What Is a Bond? Fixed-Income Investing Explained

Shares get the headlines, but bonds are the larger and arguably more important market — the machinery through which governments and companies borrow trillions, and a core building block of most sensible investment portfolios. Yet bonds are widely misunderstood. People assume they are simply "safe," or are baffled by the way commentators talk about prices and yields moving in opposite directions. This guide explains what a bond actually is, how fixed income works, why bond prices behave the way they do, and the risks hiding behind the reassuring label of "safe."

This article is general information about bonds, not investment advice. The value of bonds and bond funds can fall as well as rise, and you may get back less than you put in. Consider professional advice for your own situation.

What a bond is

A bond is a loan you make to a borrower — usually a government or a company — which in return pays you regular interest and promises to repay the original amount on a set date. When you buy a bond, you are not owning a slice of a business as you would with a share; you are the lender, and the issuer is the borrower.

A few terms describe the key features:

• Face value (or par): the amount the bond will repay at the end, often a round figure like 100.
• Coupon: the interest rate the bond pays, usually as a percentage of face value, on a fixed schedule.
• Maturity: the date the issuer repays the face value and the loan ends.

Because the income is typically fixed and scheduled, bonds are known as fixed income. A government bond issued by the UK is called a gilt; companies issue corporate bonds. The borrower gets the money it needs up front; the lender gets a stream of interest and, all being well, their capital back at the end.

How bonds differ from shares

The distinction between a bond and a share is fundamental and worth getting straight:

This is why bonds and shares play different roles. Shares offer higher long-term growth but with bigger swings; bonds offer steadier income and tend to be less volatile, which is why they are often used to balance a portfolio. Understanding both is part of getting to grips with stock market basics and investing more generally.

The crucial bit: prices and yields move opposite ways

The single most important — and most counterintuitive — fact about bonds is that their market price and their yield move in opposite directions.

Here is why. A bond pays a fixed coupon, set when it is issued. Once it is trading on the open market, its price can change, but the coupon does not. The yield is the return an investor actually gets relative to the current price.

Imagine you hold a bond paying a fixed 4 percent. Now suppose interest rates rise, and newly issued bonds pay 6 percent. Your 4 percent bond suddenly looks unattractive, so to sell it you would have to drop the price — and as the price falls, the effective yield for a new buyer rises towards 6 percent. The reverse happens if rates fall: your higher-paying bond becomes more desirable, its price rises, and its yield falls.

When interest rates rise, existing bond prices fall; when rates fall, bond prices rise. Price and yield are two ends of the same see-saw.

This inverse relationship is why central bank decisions matter so much to bond investors. When the Bank of England changes its base rate, it ripples through the entire bond market.

The risks behind "safe"

Bonds are often described as safe, and high-quality government bonds genuinely are relatively low risk. But "lower risk than shares" is not the same as "no risk," and several real dangers apply:

• Interest-rate risk. As above, rising rates push down the price of existing bonds. Longer-dated bonds are more sensitive to this.
• Inflation risk. Because most bonds pay a fixed amount, high inflation erodes the buying power of those payments and of the capital returned at maturity.
• Credit (default) risk. A company — or, rarely, a government — might be unable to pay the interest or repay the capital. This risk varies hugely: a top-rated government bond is very different from a low-rated high-yield (or "junk") corporate bond that pays more precisely because it is riskier.
• Liquidity risk. Some bonds are harder to sell quickly at a fair price.

Credit-rating agencies grade issuers to indicate default risk, with higher-rated bonds considered safer and paying less, and lower-rated bonds paying more to compensate for the risk. The golden rule of investing applies: higher potential return generally means higher risk.

How ordinary investors hold bonds

Few individual investors buy single bonds directly. Most gain exposure through bond funds or exchange-traded funds (ETFs), which hold many bonds at once. The advantages are practical:

• Diversification across many issuers, reducing the impact of any one default.
• Affordability, since you can invest small amounts.
• Ease of trading, compared with buying and selling individual bonds.

Spreading risk like this is the essence of diversification, and it is exactly why funds are popular with everyday investors. Bonds and bond funds are commonly held inside tax-efficient wrappers — an ISA or a pension — so the income and any gains are sheltered. As always, check the fund's charges and what it actually holds before investing.

The bottom line

A bond is simply a loan to a government or company that pays you fixed interest and returns your capital at a set date — which is why the asset class is called fixed income. Bonds differ from shares in that you are a lender rather than an owner, ranking ahead of shareholders and generally facing less volatility but lower long-term growth. The defining quirk to remember is that bond prices and yields move in opposite directions, driven heavily by interest rates, and the reassuring word "safe" hides genuine risks from inflation, rate moves and default. Because this is general information rather than advice, and the value of bonds can fall as well as rise, use resources like MoneyHelper and the FCA's InvestSmart and consider professional guidance for your own plans.