default. Corporate bonds are rated by credit agencies: investment-grade bonds (BBB- and above) are considered lower risk; high-yield bonds (also called junk bonds) carry higher risk and higher yields. Household names like Vodafone, BP and Tesco all issue bonds traded on UK markets.

Index-linked bonds

Both governments and companies issue bonds whose coupon and/or principal adjusts with inflation. In the UK, index-linked gilts adjust with the Retail Prices Index (RPI). They offer lower initial yields than conventional bonds but protect against inflation eroding the real value of returns. They are widely used by pension funds with inflation-linked liabilities.

Green and sustainable bonds

Proceeds are earmarked for environmental or social purposes. The UK government's green gilt programme, through which over £47.9 billion had been raised by end of 2024/25, is one example. The green bond market has grown significantly, with corporates, supranational organisations and governments all issuing bonds under environmental, social and governance frameworks.

Bonds vs stocks: how do they compare?

Bonds and equities serve different roles in a portfolio. Understanding the differences is fundamental to building a balanced investment strategy. Our bonds vs stocks comparison covers this in detail, but here is a summary

It’s important to understand how bonds and stocks can work together in a portfolio. Bonds typically provide stability and income; stocks provide long-term growth potential. The appropriate balance depends on your time horizon, risk tolerance and income needs.

How to invest in bonds in the UK

There are several routes to bond exposure for UK investors:

1. Direct gilt purchase

UK government bonds can be bought through the DMO's Purchase and Sale Service (no commission, minimum £100) or through investment platforms with ISA and SIPP eligibility

2. Bond ETFs

Exchange-traded funds tracking bond indices, such as the iShares Core UK Gilts UCITS ETF or Vanguard UK Government Bond ETF, provide diversified bond exposure in a single trade. Both are ISA and SIPP-eligible. Bond ETFs trade like shares throughout the day and are one of the most cost-effective ways to access fixed income markets.

3. Corporate bond funds

Investment funds or ETFs that hold a diversified portfolio of corporate bonds, such as the iShares Corporate Bond UCITS ETF, offer access to investment-grade corporate credit with a single trade.

4. Spread bets and CFDs

For traders, we offer leveraged exposure to government bond prices through spread bets and CFDs, allowing positions in rising or falling bond markets without owning the underlying security. These are short-term instruments and not appropriate for long-term investment. 

Bond risks to understand

Bonds are widely regarded as lower risk than equities, but they carry their own set of risks:

Bonds in the current environment

With the Bank of England Bank Rate at 3.75% and the 10-year gilt yield at approximately 4.82% as of mid-June 2026, bonds now offer income returns that were not available during the low-rate years of 2009-2021. This has renewed retail investor interest in the asset class, particularly for higher-rate taxpayers who can exploit the CGT exemption on gilts. For investors thinking about how bonds fit into a tax-efficient investment strategy, the current environment makes gilts particularly worth considering alongside equities.

The key uncertainty is the direction of interest rates. If rates fall further, bond prices will rise, rewarding investors who bought at current yield levels. If rates rise unexpectedly, particularly due to persistent inflation, bond prices will fall. The 10-year gilt yield near 4.82% represents the market's current view of where long-term rates will settle, but that view can change rapidly.

Bond FAQs