Bonds and gilts are the foundation of the fixed-income investment world. They offer predictable income, lower risk than shares, and a valuable role in balancing a diversified investment portfolio. With yields now at their most attractive levels in over a decade, understanding how they work is especially relevant.
What Is a Bond?
A bond is a loan from an investor to a borrower — typically a government or a company. The borrower pays:
- Regular interest payments (called the coupon) — usually twice a year for gilts, annually or semi-annually for corporate bonds
- Return of the original investment (the face value or par value) at a set date in the future (the maturity date)
Example: A Simple Gilt
| Feature | Detail |
|---|---|
| Bond | UK Treasury 4.5% 2032 |
| Face value | £100 |
| Coupon | 4.5% (£4.50 per year per £100 face value) |
| Maturity | 2032 |
| Interest payments | £2.25 every six months |
| At maturity | You receive your £100 back |
If you hold this gilt to maturity, you know exactly what income you’ll receive and exactly when you’ll get your money back. This certainty is the core appeal of bonds.
Types of UK Bonds
UK Government Gilts
| Type | Description | Risk |
|---|---|---|
| Conventional gilts | Fixed coupon, fixed maturity | Very low |
| Index-linked gilts | Coupon and maturity value adjust with inflation (RPI) | Very low |
| Treasury bills | Short-term (under 1 year), no coupon, sold at a discount | Very low |
Corporate Bonds
| Type | Description | Risk |
|---|---|---|
| Investment-grade | Issued by large, financially strong companies (rated BBB or above) | Low–Medium |
| High-yield (junk bonds) | Issued by less financially secure companies (rated below BBB) | Medium–High |
Other Types
- Local authority bonds — issued by UK councils
- Retail bonds — corporate bonds specifically aimed at individual investors
- Emerging market bonds — issued by developing country governments
Understanding Bond Yields
The yield tells you the return you’ll earn on a bond at its current price. Key yield concepts:
Coupon Yield
Simply the annual coupon divided by the face value: a 4% coupon on a £100 bond = 4%.
Current Yield
The annual coupon divided by the current market price. If that 4% coupon bond is trading at £95, the current yield is 4.21% (£4 ÷ £95).
Yield to Maturity (YTM)
The total return you will earn if you buy the bond at today’s price and hold it to maturity, accounting for both coupon payments and any capital gain or loss at maturity. This is the most useful measure for comparison.
The Inverse Relationship: Price and Yield
Bond prices and yields move in opposite directions. When interest rates rise:
- New bonds offer higher coupons
- Existing bonds with lower coupons become less attractive
- Existing bond prices fall to make their yield competitive
When interest rates fall, the reverse happens — existing bonds become more valuable. This is why fixed-income portfolios can lose value in the short term when the Bank of England raises rates.
Why Hold Bonds?
1. Predictable Income
Bonds pay a known amount at known intervals — ideal for investors who need reliable income, such as retirees.
2. Lower Volatility Than Shares
Bonds (especially gilts) are far less volatile than equities. A portfolio with a bond allocation will generally experience smaller drops in value during stock market downturns.
3. Diversification
Bonds often move in the opposite direction to shares — when stocks fall, government bonds tend to rise as investors seek safety. This counterbalancing effect smooths your overall portfolio returns.
4. Capital Preservation
If you hold a bond to maturity, you receive the face value back (assuming no default). This provides certainty that equities cannot match.
How to Add Bonds to Your Portfolio
Individual Gilts
Buy directly through the Debt Management Office or via an investment platform. Best for investors who want to hold specific maturities to match future spending needs.
Bond Funds and ETFs
A bond fund holds hundreds of bonds, providing diversification and simplicity:
| Fund Type | Example Use | Typical Yield |
|---|---|---|
| Short-term gilt fund | Low volatility, near-cash | 4–5% |
| All gilts fund | Broad UK government bond exposure | 4–5% |
| Index-linked gilt fund | Inflation protection | 1–2% (plus inflation) |
| Investment-grade corporate bond fund | Higher yield with moderate risk | 5–6% |
| Strategic bond fund | Actively managed across bond types | 5–7% |
Allocation Guidelines
A common rule of thumb is to hold your age as a percentage in bonds — so a 40-year-old might hold 40% bonds, 60% equities. However, this is a rough guide:
| Age / Stage | Suggested Bond Allocation |
|---|---|
| 20s–30s (long time horizon) | 0–20% |
| 40s–50s (medium horizon) | 20–40% |
| Late 50s–60s (approaching retirement) | 40–60% |
| In retirement | 40–70% |
Adjust based on your risk tolerance, other income sources, and when you need the money. Use our ISA calculator to model how different equity/bond splits might grow over time.
Tax on Bonds
| Bond Type | Income Tax | Capital Gains Tax |
|---|---|---|
| Gilts | Coupon is taxable income | Exempt from CGT |
| Corporate bonds | Taxable income | Exempt if a qualifying bond |
| Bond funds | Taxable income | Taxable gains |
| All bonds in ISA/SIPP | Tax-free | Tax-free |
The CGT exemption on gilts makes them attractive for higher-rate taxpayers investing outside an ISA.
Risks of Bonds
- Interest rate risk — bond prices fall when interest rates rise
- Inflation risk — fixed coupons lose purchasing power if inflation exceeds the yield
- Credit risk — corporate bonds may default (extremely rare for gilts)
- Reinvestment risk — when your bond matures, you may only be able to reinvest at lower rates
- Liquidity risk — some corporate bonds are hard to sell at a fair price
For most investors, holding bonds through a diversified fund within a Stocks and Shares ISA or pension is the simplest and most tax-efficient approach.