What are bonds and how do they work?
Guide Summary
- Bonds are loans made by investors to governments or companies in exchange for interest payments.
- They’re generally lower risk than stocks, making them a useful tool for income and capital preservation.
- You can invest in bonds through funds, ETFs, or directly, using tax-efficient wrappers like ISAs.
How do bonds work?
When a government or company needs to raise money, it can issue a bond. As an investor, you lend them a set amount and they agree to pay you a fixed interest rate (called the coupon) every year e.g. 3%.
After a set number of years (the term), they pay you back the £1,000. This is known as the bond lifecycle:
- Issuance – You buy the bond (or a fund that holds bonds).
- Interest payments – You receive regular income, typically annually or semi-annually.
- Maturity – At the end of the term, the bond is repaid in full.
Bond prices can also rise and fall in value if traded on the secondary market — for example, if interest rates change or the issuer’s credit rating shifts.
Types of bonds explained
Here are the main categories of bonds you’ll come across:
- Government bonds (gilts) – Issued by the UK government. Generally considered very low risk, but with lower returns.
- Corporate bonds – Issued by companies to raise funds. Riskier than gilts, but they usually offer higher interest.
- Green bonds – Used to fund environmentally-friendly projects. Growing in popularity among ethical investors.
- Index-linked bonds – Designed to keep pace with inflation, as the payments rise in line with a price index like the CPI.
- In the US: Savings Bonds, which are government-issued and often used for long-term savings goals. These differ from UK bonds in structure and taxation, and are only available to US citizens.
Why invest in bonds?
Bonds can play a key role in a well-rounded portfolio. Here’s why:
- Income generation – Regular interest payments can provide a steady stream of income.
- Capital preservation – Bonds tend to be more stable than stocks, so they can help protect your investment.
- Diversification – Adding bonds can smooth out the ups and downs of a stock-heavy portfolio.
Risks and disadvantages of bonds
Bonds are lower risk than stocks — but not risk-free. Here’s what to consider:
- Credit risk – The issuer might fail to pay interest or repay the loan (this is rare with government bonds, more possible with corporate bonds).
- Interest rate risk – If interest rates rise, existing bond prices can fall. Inflation risk – If inflation outpaces your bond’s return, your real purchasing power can shrink.
- Liquidity risk – Some bonds can be harder to sell quickly without losing value, especially in a downturn.
How to invest in bonds (UK)
There are a few ways to invest in bonds as a UK investor:
- Bond funds or ETFs – These are collections of bonds bundled together, offering easy access and instant diversification.
- Direct purchase – You can also buy individual gilts or corporate bonds through some investment platforms.
- Use tax-efficient wrappers – Investing through a Stocks & Shares ISA or a pension (not available with Chip) helps you keep more of your returns.
How do I invest in bonds?
Start by choosing a platform, selecting a bond fund or individual bond, and deciding how much to invest. Funds and ETFs are often easier for beginners.
Who should consider investing in bonds?
Bonds can suit a wide range of investors, including:
- Investors approaching retirement – Looking for steady income and capital protection.
- Cautious investors – Seeking lower volatility than stocks.
- Income-seekers – Wanting predictable returns through interest payments.
If you’re someone with a lower risk tolerance or nearing a major financial milestone, bonds can provide valuable balance in your investment mix.
Common bond-related terms explained
- Yield – The return you earn from a bond, usually expressed as a percentage.
- Coupon – The interest payment a bond pays, often annually.
- Maturity – When the bond issuer repays the original amount borrowed.
- Par value – The bond’s face value, typically £100 or £1,000.
- Credit rating – An assessment of how risky a bond issuer is. Higher ratings mean lower risk.
- Bearer bonds – Rare today, these are unregistered bonds where whoever holds the paper owns the bond.
- Duration – A measure of a bond’s sensitivity to interest rate changes.
- Callable bonds – Bonds the issuer can repay early, which can affect returns.
Investment bonds summary
Bonds are a type of investment where you lend money to a government or company in exchange for interest payments.
They’re generally lower risk than stocks, making them popular for income, stability, and diversification. While they come with their own risks — like interest rate changes or inflation — bonds can play a key role in your long-term financial plan.
In our next guide, we’ll cover exchange-traded funds (ETFs) — what they are, how they work, and why they’re one of the most popular investment choices for both beginners and seasoned investors.
FAQs
What are bonds in simple terms?
Bonds are loans you give to a government or company. In return, they pay you regular interest and repay your money after a set time.
Are bonds a good way to invest?
Yes, especially if you're looking for stability and income. They may not grow as fast as stocks, but they’re generally lower risk.
How do beginners invest in bonds?
The easiest way is through bond funds or ETFs on an investment platform. You can also use a Stocks & Shares ISA to invest tax-free.
What are the disadvantages of bonds?
Bonds carry risks like interest rate changes, inflation, and defaults. Some can also be harder to sell quickly if you need access to your money.
When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not offer financial advice and this should not be considered as a personal recommendation. Diversifying means spreading your investments across different sectors, countries and asset classes.
Direct investment into individual bonds is not available via the Chip platform. Chip offers investment funds that invest in different assets as a collective investment.
